Variable Prepaid Forward Contracts: Selling Without Selling for Tax Purposes

An executive holds 50,000 shares of employer stock at $200, basis $25. She needs $6 million of cash for a house purchase but does not want to sell: the embedded gain would trigger $1.6 million of federal and state tax. A variable prepaid forward contract gives her $7 million in cash today against an agreement to deliver a variable number of her shares in three years. The number of shares depends on the stock price at settlement, with caps and floors that function like a collar.

No sale has happened yet. The IRS accepts that the forward is a financing transaction, not a sale, as long as the structure meets IRC §1259 safe harbors and avoids being treated as a constructive sale. The gain is deferred until the forward settles in three years. By then she can pay the contract off with other shares, roll to a new contract, or let the original shares settle at whatever the delivery schedule dictates.

The structure is one of the cleanest ways for a concentrated holder to raise cash without triggering immediate gain, but the pricing is tight and the execution window for safe-harbor compliance is narrow.

How the mechanics work

A variable prepaid forward (VPF) is a contract between the stockholder and a counterparty (usually an investment bank). The stockholder pledges a block of shares and receives a cash payment up front, typically 75% to 90% of the pledged shares’ current market value. The counterparty takes custody or a security interest in the pledged shares.

At settlement (typically two to five years later), the stockholder delivers a variable number of shares based on the stock price at that time:

• If the stock is below a “floor” price, the stockholder delivers all pledged shares.
• If the stock is above a “cap” price, the stockholder delivers fewer shares (because each share is worth more, fewer are needed to satisfy the contract).
• Between the floor and cap, the stockholder delivers a sliding number of shares.

The floor and cap together function like a collar. The stockholder has downside protection (cannot lose more than the floor) and capped upside (above the cap, the stockholder keeps any extra appreciation on the shares not delivered).

Why the IRS does not treat it as a sale today

IRC §1259 would treat a transaction as a constructive sale if the holder “substantially eliminated” risk of loss and opportunity for gain on the appreciated position. A VPF structured within safe harbor avoids this treatment by:

1. Preserving meaningful upside for the holder (the cap is set above the current price by a material margin).
2. Preserving meaningful downside risk (the floor is set below the current price).
3. Allowing settlement in cash or shares at the holder’s option (avoiding fixed-price delivery).
4. Staying outside the “pre-arranged” disposition patterns the IRS has challenged in published rulings.

The IRS issued Revenue Ruling 2003-7 addressing VPFs specifically, approving a common structure but imposing conditions. The ruling requires that the holder retain the ability to deliver different shares (not the pledged ones) at settlement and that the economic terms include genuine price variability.

Structures that hew closely to Rev. Rul. 2003-7 are generally respected as non-sale transactions. Structures that drift (overly tight collars, share-lending arrangements that transfer beneficial ownership, fixed delivery amounts) have been challenged. The IRS has won some challenges; the Anschutz case (United States v. Anschutz Corp., 135 T.C. 78 (2010)) is the leading adverse precedent and narrowed the safe ground.

Economic cost of the structure

The cash payment is not free money. The bank is essentially lending the cash and taking equity risk on the collar. The implicit financing cost is typically 5% to 9% annualized, embedded in the pricing of the collar and the discount to market value.

Components:

• Discount to current market: cash advance is 75-90% of the pledged shares’ value.
• Implicit interest: the bank earns a spread between its cost of capital and the effective rate.
• Option premiums: the floor (put protection) costs, the cap (call limit) funds some of that cost.
• Dealer margin: fees baked into the pricing.

For a three-year contract on a $10 million pledged position, typical economics might be: cash advance $8.5 million (85%), floor 90% of current, cap 125% of current, net implicit cost $600K-$900K over the three-year term.

Compare this to selling today: $10 million sale produces long-term gain taxed at 23.8% federal plus state. For a California holder with low basis, that’s roughly $3.5M of immediate tax. The VPF defers that $3.5M for three years, at a cost of $600K-$900K. Effective rate of deferral is roughly 7% per year on the deferred tax.

Comparison: VPF vs alternatives

Approach	Cash today	Tax today	Lockup	Downside protected	Upside retained
Outright sale	~76% of value (net of tax)	Full	None	Full (proceeds in cash)	None
VPF	75-90% of value	None	2-5 years	Yes, to floor	Yes, to cap
Margin loan	30-50% of value	None	On-demand callable	No	Yes, fully
SBLOC	30-50% of value	None	Callable	No	Yes, fully
Collar + SBLOC combo	Depends	None	Collar term	Yes	To cap

VPFs compete most directly with collar-plus-loan structures. The VPF consolidates the hedge and the financing into one contract, often with better pricing than assembling the pieces separately.

Section 16, 10b5-1, and insider issues

Executives subject to Section 16 of the Exchange Act must report VPF entries on Form 4. The Form 4 filing discloses the pledge, cap, floor, and settlement date, making the structure visible to the market. Some executives have faced reputational or disclosure blowback when Form 4 filings disclosed large VPF positions; the market sometimes reads them as a backdoor sale.

10b5-1 compliance is required for executives with material non-public information. VPFs should be executed through a 10b5-1 plan or during a clean window. The plan must be established at a time when the executive has no MNPI.

Company stock plans may have pledge restrictions. Pledging shares for a VPF requires company approval in many public-company stock plans. Check the plan agreement and any company-wide anti-pledging policy.

What settlement looks like

At contract maturity, the holder has options:

1. Deliver the pledged shares. Based on the stock price at settlement and the cap/floor, a variable number of shares flow to the counterparty. The shares delivered are sold by the counterparty (or held), and the gain is recognized at that time.

2. Deliver different shares. The holder can deliver other shares of the same stock (not the pledged ones). Useful if the pledged shares have higher basis than other lots the holder owns, or if the holder wants to keep specific lots.

3. Cash settle by paying off the contract. Requires buying back the exposure with cash. Rarely economically optimal but available.

4. Roll into a new VPF. Enter a new contract that covers the settlement obligation of the old one. Effectively continues the deferral.

Rolling indefinitely can extend deferral for many years. Some holders roll VPFs until death, at which point IRC §1014 steps up basis and the gain is never taxed. Whether rolling survives IRS scrutiny depends on the facts; consistent, arm’s-length rolls that reflect genuine economic choices are usually fine.

Frequently asked

What is the minimum position size? Most bank-dealer VPF desks require $5 million to $10 million of underlying stock. Some boutique providers go lower.

Can I enter a VPF on restricted or pre-IPO stock? Private-stock VPFs exist but are rare and pricing is much less favorable. The standard product is on liquid public stock.

What happens if the company is acquired before settlement? The contract typically provides for cash settlement based on the acquisition price. Specifics vary by contract.

Are VPFs subject to mark-to-market treatment? No, not for the holder. The contract is treated as an open transaction until settlement. The counterparty (a dealer) may have different treatment under its own tax regime.

How is basis allocated at settlement? The basis of the delivered shares is the basis of the specific lots identified as delivered. If the holder uses highest-basis lots to settle, the recognized gain is lower.

Next step

If you are considering a VPF, request indicative pricing from two or three dealer banks for your specific position and contract term. Compare the net economics (implicit financing cost plus opportunity cost of the upside cap) against the after-tax proceeds of an outright sale, a margin loan, and a collar-plus-SBLOC combination. Involve your tax counsel on the §1259 safe-harbor analysis before signing. For most executives, this is a once-or-twice-in-a-lifetime structure, so the advisory cost of getting it right is worth paying.