IRVINE, Calif. — The Internal Revenue Service is threatening to bring more cases against wealthy investors who have used a popular technique to hedge concentrated stock holdings.
IRVINE, Calif. — The Internal Revenue Service is threatening to bring more cases against wealthy investors who have used a popular technique to hedge concentrated stock holdings.
The agency has reiterated a year-old warning that a type of stock collar known as a “variable prepaid forward contract” resulted in sale of the stock for tax purposes.
In a memo last month, the IRS encouraged its staff members to “develop these cases” and said: “We stand ready to assist you in the legal analysis.”
Under a prepaid forward arrangement, clients get cash upfront and contract with brokerage firms to deliver a variable number of shares or cash several years later, at which time taxes are due.
Last year, the IRS issued a technical-advice memorandum that challenged arrangements where the brokerage firm also borrows the client’s shares and shorts them as part of a hedge (InvestmentNews, May 8).
That kind of structure created a sale, the IRS said.
Wall Street has sold billions of dollars of these deals. If stock loans were involved, clients could owe taxes and possibly penalties.
The latest memo from the IRS “certainly removes any doubt from this issue,” said Robert Gordon, chief executive at Twenty-First Securities Corp. in New York, a boutique that uses hedging techniques for wealthy investors.
“It’s a nail in [the] coffin” for contracts that involved stock lending, he said.
Mr. Gordon said that since last year, when the IRS issued its first warning memo, the industry largely has stopped using share-lending agreements with clients.
The IRS didn’t respond to requests for comment.
Tough languageCritics seek clarity
Critics have blasted the IRS’ view that a contract to sell shares and a share-lending agreement is one transaction, which causes a constructive sale.
In a detailed letter to the IRS in November, New York-based law firm Skadden Arps Slate Meagher & Flom LLP, which represents industry interests, said that the IRS’ analysis is “vague and imprecisely articulated.”
Kenneth Gideon, a Skadden Arps partner in Washington, declined to comment.
Industry lawyers say that the IRS’ analysis contradicts a tax revenue ruling from 2003.
In its memo last month, the IRS shot back, Mr. Leeds said.
The agency called arguments from industry lawyers “specious” and “misdirected,” and said that viewing a sale-and-lending agreement separately “would be ignoring the economic realities of the transaction.”
Mr. Leeds said that the IRS is upset that the industry didn’t make clear the extent to which share lending was occurring when the agency took comments on its 2003 ruling.
Meanwhile, the IRS is looking into how the Street has structured prepaid forward contracts.
Mr. Leeds said that he represents some financial institutions that “have received very broad requests [from the IRS] for information on variable prepaid forward contracts.”
The agency summoned the information in connection with audits of the institutions’ clients, he said.
The largest requests for information started in August and have continued, Mr. Leeds said.
