Key Takeaways
- Receive upfront cash by pledging shares as collateral.
- Defers capital gains tax until contract settlement.
- Settlement shares vary based on stock price floors and caps.
- Avoids immediate taxable sale if properly structured.
What is Variable Prepaid Forward Contracts?
A variable prepaid forward (VPF) contract is a financial arrangement allowing shareholders to receive immediate cash—typically 75-90% of their stock's current market value—while deferring capital gains taxes until a future settlement date. This deferral occurs because the contract delays the sale event until shares or cash are delivered later, often between one and five years.
This strategy is especially useful for investors or executives holding large, concentrated positions in a single stock, enabling liquidity without triggering immediate tax consequences under IRS rules. The structure often resembles a collateralized loan, with shares pledged as security.
Key Characteristics
Variable prepaid forward contracts combine several distinctive features that balance liquidity, tax deferral, and price exposure:
- Upfront Cash Payment: Receive a prepayment, usually 75-90% of the stock's market value, providing immediate liquidity.
- Variable Settlement: Deliver a variable number of shares or cash at maturity, depending on the stock price relative to predefined floor and cap prices.
- Tax Deferral: Capital gain recognition is postponed until settlement, avoiding immediate tax liabilities.
- Price Protection: A floor price limits downside exposure, while a cap price restricts upside participation.
- Counterparty Involvement: Typically structured with investment banks acting as counterparties, similar to secured lending.
- No Immediate Voting or Dividends: Shares are pledged, often suspending shareholder rights during the contract term.
How It Works
In a VPF contract, you pledge a block of your shares as collateral to an investment bank or counterparty and receive an upfront cash payment discounted for time and risk. This prepayment acts like a loan secured by your shares but avoids immediate sale treatment for tax purposes if properly structured.
At settlement, the number of shares or cash you deliver depends on the stock price relative to agreed floor and cap prices. If the stock price falls below the floor, you deliver more shares to cover the prepayment. If the price rises above the cap, you deliver fewer shares plus a cash payment reflecting gains above the cap. This variable delivery mechanism maintains your economic exposure while managing downside risk.
Examples and Use Cases
Variable prepaid forward contracts are popular among executives and investors seeking liquidity without triggering immediate taxes. Here are some practical examples:
- Airlines: Executives at Delta and American Airlines have used VPFs to monetize large stock holdings while deferring capital gains taxes.
- Index Funds: Investors holding broad market ETFs like SPY or IVV may use VPFs to access liquidity or hedge positions without immediate tax impact.
- Concentrated Stock Positions: Founders or employees of company stock often employ VPFs to diversify portfolios and reduce risk.
Important Considerations
While VPF contracts offer attractive tax deferral and liquidity benefits, they carry risks and complexities. Counterparty risk is significant, as your cash depends on the bank's solvency. Also, upside potential is limited by the cap, meaning you may forfeit gains above a certain price.
IRS scrutiny requires careful contract design to avoid triggering constructive sale rules, and rolling VPFs can be costly if the stock price drops sharply. Consulting tax and legal experts is essential before entering these agreements to navigate evolving regulations and ensure proper accounting treatment, such as in your T-account.
Final Words
Variable prepaid forward contracts offer a strategic way to access liquidity while deferring capital gains taxes on concentrated stock positions. Consider consulting a tax advisor to tailor a VPF structure that aligns with your financial goals and complies with IRS rules.
Frequently Asked Questions
A Variable Prepaid Forward contract lets shareholders receive immediate cash—usually 75-90% of their stock's current market value—while deferring capital gains taxes until a future settlement date. At settlement, they deliver a variable number of shares or cash based on the stock price.
VPFs are ideal for executives or investors with large, concentrated stock holdings who want liquidity to diversify without triggering immediate taxes. This strategy helps defer taxes while maintaining economic exposure to the stock.
At maturity, the number of shares or cash an investor delivers depends on the stock price relative to predefined floor and cap prices. If the price is below the floor, the investor delivers a fixed maximum number of shares; between floor and cap, shares are based on the prepayment divided by stock price; above the cap, fewer shares or cash equivalent are delivered.
Because no actual sale occurs at the contract's start, capital gains taxes are deferred until settlement when shares or cash are delivered. This structure, if properly designed, avoids IRS constructive sale rules, allowing tax deferral over the contract term.
Key terms include the upfront prepayment amount (usually 75-90% of stock value), the floor price that limits downside exposure, and the cap price that limits upside. The prepayment acts like a collateralized loan with shares pledged as security.
Properly structured VPF contracts avoid triggering taxable events upfront because no constructive sale occurs. However, rolling or terminating the contract prematurely without careful planning might cause taxable events.
The upfront payment is a discounted percentage of the current stock value, typically 75-90%, accounting for the contract duration and embedded risk. This prepayment provides immediate liquidity while deferring tax obligations.
If the stock price exceeds the cap, the investor delivers fewer shares or a cash equivalent equal to the prepayment plus any amount above the cap. This arrangement caps the upside delivered to the counterparty and adjusts final settlement accordingly.
