• Home
  • Tutorials
    • Intro to Margin Accounts
    • Portfolio Margin 101
    • How Portfolio Margin Works
  • Resources
    • Option Strategies - Reg T Margin
    • Option Strategies - Portfolio Margin
    • Margin Calculators for Options
    • Regulatory Timeline
    • Stress Test Market Moves
    • P&L Offsets
    • Brokers Offering Portfolio Margin
    • Margin Rate Comparison
  • FAQs
  • About Us
    • Disclaimer
  • Blog
The Margin Investor

Prepaid Variable Forward strategy takes heat from IRS, Portfolio Margin to the Rescue?

11/22/2011

6 Comments

 
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.
To fully grasp the attractiveness of the PVF it's important to understand two key assumptions:
Picture
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.

Picture
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.  

6 Comments
Fforthepeople
12/12/2011 07:10:12 am

Do these guys ever pay any money? Just too many loopholes.

Reply
Denver
12/12/2011 07:13:21 am

Interesting approach. Is the portfolio margin approach something that could be used by someone who's not a billionaire? I have a 300k capital gain on a stock I've held since 1999.

Reply
Asset Advisor
7/22/2015 11:21:53 am

Just browsing and Noticed no one responded. this can be done for your account. I specialize in it. Let me know if that's still relavent.

Reply
Doug T
12/12/2011 07:43:37 am

hmmm...so if I keep rolling the options forward before they expire does that mean I can postpone capital gains taxes forever?

Reply
Omni Tech Support link
9/5/2013 05:28:10 pm

Buffett-Ducking Billionaires Avoid Reporting Cash Gains to IRS was a fantastic piece of article by Jesse Drucker. Interesting to read about the growing list of billionaires and the IRS issues with prepaid variable forwards. Anyway, thanks for this post!

Reply
Malenki Rich
9/5/2014 05:38:32 am

The thought behind this tax loophole is that you can keep postponing the tax break. An investor could hold this forever, and pass it on to heirs. You may have 4 million dollars and never pay tax on it- if you can keep postponing it forever. The margin requirement for this will be the absolute minimum- 0.375 per contract. It will be roughly 0.75%.
Your trading costs will be covered by the dividend yield.
This dividend yield will be taxable. Let us say you have implemented a collar on AT&T- you bought it a few years ago- and now you have a $7 per share profit that you do not want to pay capital gains on. This is about 20% of the current stock price.
The taxes you pay on the dividend should be considered.

I think you could borrow the stock- and this I think reduces the risk of the stock getting called away. You could close out the call position by the end of the day.

Reply

Your comment will be posted after it is approved.


Leave a Reply.

    Author

    Jason Apolee is a contributing editor to The Margin Investor where he focuses on news commentary and evaluating broker offerings.

    RSS Feed

    Archives

    November 2013
    February 2013
    January 2013
    November 2012
    July 2012
    May 2012
    January 2012
    December 2011
    November 2011

    Categories

    All
    Academic Papers
    Bonds
    Brokers
    Buy-write
    Capital Gains
    Covered Call
    Discount Brokers
    Dividend Yield
    Earnings
    Financial Crises 2008
    Hedging
    High Yield
    Indexes
    Leverage
    M&A
    Margin Rates
    News Info
    Portfolio Risk
    Recession
    Stock Concentration
    Strategy Based Margin
    Systematic Margin Risk
    Taxes
    Trading
    Trading Strategies
    Videos

Powered by Create your own unique website with customizable templates.
Photos from neurmadic aesthetic, DonkeyHotey