Estate of McKelvey

          Argued: June 5, 2018

         Appeal from the May 22, 2017, decision of the United States Tax Court rejecting the claim of the Commissioner of Internal Revenue that the Estate of Andrew J. McKelvey owed $41 million in taxes with respect to McKelvey's 2008 income tax return for omitting what the Commissioner alleged were short- and long-term capital gains arising from the execution of new contracts extending the valuation dates of two variable prepaid forward contracts.

         Decision reversed, and case remanded for (1) determination, in light of this opinion, of whether the termination of obligations that occurred when the new contracts were executed resulted in taxable short-term capital gains, and (2) calculation of the amount of long-term capital gains that resulted from the constructive sales of the collaterized shares. Judge Cabranes concurs with a separate opinion.

          Clint A. Carpenter, (David A. Hubbert, Deputy Asst. Atty. General, Gilbert S. Rothenberg, Joan I. Oppenheimer, on the brief), Tax Division, Appellate Section, U.S. Dep't. of Justice, Washington, D.C., for Respondent- Appellant Commissioner of Internal Revenue.

          Mark D. Lanpher, (Robert A. Rudnick, Kristen M. Garry, on the brief), Shearman & Sterling LLP, Washington, D.C., for Petitioner- Appellee Estate of Andrew J. McKelvey.

          Before: NEWMAN, CABRANES, and CARNEY, Circuit Judges.

          Jon O. Newman, Circuit Judge

         This appeal concerns somewhat unusual financial instruments known as variable prepaid forward contracts ("VPFCs"). A VPFC is an agreement between a short party (typically, the shareholder of a large quantity of low-basis, appreciated stock) and a long party (typically an investment bank). The long party agrees to pay the shareholder a substantial sum of money equal to the value of the stock discounted to present value. In exchange, the shareholder agrees to deliver to the long party on a specified settlement date up to a maximum number of shares of stock (or their cash equivalent), the exact number to be determined by the price of the shares on a specified valuation date. The short party also agrees to secure its delivery obligation with the maximum number of shares to be delivered at settlement. A VPFC usually sets a floor price and a cap price that limit the number of shares to be delivered in the event that the share price on the valuation date is below the floor price, above the cap price, or between them. The issues on this appeal arise because a shareholder, after executing two similar VPFCs with two financial institutions, paid substantial sums of money to each institution to obtain an extension of the settlement date and, more significantly, the valuation date.

         There are two precise issues. The first is whether, with respect to each contract, the extensions resulted in a short-term capital gain. The Commissioner of Internal Revenue ("Commissioner") contends that a short-term capital gain occurred because either (1) the extension of the valuation date resulted in an exchange of property with a more valuable new contract replacing the original contract or (2) a termination of the delivery obligation occurred because the obligation in the first contract to deliver shares on the original settlement date was extinguished.

         The second issue is whether, with respect to each contract, the extension of the valuation date also resulted in a long-term capital gain. The Commissioner contends that the execution of each new contract resulted in a constructive sale of the shares pledged as collateral to secure the obligation of the new contract. His reason for this claim is that, on the date of the new contract, the share price of the stock pledged as collateral was so far below the floor price that there was no more than a fifteen and thirteen percent probability, respectively, for each contract that the share price would reach that floor price and therefore, under each contract, the shareholder would almost certainly be required to deliver the maximum number of collateralized shares. As a result, the Commissioner contends, the number of shares to be delivered at settlement was "substantially fixed" within the meaning of 26 U.S.C. § 1259(d)(1) on the date of each new contract, resulting in a long-term capital gain on shares constructively sold.

         These rather esoteric issues arise on an appeal by the Commissioner from the May 22, 2017, decision of the United States Tax Court (Robert P. Ruwe, Judge) rejecting the Commissioner's claims to collect $41, 257, 103 from the estate of Andrew J. McKelvey ("Estate") for both short- and long-term capital gain taxes alleged to have been incurred by the decedent in 2008.

         Background

         McKelvey, who died on November 27, 2008, was the founder and principal shareholder of Monster Worldwide, Inc. ("Monster"), a publicly traded company that maintains a website, monster.com, which helps job-seekers find jobs. In 2007, McKelvey executed two VPFCs, one with Bank of America, N.A. ("Bof A") as long party and another with Morgan Stanley & Co. International plc ("MSI") as long party.

         The Bof A VPFC. Under the Bof A contract, which became effective September 11, 2007, Bof A agreed to pay McKelvey $50, 943, 578.31 on September 14, 2007; he agreed to pledge 1, 765, 188 shares of Monster stock to secure his obligation to Bof A; and he agreed to deliver to Bof A up to 1, 765, 188 shares of Monster stock (or the cash equivalent) at settlement. Settlement was to be made by delivering to Bof A up to ten percent of the 1, 765, 188 shares on each of ten consecutive weekdays between September 11 and 24, 2008. At the close of trading on the NASDAQ on September 11, 2007, the price of Monster stock was $32.91.

         The contract provided that the actual number of shares to be delivered on each of the ten settlement dates would be determined in one of three ways, depending on the closing price of Monster stock on each of the ten dates. If the closing price on a settlement date was less than (or equal to) $30.4610 ("Bof A floor price"), the number of shares to be delivered on each of the ten dates would be 176, 519 (ten percent of 1, 765, 188).^[1] If the closing price on a settlement date was more than the Bof A floor price but less than (or equal to) $40.5809 ("Bof A cap price"), the number of shares to be delivered on each of the ten dates would be a fraction of 176, 519: the numerator of the fraction would be the Bof A floor price and the denominator would be the Monster stock closing price. If the closing price on a settlement date was more than the Bof A cap price, the number of shares to be delivered would be a more complicated fraction of 176, 519: the numerator of the fraction would be the closing price minus the difference between the Bof A cap price and the Bof A floor price, and the denominator would be the closing price.

         These three methods of determining the number of shares to be delivered at settlement would yield curious results. To illustrate these results, it will be convenient to ignore the fact that ten percent of the total number of the 1, 765, 188 shares would be delivered on each of ten consecutive weekdays and consider the collateralized shares as a bloc. If the closing price was equal to, or any price below, the floor price, the number of shares to be delivered would always be the total number of shares pledged as collateral, which would be the maximum number of shares required to be delivered at settlement. If the closing price was between the floor price and the cap price, the number of shares to be delivered would decline from 1, 765, 188 the closer the closing price was to the cap price. The decline would end when the closing price equaled the cap price, at which point the number of shares to be delivered would be 1, 324, 993 (1, 765, 188 times 30.4610/40.5809).^[2] If the closing price was any price above the cap price, the number of shares to be delivered would increase from 1, 324, 993 and continue to increase the more the closing exceeded the cap price. The increase would be continuous as the closing price increased and the number of shares to be delivered approached the total number of the collateralized shares, but the number of shares to be delivered would never exceed that maximum total number. These effects are illustrated in the following table, showing an example of how many shares of a 1, 000-share bloc would be delivered at various closing prices: some below or equal to the floor price of 30.5 (rounded), some between the floor price and the cap price of 40.6 (rounded), and some above the cap price. The table also shows the fraction used to determine the number of shares to be delivered.

closing price:	20	25	30.5	35	40	40.6	45	50	60
fraction:			30.5/35	30.5/40	30.5/40.6	34.9/45	39.9/50	49.1/60
shares delivered:	1000	1000	1000	850	763	751	776	798	818

         Under the Bof A contract, McKelvey had the option to settle the contract with the "cash equivalent" no matter which of the three methods for determining the number of shares to be delivered was applicable. The cash equivalent for each share to be delivered was 105 percent of the closing share price three trading days prior to the valuation date for the first portion of the collaterized shares to be delivered, which was September 11, 2008.^[3] Of course, had McKelvey used the cash equivalent option (for both the Bof A and MSI contracts), he would have had to pay a substantial sum of money.

         On July 24, 2008, two months before the ten settlement dates, McKelvey paid Bof A $3, 477, 949.92 to amend the Bof A contract by extending the original settlement dates, which also served as valuation dates, from ten consecutive weekdays in September 2008 to ten consecutive weekdays in February 2010 ("amended contract"). No other terms of the 2007 Bof A contract were changed. On the date of the Bof A extension, the closing price of Monster stock was $18.24.

         The MSI VPFC. Under the MSI contract, effective September 24, 2007, MSI agreed to pay McKelvey $142, 626, 185.80 on September 27, 2007; he agreed to pledge 4, 762, 000 Monster shares to secure his obligation to MSI; and he agreed to deliver to MSI up to 4, 762, 000 Monster shares (or the cash equivalent) on September 24, 2008. At the close of trading on the NASDAQ on September 24, 2007, the price of Monster stock was $33.47.

         The contract provided that the actual number of shares to be delivered on the settlement date would be determined in one of three ways depending on the average of the closing prices of Monster stock on ten valuation dates ("average price"). If the average price was less than (or equal to) $30.894 ("MSI floor price"), the number of shares to be delivered would be 4, 762, 000. If the average price was more than the MSI floor price but less than (or equal to) $35.772 ("MSI cap price"), the number of shares to be delivered would be a fraction of 4, 762, 000, the numerator of the fraction to be the MSI floor price and the denominator to be the average price. If the average price was more than the MSI cap price, the number of shares to be delivered would be a more complicated fraction of 4, 762, 000: the numerator of the fraction would be the average price minus the difference between the MSI cap price and the MSI floor price, and the denominator would be the average price. These three methods of calculation yielded precisely the same curious results described above with respect to the Bof A contract when the closing price was equal to or below the MSI floor price, above the MSI cap price, or between them.

         Under the MSI contract, like the Bof A contract, McKelvey had the option to settle the contract with the "cash equivalent" no matter which of the three methods for determining the number of shares to be delivered was applicable, but the calculation of the cash equivalent differed from the Bof A contract. Under the MSI contract, the cash equivalent was the number of shares to be delivered multiplied by the closing price of Monster stock on the last of the ten averaging dates.^[4] That date was September 24, 2008.

         On July 15, 2008, two months before the settlement date, McKelvey paid MSI $8, 190, 640 to amend the MSI contract by extending the original settlement date from September 24, 2007, to January 15, 2010, and to extend the dates on which the average price would be determined from ten consecutive weekdays in September 2008 to ten consecutive weekdays in January 2010 ("amended contract"). No other terms of the 2007 MSI contract were changed. On the date of the MSI extension, the closing price of Monster stock was $17.28.

         On the dates of the extensions of both the Bof A and MSI contracts, the value of McKelvey's Monster shares was about $114 million. If McKelvey had delivered his Monster shares on those dates instead of extending the settlement and valuation dates of the VPFCs, he would have realized a substantial capital gain.

         Settlement of amended contracts.

         After McKelvey's death, the Estate settled the amended Bof A contract by delivering 1, 757, 016 Monster shares to Bof A on May 8, 2009, ^[5] and settled the amended MSI contract by delivering 4, 762, 000 Monster shares to MSI on August 5, 2009. Both the original VPFCs and the amended contracts provided for expedited settlement in the event of various occurrences including McKelvey's death. The parties make no claim that the expedited settlements have any significance to the issues on appeal. The Estate obtained a stepped-up basis for the Monster shares. See 26 U.S.C. § 1014(a)(1).

         To recapitulate: by executing both VPFCs in September 2007, McKelvey received about $194 million, ^[6] pledged about 6.5 million Monster shares, ^[7] then worth about $218 million, ^[8] and agreed to deliver one year later between about 5.4 million^[9] and 6.5 million Monster shares (then worth between about $181 million^[10]and $218 million). Ten months later, McKelvey paid $11, 668, 590 to execute amended contracts, which extended the settlement dates and the valuation dates that would determine the number of shares to be delivered at settlement. The Estate settled the amended contracts by delivering 6, 519, 016 Monster shares, which the Commissioner states were worth about $88 million, to Bof A and MSI. Neither McKelvey nor the Estate paid any income taxes with respect to the Monster shares.

         McKelvey's 2008 income tax return.

         McKelvey's 2008 federal income tax return, filed by the executor of his Estate, reported no income attributable to the execution of the amended contracts. The Estate's reason for not reporting any short-term capital gain was its view that the extensions of the settlement and valuation dates did not result in a taxable exchange of the original VPFCs for the amended contracts. The Estate's reason for not reporting any long-term capital gain was its view that such a gain could not have occurred until the amended contracts were settled by delivery of Monster shares to Bof A and MSI, and, by that time, the shares had ...