906 F.3d 26
2d Cir.2018Background
- Andrew McKelvey executed two variable prepaid forward contracts (VPFCs) in 2007 with BofA and Morgan Stanley: he received ~$194M up front, pledged ~6.5M Monster shares as collateral, and agreed to deliver a price‑dependent number of shares in Sep 2008.
- In mid‑2008, with Monster's share price much lower, McKelvey paid the banks ~$11.7M to amend each VPFC and extend the valuation/settlement dates into 2010.
- McKelvey died in Nov 2008; the Estate later settled the amended contracts in 2009 by delivering the collateral shares and reported no 2008 income from the amendments.
- The IRS issued a $41M+ deficiency asserting (1) short‑term capital gains from termination/exchange of the original VPFCs and (2) long‑term capital gains under the constructive‑sale rules (26 U.S.C. §1259) because the number of shares to be delivered was "substantially fixed."
- The Tax Court, on stipulated facts, ruled for the Estate: no taxable exchange (contract rights were not property) and no constructive sale; the Estate bore the burden to rebut the deficiency.
- The Second Circuit reversed as to constructive sale (held amended contracts made the deliverable amount "substantially fixed" given high probabilities based on Black‑Scholes analysis) and remanded to determine whether termination of obligations produced short‑term gain and to quantify long‑term gain.
Issues
| Issue | Plaintiff's Argument (Estate/McKelvey) | Defendant's Argument (Commissioner) | Held |
|---|---|---|---|
| Whether extending VPFC valuation/settlement dates was a taxable "exchange" or termination producing short‑term capital gain | Estate: No taxable exchange—McKelvey had already received prepaid cash and held only obligations (not property); thus no §1001 disposition; extensions preserved "open" nature | Commissioner: Amendments replaced originals (fundamental change) and terminated prior obligations, triggering gain under §1234A(1) | Court: Rejected taxable‑exchange theory (no property to exchange). Found amendments did replace originals; remanded to Tax Court to decide termination/amount of any short‑term gain |
| Whether amended contracts caused a constructive sale of pledged shares (long‑term gain under §1259) because the deliverable amount was "substantially fixed" | Estate: No constructive sale—the transactions remained "open" and shares to be delivered were not fixed; settlement could use non‑collateral shares so identity and basis varied | Commissioner: At amendment dates stock was so far below floor that probability of delivery of the full collateral was very high (~85–87%), so the deliverable amount was "substantially fixed," triggering §1259 constructive sale | Court: Accepted probability analysis (Black‑Scholes) and held the record showed the deliverable amount was "substantially fixed;" reversed Tax Court on §1259 and remanded to quantify long‑term gain |
Key Cases Cited
- Frank Lyon Co. v. United States, 435 U.S. 561 (Sup. Ct.) (tax analysis must account for economic realities)
- Progressive Corp. v. United States, 970 F.2d 188 (6th Cir.) (use of probability to assess whether in‑the‑money options are effectively obligations; remand to determine virtual certainty)
- Greene v. United States, 79 F.3d 1348 (2d Cir.) (tax analysis should reflect marketplace economic realities)
- Welch v. Helvering, 290 U.S. 111 (Sup. Ct.) (taxpayer bears burden to show deficiency incorrect)
- General Electric Co. v. Commissioner, 245 F.3d 149 (2d Cir.) (standard of review: de novo review of Tax Court decisions on stipulated records)
- Pilgrim's Pride Corp. v. Commissioner, 779 F.3d 311 (5th Cir.) (§1234A(1) treats termination of contractual rights with respect to capital assets as gain from sale)