Estate of Andrew J. McKelvey, Bradford G. Peters

United States Tax Court
161 T.C. No. 9ESTATE OF ANDREW J. McKELVEY, DECEASED, BRADFORD G.
PETERS, EXECUTOR,
Petitioner
v.
COMMISSIONER OF INTERNAL REVENUE, 1
Respondent
—————
Docket No. 26830-14. Filed November 2, 2023.
—————
Decedent (D) entered into variable prepaid forward
contracts (first set of VPFCs) with two investment banks
in 2007. Pursuant to the terms of the first set of VPFCs,
the investment banks made cash payments to D, and D was
obligated to deliver variable quantities of stock or their
cash equivalent to the investment banks on specified
future settlement dates in 2008 (original settlement dates).
Treating the execution of the first set of VPFCs as an open
transaction, D did not report any gain or loss for 2007 in
connection with entering into the first set of VPFCs.
In 2008, before the original settlement dates, D paid
consideration to the investment banks to exchange the first
set of VPFCs for an amended set of VPFCs that had
settlement dates in 2010 (second set of VPFCs). Treating
the first set of VPFCs as remaining open after the
exchanges, D did not report any gain or loss for 2008 with
respect to those VPFCs as a result of the exchange. Later
in 2008, and after the exchanges, D passed away. R
determined with respect to D’s 2008 tax year that the
exchanges of the VPFCs constituted sales or exchanges of
1 This opinion supplements our previously filed opinion Estate of McKelvey v.
Commissioner, 148 T.C. 312 (2017), reversed and remanded, 906 F.3d 26 (2d Cir. 2018).
Served 11/02/23
2
property under 26 U.S.C. § 1001, that the exchanges also
resulted in constructive sales under 26 U.S.C. § 1259 of the
stock shares D used to collateralize the first set of VPFCs,
and that, as a result, D should have reported gain from the
transactions.
In Estate of McKelvey v. Commissioner (Estate of
McKelvey I), 148 T.C. 312 (2017), we held that D’s
treatment of the first set of VPFCs as remaining open after
the exchanges was appropriate and that the exchanges
constituted neither the sale nor the exchange of property
under 26 U.S.C. § 1001 nor resulted in constructive sales
of stock under 26 U.S.C. § 1259. Consequently, we
concluded D did not have gain from the exchanges with
respect to 2008. In Estate of McKelvey v. Commissioner
(Estate of McKelvey II), 906 F.3d 26 (2d Cir. 2018), the U.S.
Court of Appeals for the Second Circuit reversed,
determining that the exchanges of the VPFCs terminated
the first set of VPFCs and resulted in the constructive sale
of stock under 26 U.S.C. § 1259. The Second Circuit
remanded for us to determine whether the exchanges
terminated D’s underlying obligations with respect to the
first set of VPFCs for purposes of 26 U.S.C. § 1234A and, if
so, the amount of D’s gain from the termination. The
Second Circuit also remanded for us to determine D’s gain
with respect to the constructive sale of stock under 26
U.S.C. § 1259, an amount which the parties subsequently
stipulated.
In the light of the Second Circuit’s decision in Estate
of McKelvey II, we reach the following holdings.
Held: Upon the exchange of the first set of VPFCs for
the second set of VPFCs, the first set of VPFCs was closed
and D’s underlying obligations with respect to that first set
terminated for purposes of 26 U.S.C. § 1234A.
Held, further, D realized $71,668,034 of short-term
capital gain for tax year 2008 from the exchange of VPFCs.
—————
Robert A. Rudnick, Kristen M. Garry, Mark D. Lanpher, and Nathan K.
Tasso, for petitioner.
3
Steven N. Balahtsis, Steven A. Sirotic, Francesca M. Ugolini, Elizabeth
P. Flores, Michael A. Sienkiewicz, and Clint A. Carpenter, for
respondent.
SUPPLEMENTAL OPINION
MARSHALL, Judge: 2 This case is before the Court on remand
from the U.S. Court of Appeals for the Second Circuit for further
consideration consistent with its opinion in Estate of McKelvey v.
Commissioner (Estate of McKelvey II), 906 F.3d 26 (2d Cir. 2018),
reversing and remanding our decision in Estate of McKelvey v.
Commissioner (Estate of McKelvey I), 148 T.C. 312 (2017).
In Estate of McKelvey I, we considered whether Andrew J.
McKelvey (decedent) realized over $200 million in short-term and long-
term capital gain pursuant to sections 1001 and 1259, respectively, by
executing amendments extending two variable prepaid forward
contracts (VPFCs) in 2008 (year at issue). 3 In so doing, we rejected
respondent’s contention that decedent’s execution of the extensions
constituted taxable exchanges of “property” under section 1001. Estate
of McKelvey I, 148 T.C. at 320–32. We also rejected his contention that
the extensions resulted in constructive sales under section 1259 of the
collateralized stock shares decedent pledged under the VPFCs. Estate
of McKelvey I, 148 T.C. at 332–33. We thus concluded that the
extensions did not trigger any capital gain for the year at issue. Id.
at 320–33.
In Estate of McKelvey II, the Second Circuit agreed with us that
decedent’s execution of the extensions did not constitute exchanges of
“property,” such that no short-term capital gain was triggered pursuant
to section 1001. Estate of McKelvey II, 906 F.3d at 34. However, it also
considered a new, alternative argument by respondent that the
extensions nevertheless triggered short-term capital gain under section
2 By order of the Chief Judge, this case was reassigned from Judge Robert P.
Ruwe to Judge Alina I. Marshall for disposition.
3 Unless otherwise indicated, statutory references are to the Internal Revenue
Code, Title 26 U.S.C. (Code), in effect at all relevant times, regulation references are
to the Code of Federal Regulations, Title 26 (Treas. Reg.), in effect at all relevant times,
and Rule references are to the Tax Court Rules of Practice and Procedure. Some
monetary amounts are rounded to the nearest dollar.
4
1234A by terminating decedent’s obligations under the original VPFCs. 4
Estate of McKelvey II, 906 F.3d at 34–35. With respect to this argument,
the Second Circuit concluded that, although not exchanges of “property”
for purposes of section 1001, the original VPFCs were exchanged for
amended VPFCs. Estate of McKelvey II, 906 F.3d at 34–35. It
correspondingly remanded the case for us to determine “whether the
replacement of the obligations in the original VPFCs with the
obligations in what we hold are new contracts satisfies the criteria for a
termination of obligations that gives rise to taxable income, presumably
capital gain, and the amount of such gain.” Id. at 35; see also id. at 41(directing the Court, more succinctly, to determine “whether the
termination of obligations that occurred when the amended contracts
were executed resulted in taxable short-term capital gains”).
Additionally, the Second Circuit reversed our holding as to section
1259, concluding that the extensions did result in constructive sales of
the collateralized shares that triggered long-term capital gains. Estate
of McKelvey II, 906 F.3d at 40–41. In the light of this conclusion, the
Second Circuit further mandated that we calculate the amount of such
gain. Id. at 41. The parties having subsequently stipulated that amount
as $102,406,962.12, only the issues identified by the Second Circuit with
respect to the “replacement of the obligations in the original VPFCs with
the obligations in . . . [the] new contracts” remain.
In the light of the Second Circuit’s holdings, we will refer to the
transactions at issue as “replacements” or “exchanges” for the remainder
of this Opinion.
Background
The facts material to the issues under consideration have already
been set forth in Estate of McKelvey I. 5 For convenience, we restate them
here.
4 The parties agreed the Second Circuit could consider this argument because
petitioner had asserted before this Court that the extensions did not result in a
termination of decedent’s obligations under the original VPFCs. Estate of McKelvey II,
906 F.3d at 34.
5 This case was submitted fully stipulated under Rule 122, and in Estate of
McKelvey I we incorporated by reference the parties’ First Amended, Second, and Third
Stipulations of Facts and attached Exhibits. Estate of McKelvey I, 148 T.C. at 313. In
briefing the case for remand, respondent requested additional findings of fact,
5
At the time the Petition was filed, Bradford G. Peters had been
appointed executor of decedent’s estate by the Surrogate’s Court of the
State of New York, New York County. 6
Decedent was the founder and chief executive officer of Monster
Worldwide, Inc. (Monster), a company known for its website,
monster.com. Monster.com helps inform job seekers of job openings that
match their skills and desired geographic location. Decedent died on
November 27, 2008. Bradford G. Peters is the executor of decedent’s
estate.
I. Bank of America
Effective September 11, 2007, decedent entered into a VPFC with
Bank of America, N.A. (BofA), with respect to 1,765,188 shares of
Monster class B common stock owned by decedent (BofA VPFC). 7
Pursuant to the terms of the BofA VPFC, decedent received from BofA
a cash prepayment of $50,943,578.31 on September 14, 2007. In
exchange, decedent agreed to deliver to BofA, over the course of ten
separate settlement dates in September 2008, up to 1,765,188 Monster
shares or the cash equivalent. The actual number of Monster shares (or
the cash equivalent) required for delivery on each settlement date would
vary according to the stock market closing price of Monster shares on
each specified settlement date. Three different scenarios were
contemplated in the BofA VPFC. If the Monster stock closing price on a
particular settlement date was less than or equal to $30.4610 per share
(BofA floor price), the number of Monster shares (or cash equivalent)
deliverable to BofA on the settlement date would be as follows:
Monster Shares
Settlement Date Deliverable to BofA
9/11/08 176,518
9/12/08 176,518
proposing valuations for the VPFCs both before and after the exchange. The
valuations, but for a few rounding differences, align with the valuations which both
parties stipulated in the Third Stipulation of Facts. We therefore decline respondent’s
request.
6 The parties stipulate that at the time the Petition was filed, petitioner’s
address was in West Islip, NY.
7 At the close of trading on the National Association of Securities Dealers
Automated Quotation (NASDAQ) on September 11, 2007, the share price of Monster
was $32.91.
6
9/15/08 176,519
9/16/08 176,519
9/17/08 176,519
9/18/08 176,519
9/19/08 176,519
9/22/08 176,519
9/23/08 176,519
9/24/08 176,519
If the Monster stock closing price on a particular settlement date
was greater than the BofA floor price but less than or equal to $40.5809
per share (BofA cap price), then the number of Monster shares (or cash
equivalent) deliverable to BofA would be the product of:
BofA floor price_
176,519 ×
Stock closing price
The multiplier used for the September 11 and 12, 2008,
settlement dates is 176,518 instead of 176,519.
If the Monster stock closing price on a particular settlement date
was greater than the BofA cap price, then the number of Monster shares
(or cash equivalent) deliverable to BofA would be the product of:
BofA floor price + Stock closing price – BofA cap price
176,519 ×
Stock closing price
The multiplier used for the September 11 and 12, 2008, settlement dates
is 176,518 instead of 176,519.
On each settlement date, decedent could elect to settle the VPFC
by delivering the requisite number of Monster shares or the cash
equivalent. Decedent pledged 1,765,188 Monster shares to BofA to
secure his obligations under the BofA VPFC but could substitute other
collateral, subject to BofA’s approval, at any time during the term of the
VPFC.
7
On July 24, 2008, decedent paid BofA $3,477,949.92 in additional
consideration to extend the BofA VPFC settlement dates (BofA
extension), as follows: 8
Original BofA Extended BofA
Settlement Date Settlement Date
9/11/08 2/1/10
9/12/08 2/2/10
9/15/08 2/3/10
9/16/08 2/4/10
9/17/08 2/5/10
9/18/08 2/8/10
9/19/08 2/9/10
9/22/08 2/10/10
9/23/08 2/11/10
9/24/08 2/12/10
The BofA extension further provides: “Except as amended herein, all
other terms and conditions of the . . . [BofA VPFC] shall remain in full
force and in effect.”
Following decedent’s death, petitioner settled the BofA VPFC by
delivering to BofA 1,757,016 shares of Monster stock on or about May 8,
2009. 9
II. Morgan Stanley
Effective September 24, 2007, decedent entered into an
agreement with Morgan Stanley & Co. International plc (MSI), with
respect to 4,762,000 shares of Monster common stock (MSI VPFC). 10
Pursuant to the terms of the MSI VPFC decedent received from MSI a
8 At the close of trading on the NASDAQ on July 24, 2008, the share price of
Monster was $18.24.
9 It appears that the original BofA VPFC provided for expedited settlement
upon the occurrence of certain default or termination events, such as decedent’s death.
Neither party attaches any significance to the fact that there was an event triggering
settlement before the contractually specified dates.
10 At the close of trading on the NASDAQ on September 24, 2007, the share
price of Monster was $33.47.
8
cash prepayment of $142,626,185.80 on September 27, 2007. In
exchange, decedent agreed to deliver to MSI, on or about September 24,
2008, up to 4,762,000 Monster shares or the cash equivalent. The actual
number of Monster shares (or cash equivalent) required for delivery
would vary according to the average closing price of Monster stock on
specified dates (averaging dates). The averaging dates used to calculate
the number of deliverable shares under the MSI VPFC were the same
ten settlement dates used in the original BofA VPFC.
Similarly to the BofA VPFC, three different scenarios were
contemplated in the MSI VPFC. If the average closing price of Monster
stock over the ten averaging dates was less than or equal to $30.894 per
share (MSI floor price), then decedent would be required to deliver to
MSI 4,762,000 Monster shares or the cash equivalent. If the average
closing price of Monster stock over the ten averaging dates was greater
than the MSI floor price but less than or equal to $35.772 per share (MSI
cap price), then the number of Monster shares (or cash equivalent)
deliverable to MSI would be calculated using the following formula:
4,762,000 × MSI floor price
Stock average price
If the average closing price of Monster stock over the 10 averaging dates
was greater than the MSI cap price, then the number of Monster shares
(or cash equivalent) deliverable to MSI would be calculated using the
following formula:
4,762,000 × MSI floor price + average price – MSI cap price
Stock closing price
The terms of the MSI VPFC, like the terms of the BofA VPFC,
provided that decedent could elect to settle the contract either by
delivering the requisite number of Monster shares or by paying the cash
equivalent. Decedent pledged 4,762,000 Monster shares to secure his
obligations under the MSI VPFC but could substitute other collateral,
subject to MSI’s approval, at any time during the term of the MSI VPFC.
On July 15, 2008, decedent paid MSI $8,190,640 in additional
consideration to extend the MSI VPFC averaging and settlement date(s)
9
(MSI extension). 11 Pursuant to the terms of the MSI extension decedent
and MSI postponed the settlement date of the MSI contract from
September 24, 2008, to January 15, 2010. The MSI extension also
postponed the ten averaging dates to be used for the calculation of the
average closing price, as follows:
Original MSI Extended MSI
Settlement Date Settlement Date
9/11/08 1/4/10
9/12/08 1/5/10
9/15/08 1/6/10
9/16/08 1/7/10
9/17/08 1/8/10
9/18/08 1/11/10
9/19/08 1/12/10
9/22/08 1/13/10
9/23/08 1/14/10
9/24/08 1/15/10
The MSI extension further provides: “This Confirmation supplements,
forms part of, and is subject to, the . . . [MSI VPFC] . . . between you
and us. All provisions in the . . . [MSI VPFC] govern this Confirmation
except as expressly modified below.”
Following decedent’s death, petitioner settled the MSI VPFC by
delivering to MSI 4,762,000 shares of Monster stock on or about
August 5, 2009. 12
11 At the close of trading on the NASDAQ on July 15, 2008, the share price of
Monster was $17.28.
12 It appears that the original MSI VPFC, like the original BofA VPFC,
provided for expedited settlement upon the occurrence of certain default or termination
events, such as decedent’s death. Neither party attaches any significance to the fact
that there was an event triggering settlement before the contractually specified dates.
Petitioner received a $95,240 credit from MSI at settlement, and the parties do not
explain and it is unclear from the record why MSI credited this amount.
10
III. Tax Return
Petitioner timely filed Form 1040, U.S. Individual Income Tax
Return, for decedent’s taxable year 2008. On August 14, 2014,
respondent issued a notice of deficiency to petitioner for decedent’s
taxable year 2008. Respondent determined in the notice of deficiency
that decedent, upon executing the BofA and MSI extensions in 2008,
realized capital gain of $200,886,619. Respondent’s determined gain
comprised: (1) decedent’s realization of short-term capital gain of
$88,096,811.03 from his exchange of the VPFC extensions (amended, or
second set of, VPFCs) for the original VPFCs (first set of VPFCs); 13 and
(2) decedent’s realization of $112,789,808.64 14 of long-term capital gain
from the constructive sales of Monster shares pledged under the
VPFCs. 15 Respondent’s determination of long-term capital gain is based
on decedent, as the founder of Monster, having a zero basis in the
Monster shares pledged as collateral to BofA and MSI. 16 Petitioner
timely filed a Petition with the Court disputing respondent’s
determinations in the notice of deficiency.
Discussion
I. Taxability of the Replacement of Obligations
The first question we have been asked to address is whether a
taxable termination of obligations occurred when decedent exchanged
VPFCs with BofA and MSI, resulting in taxable gain. The Second
Circuit opined briefly on the exchanges, holding that the extensions of
13 Respondent’s computation of short-term capital gain is based on
(1) decedent’s holding period for the original VPFCs before extension and (2) an
amount realized for each original VPFC equal to the product of (i) the number of
Monster shares pledged as collateral and (ii) the excess of the floor prices under the
original VPFCs over the Monster closing price on July 15, 2008, of $17.28 per share
14 In Estate of McKelvey I, 148 T.C. at 318, this amount was misstated as
$112,789,808.03.
15 Respondent’s computation of long-term capital gain is based on (1) decedent’s
long-term holding period for the Monster shares and (2) an amount realized equal to
the product of (i) the number of Monster shares pledged as collateral under the original
VPFCs and (ii) the Monster closing price on July 15, 2008, of $17.28 per share.
16 Pursuant to a 2010 settlement between the Internal Revenue Service (IRS)
Office of Appeals and petitioner regarding decedent’s taxable year ending December
31, 2002, decedent recognized capital gain of $12,077,427 with respect to 2,500,000
Monster shares. Neither party addresses the impact, if any, of this capital gain
recognition on the VPFC transactions, and therefore we do not consider it.
11
the valuation dates resulted in the replacement of the original contracts.
Estate of McKelvey II, 906 F.3d at 35. More specifically, the Second
Circuit concluded that extending the valuation dates by an additional
17 months for the BofA contracts and 16 months for the MSI contracts
resulted in amended contracts that replaced the original contracts. Id.The Second Circuit reasoned that the parties “changed the bets that the
VPFCs represented”, which it determined to be a “fundamental change,”
invoking a phrase from Revenue Ruling 90-109, 1990-2 C.B. 191. Estate
of McKelvey II, 906 F.3d at 35. Revenue Ruling 90-109 discusses a
change in contractual terms that causes an old contract to be “treated
as if” it was actually exchanged for a new one. See Rev. Rul. 90-109,
1990-2 C.B. at 192 (“A change in contractual terms effected through an
option provided in the original contract is treated as an exchange under
section 1001 if there is a sufficiently fundamental or material change
that the substance of the original contract is altered through the exercise
of the option. Under such circumstances, the old contract is treated as
if it were actually exchanged for a new one.”); see also id. (referring to
the exercise of the option as resulting in a change that is “substantively
the same as an actual exchange” and as obviating the need for an “actual
exchange” but effecting a “de facto exchange”). The revenue ruling
employed the phrase “sufficiently fundamental or material change” to
indicate the point at which the original contracts had been exchanged
for new contracts, a gain recognition event as an exchange under section
1001. Id. The Second Circuit ultimately concluded that the extension
resulted in an exchange of the first set of contracts for new contracts, as
well as an exchange of the underlying obligations. Estate of McKelvey II,
906 F.3d at 35.
The Second Circuit stopped short, however, of reaching a holding
on whether a termination of obligations occurred. Id. On appeal,
respondent raised an alternative claim that the exchanges resulted in
the termination of derivative obligations with respect to capital assets.
Id. at 34–35. Respondent argued that such a termination of obligations
resulted in short-term capital gain under section 1234A. Estate of
McKelvey II, 906 F.3d at 34–35. The parties acknowledged that
respondent was entitled to raise the new claim, and the Second Circuit
left for us to address on remand the issue of whether decedent realized
short-term capital gain under section 1234A.
A. Termination of the Obligations Under the VPFCs
The Second Circuit described the exchanges as a “replacement of
the obligations,” establishing that by executing the transactions,
12
decedent surrendered one set of obligations and cash in an exchange for
an entirely separate set of obligations that, in turn, represented
fundamentally changed bets. Estate of McKelvey II, 906 F.3d at 35; see
Rev. Rul. 90-109. In order to determine whether such an exchange
qualifies as a taxable termination of the first set of obligations, we turn
to guidance regarding the treatment of options contracts. 17 Broadly
speaking, an option is the right to buy or sell a stock at a certain price
within a set period and involves a buyer (or holder) and a seller (also
known as a writer or grantor). Laureys v. Commissioner, 92 T.C. 101,
102 (1989). Revenue Ruling 90-109 applies sale or exchange treatment
to fundamental changes in the terms of options contracts. See Estate of
McKelvey II, 906 F.3d at 35. The revenue ruling states that where a
change to contractual terms effected through an option provided in the
original contract is so substantial as to amount to a fundamental or
material change, the “old contract is treated as if it were actually
exchanged for a new one.” Rev. Rul. 90-109, 1990-2 C.B. at 192. Such
treatment is “substantively the same as an actual exchange of contracts
and is a sale or other disposition for purposes of section 1001.” Id.; see
supra p. 11.
While VPFCs are not options themselves, options are similar,
open transactions from which principles can be applied to VPFCs, a
shared treatment acknowledged through prior IRS guidance and the
Second Circuit. See Rev. Rul. 78-182, 1978-1 C.B. 265; Rev. Rul. 58-234,
1958-1 C.B. 279; see also Estate of McKelvey II, 906 F.3d at 35 (“The new
valuation dates in the amended contracts resulted in new contracts just
as new expiration dates for option contracts result in new option
contracts.”). From the grantor’s perspective, the obligations under an
option contract terminate, in relevant part, through the grantor’s
repurchase of the option from the holder or the grantor’s purchase of an
option with terms identical to the original option granted and
designating the purchase as a closing transaction. Laureys, 92 T.C.
at 102–04; Treas. Reg. § 1.1234-3(b)(1). Each option has its own identity
and is a separate asset from all other options, so the holding period of
17 The Second Circuit left the issue of “whether the replacement of obligations
. . . satisfies the criteria for a termination of obligations that gives rise to taxable
income” to be decided by this Court. Estate of McKelvey II, 906 F.3d at 35 (emphasis
added). The Second Circuit also directed this Court to determine “whether the
termination of obligations that occurred when the amended contracts were executed
resulted in taxable short-term capital gains.” Id. at 41 (emphasis added). In the light
of the former statement and discussion by the Second Circuit, we understand the latter
statement to not be a conclusion with respect to whether a termination occurred for
purposes of section 1234A.
13
an option does not relate back to prior option contracts. Reily v.
Commissioner, 53 T.C. 8, 12 (1969). The time factor goes to the very
essence of options contracts. Id.The Second Circuit held that decedent’s extensions of the VPFCs
represented such fundamental changes as to warrant treatment as if
actual exchanges of the old and new contracts had occurred. Estate of
McKelvey II, 906 F.3d at 35. In treating decedent’s extensions of the
contracts as if the first set of VPFCs was actually exchanged for the
second set of VPFCs, the exchange takes the form of an option
repurchase. Decedent made payments to MSI and BofA and undertook
obligations as part of the new contracts, in exchange for the termination
of the prior contracts. Decedent repurchased the options held by MSI
and BofA, thereby executing closing transactions that terminated his
obligations with respect to the first set of contracts. See Treas. Reg.
§ 1.1234-3(b)(1)(i); see also Laureys, 92 T.C. at 102–04. Decedent’s
obligations under the first set of VPFCs do not relate forward to his
separate obligations under the second set of VPFCs, and likewise the
obligations under the second set of VPFCs do not relate back to his
obligations under the first set. See Reily, 53 T.C. at 12. We therefore
find that, upon executing the exchanges, decedent terminated the
obligations under the first set of VPFCs.
B. Sale Treatment Under Section 1234A
Although entry into a VPFC is not a taxable event, its termination
and replacement are another matter. The Second Circuit established its
agreement with our conclusion in Estate of McKelvey I that, at the time
the VPFCs were extended, decedent did not have any rights in the
VPFCs that could constitute property; but instead all that remained
were his obligations to deliver Monster shares (or their cash equivalent)
such that there was no taxable exchange of “property” for purposes of
section 1001. It remanded, however, for us to consider the exchanges of
the original VPFCs for the amended contracts in the context of section
1234A. 18 Estate of McKelvey II, 906 F.3d at 34–35. Section 1234A, in
relevant part, determines the taxable treatment of the termination of
obligations with respect to capital assets, providing:
18 In so doing, the Second Circuit was careful to note the parties’ agreement
that the case concerns contracts that are not debt instruments and that it was making
“no implication as to the tax consequences of fundamental changes in debt
instruments.” Estate of McKelvey II, 906 F.3d at 35 n.13.
14
Gain or loss attributable to the cancellation, lapse,
expiration, or other termination of—
(1) a right or obligation . . . with respect to
property which is (or on acquisition would be) a
capital asset in the hands of the taxpayer
....
shall be treated as gain or loss from the sale of a capital
asset.
Thus, by its terms, section 1234A(1) applies to the termination of
obligations with respect to capital assets, which include derivative or
contractual rights to buy or sell such assets. Pilgrim’s Pride Corp. v.
Commissioner, 779 F.3d 311, 317 (5th Cir. 2015), rev’g on other grounds
141 T.C. 533 (2013); see also Estate of McKelvey II, 906 F.3d at 34 (citing
same for its interpretation of section 1234A(1)). A “capital asset” for the
purposes of section 1234A means any property held by the taxpayer,
with certain exclusions that do not apply here. § 1221(a). And the
Second Circuit, to which appeal would lie, has opined that “a gain or loss
from the cancellation of a futures or forward contract would result in
capital gain or loss pursuant to [section] 1234A.” Wolff v. Commissioner,
148 F.3d 186, 188 (2d Cir. 1998), rev’g and remanding on other grounds
T.C. Memo. 1994-196.
Decedent held obligations with respect to Monster shares, which
are capital assets under section 1221(a). As the exchanges resulted in
the termination of those obligations, we hold that section 1234A(1)
applies to the exchanges. Therefore, any gain that decedent realized
from the exchanges shall be treated as gain from the sale of a capital
asset. “Short-term capital gain” is defined as the gain from the sale or
exchange of a capital asset held not more than 1 year. § 1222(1). The
period for which a taxpayer has held an option, rather than the property
that is the subject of the option, determines whether the capital gain is
short term or long term. See Treas. Reg. § 1.1234-1(a)(1). Decedent
terminated the first set of VPFCs after holding them for less than one
year, and consequently any gain that decedent realized from the
exchange is short-term capital gain.
II. Open Transaction Doctrine
As previously mentioned, VPFCs are afforded open transaction
treatment upon execution. Burnet v. Logan, 283 U.S. 404 (1931); Rev.
Rul. 2003-7, 2003-1 C.B. 363. Petitioner contends the replacement of
VPFCs requires equal treatment under the doctrine. The open
15
transaction doctrine finds its origins in the Code, which generally
concerns itself only with realized gains or losses or with unrealized gains
or losses that are reasonably certain and ascertainable. Lucas v. Am.
Code Co., 280 U.S. 445, 449 (1930). The doctrine governs transactions
where the realization of income is so uncertain or contingent as to
prevent accurate gain or loss calculations. Burnet v. Logan, 283 U.S.
404. Such limitations mean that the open transaction doctrine applies
only when we cannot determine the value of either of the exchanged
assets. Davis v. Commissioner, 210 F.3d 1346, 1348 (11th Cir. 2000),
aff’g T.C. Memo. 1998-248; see also United States v. Davis, 370 U.S. 65(1962). In scenarios where the value of only one asset is ascertainable,
the exchanged assets are deemed to be of equal value. Davis v.
Commissioner, 210 F.3d at 1348; see also Davis, 370 U.S. at 72.
Petitioner contends that the open transaction doctrine applies to
the transactions before us. Petitioner argues that in the exchanges of
VPFCs, VPFCs in the second set are open, which renders any gain
calculation from the exchanges an impossibility at that time. Petitioner
continues that, regardless of whether the Court deems them extensions
or replacements, the gain amount, identity, and cost basis of the
property to be delivered remained undetermined when the amendments
were executed. By reiterating that the ultimate exchange of cash or
property for the prepayment is what is relevant, petitioner makes clear
the view that rigid adherence to the settlement options contemplated in
the original contracts is the only way that parties to the contracts may
calculate their gain.
A. Applicability of Virginia Iron and Hicks
Petitioner attempts to support the position that the open
transaction doctrine applies with various options-writing cases,
primarily relying on Virginia Iron Coal & Coke Co. v. Commissioner, 37
B.T.A. 195 (1938), aff’d, 99 F.2d 919 (4th Cir. 1938), and Hicks v.
Commissioner, T.C. Memo. 1978-373, 37 T.C.M. (CCH) 1540. Each case
evaluates written call options that were extended at or after expiration,
and in each case the Court held that gain or loss was not realized upon
extension as uncertainty remained regarding what property would be
delivered to the taxpayers’ counterparties. Va. Iron, 37 B.T.A. 195;
Hicks, 37 T.C.M. (CCH) 1540. Virginia Iron, in relevant part, concerns
an option that the taxpayer wrote for a third party to purchase land and
mineral rights owned by the taxpayer’s subsidiary or stock in the
subsidiary owned by the taxpayer. Va. Iron, 37 B.T.A. at 196. The
option retained the third party’s purchase rights for one year in
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exchange for an up-front payment of $300,000; the purchase rights could
be renewed annually on August 1 for the following five years at a rate of
$125,000 per year. Id. The third party failed to make a payment on
August 1 of the second year, letting the option lapse, but on September
21 of that year entered into a supplemental contract, continuing the
option with some modifications. Id. The following year, the third party
formally declined to exercise the option. Id. at 197. The Board of Tax
Appeals (BTA) held that the up-front and renewal payments to the
taxpayer were not income for the years in which received, but rather
income for the year when the option was declined because only then
could “a satisfactory determination of their character” be made. Id.
at 198.
Hicks, in relevant part, concerned two real property parcels that
the taxpayer and a business partner agreed to sell to a developer. Hicks,
37 T.C.M. (CCH) at 1541. The purchase agreement, signed in December
1972, dictated that the developer would purchase the first parcel for
$208,598, and would make a downpayment of $25,000 for the second
parcel, plus an interest-bearing note for the balance of $189,162. Id.The purchase agreement stated that the closing for the second parcel
would not be more than one year after the closing for the first parcel;
however, the developer could reconvey the second parcel to the taxpayer
and his partner at no additional cost. Id. If the developer decided to
exercise its option to reconvey the second parcel, the taxpayer and his
partner would keep the downpayment. Id. In November 1973 the
developer reconveyed the second parcel, and the parties voided the note
for $189,162 and agreed to grant the developer for $10 an option to
repurchase the second parcel (purchase option). Id. at 1542. The
purchase option provided for the developer to purchase the parcel for
$204,000 between January 15, 1974, and June 7, 1975, plus $1,200 per
month after January 15, 1974. Id. The downpayment of $25,000 would
be credited against the purchase price if the developer exercised the
purchase option. Id. The Court held that any gain recognition for the
taxpayer with respect to the downpayment should be delayed until the
extended option was exercised or lapsed, on the basis that the character
of the payment could not be determined until then. Id. at 1544.
In citing Virginia Iron and Hicks, petitioner encourages the Court
to ignore whether obligations are “continuing” or “replaced,” proposing
that such terms are merely irrelevant formalisms. Instead, per
petitioner, we should focus exclusively on whether it is possible to
determine the amount and character of any gain or loss. While we agree
with maintaining a focus on whether the amount and character of any
17
gain or loss is determinable, we disagree that doing so requires us to act
as though the Second Circuit’s holding that the obligations were
replaced is “irrelevant” and ultimately unnecessary. The option
contracts at issue in Virginia Iron and in Hicks bear a few notable
differences from the VPFCs at hand, the first of which is that the BTA
in Virginia Iron and the Court in Hicks did not establish that the
expiration and subsequent renewal of the option was a replacement of
the option. Indeed, as petitioner stated on brief, the BTA was not
focused on such details and did not provide any opinion on the
distinction between “continuing” and “replacing” the contract. We, on
the other hand, are operating under the established decision that
decedent replaced the original set of VPFCs with a distinct second set.
The second difference arises from the underlying property to
which the derivative contracts relate. In both Virginia Iron and Hicks,
the options concerned the rights to purchase defined plots of real
property for a fixed amount set at the signing of each contract. Va. Iron,
37 B.T.A. at 196; Hicks, 37 T.C.M. (CCH) at 1541. As time passed, the
underlying real property the parties contemplated did not vary in
amount or price. Consequently, the bet that the parties made upon
signing resembled the position that they continued to hold in subsequent
years; the land values did not significantly change and the acres subject
to the options remained fixed. Va. Iron, 37 B.T.A. at 196; Hicks, 37
T.C.M. (CCH) at 1544. The BTA, and later the Court, found that the
option renewals left each taxpayer holding an obligation that had not
materially changed from what it was before the renewal. Va. Iron, 37
B.T.A. at 196; Hicks, 37 T.C.M. (CCH) at 1541. The same cannot be said
of decedent’s obligations. As respondent’s expert witness, Henrick
Bessembinder, revealed, the VPFCs carried substantially different
values depending on the length of time remaining on the contract and
on the share price relative to the set strike price. With an eye toward
those variables and the depressed value of the Monster shares at the
time of extension, the Second Circuit agreed that the change in
expiration dates fundamentally altered the bets that the VPFCs
represented. As these fundamental changes were not considerations in
Virginia Iron and Hicks, we find those cases to be factually distinct and
noncontrolling. 19
19 This Court relied on Virginia Iron in Estate of McKelvey I to conclude that
open transaction treatment applied to the first set of VPFCs so long as uncertainty
existed with respect to the second set of VPFCs. In the light of the Second Circuit’s
18
B. Open Transaction Doctrine as Applied to Exchanged
Contracts
Having established that we are not bound to the holdings in
Virgina Iron and Hicks, we turn to petitioner’s argument that the
VPFCs remained open through their replacement because the gain or
loss decedent would realize from the second set of VPFCs could not be
calculated at the time of replacement. Petitioner asserts, and we agree,
that the first set of VPFCs held uncertainty regarding the property to
be delivered at settlement, which led to further uncertainty regarding
decedent’s tax basis in any gain or loss calculation. However, petitioner
also asserts that the replacement of the first set of VPFCs by the second
set does not resolve any of this uncertainty as it does not identify or
determine decedent’s cost basis in the property eventually used to settle
the second set of VPFCs. In essence, petitioner’s argument is that gain
cannot be calculated on the then-closed first set of VPFCs because gain
could not yet be determined on the second set of VPFCs; uncertainty
replaced with uncertainty does not close the transaction. This argument
is at odds with the mechanics of the open transaction doctrine.
As mentioned above, the open transaction doctrine applies only
when it is impossible to determine the value of either asset exchanged.
Davis v. Commissioner, 210 F.3d at 1348. It says nothing of requiring
certainty in calculating the eventual gain of every asset or obligation
involved. We therefore look to when it is first possible to determine the
value of either asset exchanged.
Petitioner points out that, at the time of the exchange, the parties
had yet to resolve the contracts in the manner originally contemplated
and the stock or cash equivalent remained undelivered. The issue
petitioner highlights on brief is whether the exchange “resolved the
uncertainties regarding the amount, identity and cost basis of the money
or other property to be delivered in exchange for the prepayment,”
arguing it did not. But the Second Circuit has already made clear that
rigid adherence to the original design of the VPFCs is not the only
acceptable conclusion to the contracts. By extending the contracts, the
parties replaced the first set of VPFCs with the second set, transactions
the Second Circuit held to be exchanges of contracts. Estate of
McKelvey II, 906 F.3d at 35. The exchanges were a trade of decedent’s
holding that the exchanges terminated the first set of VPFCs and created a second set
of VPFCs that represented different bets, we no longer find Virginia Iron to dictate
that conclusion in this case.
19
obligations under the first set of VPFCs for decedent’s obligations under
the second set of VPFCs, plus additional payments of $8,190,640 to MSI
and $3,477,950 to BofA. This termination of the first set of VPFCs also
terminated the uncertainty that existed with respect to the identity and
the cost basis of the property to be delivered in exchange for the
prepayment under those contracts. Decedent satisfied the obligations
from the first set of VPFCs by delivering a combination of cash and new
obligations to which he was bound. Together, the cash and the new
obligations establish a value and a tax basis sufficient to calculate any
gain or loss derived from the first set of VPFCs.
It has long been established that gain is not exclusively derived
from cash-settled transactions, but rather that gain may be realized
from the “exchange of property, payment of the taxpayer’s indebtedness,
relief from a liability, or other profit realized from the completion of a
transaction.” Helvering v. Bruun, 309 U.S. 461, 469 (1940). Thus, the
fact that gain is a portion of the value of property received in the
transaction does not negate its realization. Id. Decedent made such an
exchange of obligations and property between the first and second set of
VPFCs and consequently realized the gains or losses from those
transactions. As it is possible to determine the values of property and
obligations exchanged, and from there to determine the realized gain,
the open transaction doctrine does not apply.
Petitioner is correct that the second set of VPFCs, at the time of
the exchange, existed as an open transaction. At the time of the
exchange, it would have been impossible to calculate the gain from those
VPFCs, as decedent was still free to settle the transaction in cash or
shares. However, we are not addressing decedent’s possible gain from
the second set of VPFCs; instead, we merely need their value at the time
of the exchanges. The Second Circuit is not directing us to determine
decedent’s gain with respect to all VPFCs, merely those terminated by
way of the exchanges.
III. Calculation of Gain
A. Applicability of Section 1001
Having established that the open transaction doctrine does not
apply, and that any gain derived from the transactions is classified as
short-term capital gain, we turn to the calculation of decedent’s gain at
the moments of the exchanges. Section 1001 dictates the method for
calculating such gain:
20
The gain from the sale or other disposition of property shall
be the excess of the amount realized therefrom over the
adjusted basis provided in section 1011 for determining
gain, and the loss shall be the excess of the adjusted basis
provided in such section for determining loss over the
amount realized.
§ 1001(a).
Problems arise in applying that introductory computation
paragraph to our facts as the section limits its scope to gain from the
sale or other disposition of property. See id. Both the Second Circuit
and this Court have ruled that decedent’s positions with respect to the
VPFCs are not property, but rather obligations. Estate of McKelvey II,
906 F.3d at 34; Estate of McKelvey I, 148 T.C. at 322. The capital gain
calculation as codified under section 1001 requires the sale or exchange
of property, and decedent’s gain from the VPFCs, while derived from a
sale or exchange, would seem to be omitted as nonproperty.
Yet strict adherence to the idea that such wording exempts sales
or exchanges of VPFCs from gain calculation leaves a gap in the Code’s
application of capital gain tax treatment when it comes to VPFCs and
other nonproperty derivatives. With respect to the treatment of
derivatives elsewhere in the Code, the character of the gain and loss
does not turn on the classification of the taxpayer’s position with respect
to the derivative, but rather the property to which the contract relates.
Gain or loss attributable to the sale or exchange of a securities futures
contract is considered gain or loss from the sale or exchange of the
underlying property for purposes of determining the character of the
gain or loss, and the property or nonproperty nature of the taxpayer’s
position does not dictate taxability. § 1234B. The same holds true for
the taxability of derivatives as capital assets. Gain or loss from the
cancellation or lapse of an obligation with respect to property that is a
capital asset in the hands of the taxpayer is treated as gain or loss from
the sale of a capital asset, disregarding the nonproperty nature of the
obligation. § 1234A. For options holders, gain or loss from the sale or
exchange of options in property is considered to have the same character
as gain or loss derived from the sale of the underlying property.
§ 1234(a). For options writers, the gain or loss is treated as gain or loss
from the sale or exchange of a capital asset without regard to whether
the position is property or an obligation in the hands of the writer.
§ 1234(b).
21
These examples paint a clear picture of the Code’s priorities when
it comes to taxing the gains or losses of derivatives: The nature of the
underlying property controls. Even when it is well established that the
taxpayer’s position with respect to a derivative is not property, the Code
dictates that any gain or loss is treated as if derived from property. We
will continue to evenly apply that principle to the VPFCs in question.
Consequently, the applicability of section 1001(a) is not affected by the
nonproperty nature of decedent’s position with respect to the VPFCs,
but rather by the fact that the underlying shares are property. The
underlying Monster shares are property in the hands of decedent, and
therefore section 1001(a) applies to gain from the sale or other
disposition of derivatives relating to those shares. Where section 1001
restricts gain calculations, either to property or otherwise, we will look
to the nature of the underlying shares as a basis for the section’s
applicability, rather than to the nature of the taxpayer’s position.
B. Gain Calculation Under Section 1001
The gain from the exchange is determined under section 1001 and
is calculated as the excess of the amount realized over decedent’s
adjusted basis in the VPFCs. See § 1001(a). The amount realized from
the exchange is defined as the sum of any money received plus the fair
market value of any property received other than money. § 1001(b).
Gain or loss is realized from the exchange of property for other property
differing materially either in kind or extent and is treated as income or
loss sustained. Treas. Reg. § 1.1001-1(a); see Helvering v. Bruun, 309
U.S. at 468–69 (applying section 22 of the Revenue Act of 1932, ch. 209,
47 Stat. 169, 178, the predecessor of the current section 61(a), and
holding that gain may be derived from the exchange of property,
payment of a taxpayer’s indebtedness, relief from liability, or other
profit realized from the completion of a transaction). When property is
exchanged for property in a taxable exchange, the taxpayer is taxed on
the difference between the adjusted basis of the property given and the
fair market value of the property received. Williams v. Commissioner,
37 T.C. 1099, 1106 (1962) (citing Phila. Park Amusement Co. v. United
States, 126 F. Supp. 184, 188 (Ct. Cl. 1954)).
We calculate decedent’s amount realized by taking the
prepayment amount he received and subtracting his basis in the
transactions, which consists of his payments to the VPFC holders and
decedent’s outstanding liability as a result of the second set of VPFCs in
the moment immediately following the exchanges. The calculation is as
follows:
22
Item MSI BofA Total
Prepayment to Decedent $142,626,186 $50,943,578 $193,569,764
Payment to Effect the
−8,190,640 −3,477,950 −11,668,590
Exchange of VPFCs
Value of Decedent’s
Ongoing Obligation −79,857,244 −30,375,896 −110,233,140
Following the Exchange 20
Gain — — $71,668,034
Therefore, upon termination of the first set of VPFCs, decedent
realized $71,668,034 in short-term capital gain for the taxable year
ended December 31, 2008.
IV. Conclusion
We have considered all of the arguments the parties made, and to
the extent they are not addressed herein we find the arguments to be
moot, irrelevant, or without merit.
To reflect the foregoing,
Decision will be entered under Rule 155.
20 The values of decedent’s ongoing obligations following the exchange come
from the Expert Report of Hendrik Bessembinder, a jointly submitted exhibit prepared
by respondent’s expert witness, Dr. Bessembinder. Dr. Bessembinder’s report, in
relevant part, values decedent’s obligations under the VPFCs at various relevant times
using the Black-Scholes option pricing formula.
The Black–Scholes model is a widely accepted formula for valuing European-
style options on liquid assets. It relies on five variables: (1) the exercise price of the
option; (2) the market price of the underlying asset; (3) the volatility of the underlying
asset; (4) the expiration date of the option; and (5) the risk-free interest rate. The Code
does not require us to use the Black-Scholes valuation method, but we think it is a
reasonable method for valuing the VPFC obligations here because of its wide
acceptance and stipulation by both parties with respect to its use by Dr. Bessembinder.
See 6611, Ltd. v. Commissioner, T.C. Memo. 2013-49, at *71 n.34.