Jesse Drucker of Bloomberg recently published an article (see Buffett-Ducking Billionaires Avoid Reporting Cash Gains to IRS) discussing the growing list of billionaires caught in the IRS's increasingly more dim view of prepaid variable forwards (PVF).
PVF's have become the "go-to" tax strategy for high net worth individuals seeking to monetize unrealized capital gains on publicly traded stock without actually triggering a taxable event. The PVF is simply a forward contract where the owner of the stock agrees to sell a variable number of shares to the counterparty at a fixed time in the future. The number of shares varies with the price of the security such that the total value of the sale is within a fixed range (the range is usually around 15% so that the IRS's constructive sale rule can be avoided). The PVF contract is packaged with an up-front loan from the securities buyer to the securities seller. The economic essence of the PVF transaction is that the securities seller gets paid up front (via the loan) but doesn't deliver the securities until some point in the future.
PVF's have become the "go-to" tax strategy for high net worth individuals seeking to monetize unrealized capital gains on publicly traded stock without actually triggering a taxable event. The PVF is simply a forward contract where the owner of the stock agrees to sell a variable number of shares to the counterparty at a fixed time in the future. The number of shares varies with the price of the security such that the total value of the sale is within a fixed range (the range is usually around 15% so that the IRS's constructive sale rule can be avoided). The PVF contract is packaged with an up-front loan from the securities buyer to the securities seller. The economic essence of the PVF transaction is that the securities seller gets paid up front (via the loan) but doesn't deliver the securities until some point in the future.
To fully grasp the attractiveness of the PVF it's important to understand two key assumptions:
1. Since the PVF is a single contract and title to the securities isn't transferred until the future, the IRS does not consider this a capital gain until the forward delivery date. Thus, capital gains taxes can be postponed.
2. From a securities regulatory standpoint, the PVF is viewed as a stock sale (i.e. not a loan) and therefore not subject to Federal Reserve Reg-T. This is a major advantage since the full proceeds of the loan can be used for any purposes. Basically, this is an end-run around Reg-T's 50% margin requirement.
Now it appears that - based on recent IRS rulings - assumption #1 is no longer the slam dunk it once was and billionaires like Billy Joe McCombs (the former owner of the Minnesota Vikings, San Antonio Spurs, and co-founder of Clear Channel Communications) is the latest casualty of the IRS' crackdown on the PVF strategy. Yikes!
So what's a billionaire to do?
Thomas Boczar and Doug Engman of Intelligent Edge Advisors make a compelling case for a substitute transaction with the same (or perhaps even more attractive) economic substance but with a much lower tax and IRS audit risk. In their article Portfolio Margin - Recent Developments in Single Stock Concentration, they argue that a collar and loan transaction within a Portfolio Margin Account can be used to obtain the same economic and tax benefits as the PVF. This is only possible under the new portfolio margining rules because of the lower margin requirements obtained (versus the traditional Reg-T margin).
The premise of their approach is to construct a collar position using exchange traded or otc options. This would involve selling a call option and buying a put option to hedge the security in question. A substantial percentage of the overall position value can then be withdrawn in cash from the brokerage account (or invested in other securities) as the Portfolio Margining methodology considers the position to be hedged. This all happens with the Options Clearing Corporation as the counterparty so there is less credit risk than with the PVF offered to you by your friendly neighborhood, bail-out seeking Wall St. broker-dealer (Goldman Sachs, Morgan Stanley, Citigroup, JP Morgan, etc). And guess what? It's all kosher as far as the IRS is concerned.
Billionaires rejoice!
Joking aside, the collar strategy under Portfolio Margining rules is an effective tax management approach for any investors wishing to postpone capital gains tax on large single stock positions with substantial unrealized capital gains. All investment advisors worth their salt should familiarize themselves with this approach.
So what's a billionaire to do?
Thomas Boczar and Doug Engman of Intelligent Edge Advisors make a compelling case for a substitute transaction with the same (or perhaps even more attractive) economic substance but with a much lower tax and IRS audit risk. In their article Portfolio Margin - Recent Developments in Single Stock Concentration, they argue that a collar and loan transaction within a Portfolio Margin Account can be used to obtain the same economic and tax benefits as the PVF. This is only possible under the new portfolio margining rules because of the lower margin requirements obtained (versus the traditional Reg-T margin).
The premise of their approach is to construct a collar position using exchange traded or otc options. This would involve selling a call option and buying a put option to hedge the security in question. A substantial percentage of the overall position value can then be withdrawn in cash from the brokerage account (or invested in other securities) as the Portfolio Margining methodology considers the position to be hedged. This all happens with the Options Clearing Corporation as the counterparty so there is less credit risk than with the PVF offered to you by your friendly neighborhood, bail-out seeking Wall St. broker-dealer (Goldman Sachs, Morgan Stanley, Citigroup, JP Morgan, etc). And guess what? It's all kosher as far as the IRS is concerned.
Billionaires rejoice!
Joking aside, the collar strategy under Portfolio Margining rules is an effective tax management approach for any investors wishing to postpone capital gains tax on large single stock positions with substantial unrealized capital gains. All investment advisors worth their salt should familiarize themselves with this approach.
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