Late last year, Jim Woodward, CFO of construction-equipment maker JLG Industries Inc., wanted to diversify his company stock holdings — without triggering income tax. So he bought what's known as a prepaid variable forward sale. The contract gave him cash in exchange for $862,400 worth of shares in the McConnellsburg, Pennsylvania-based company, allowing Woodward to invest in other assets while deferring tax on his capital gain until June 1, 2007.
The use of such exotic-sounding derivatives contracts has soared during the past five years. According to Thomson Financial, the number and value of registered prepaid forward contracts have climbed from 8 transactions worth $392 million in 2000 to 185 valued at $9 billion last year.
A new Internal Revenue Service opinion could reverse this trend in a hurry. In a technical-advice memorandum, the IRS states that these transactions are taxable if the executive lends company shares to the entity that arranges the deal. As it turns out, these entities — banks or other financial institutions — typically sell the stock short to hedge their own exposure. In other words, they sell shares borrowed from — who else? — the original executive in the transaction.
Such "share-lending," the IRS maintains, disqualifies the executives from deferring taxes — an about- face that could expose them to capital-gains taxes. Soon, writes Lehman Brothers tax expert Robert Willens in a research report, buyers of these contracts "may be in for a rude awakening." Many executives may be scrambling for an alternative way to diversify — and defer taxes.
A Larger, Looming Question
IRS retribution isn't the only problem facing prepaid variable forwards. Some financial planners contend that the use of such contracts to defer tax may be misguided altogether. In light of the federal budget deficit and uncertain economy, they predict that the rate on capital gains, currently 15 percent, will more likely rise than fall by the time typical contracts expire in two to five years. "The capital gains tax rate is low," notes David S. Rhine, regional director of family wealth planning for Sagemark Consulting, a division of Chicago-based insurer Lincoln National Advisors Corp. As a result, Rhine says executives who want to diversify may be better off selling outright and paying capital gains tax now.
Shareholders aren't too keen on the instruments either. From their standpoint, divestiture through forward sales is "not very desirable," notes Myrna Hellerman, a compensation expert with New York–based Sibson Consulting. Given that the Securities and Exchange Commission now requires that such transactions be disclosed in the same way as outright sales, forward sales can't be kept out of public view, and may trigger downward pressure on the stock. Consequently, says Rhine, "you've got to be aware of the risks involved, including unfavorable publicity."
Such disclosure also raises the larger issue of whether finance executives should be diversifying out of their company stock in the first place (see "Passing the Sell Test" at the end of this article). While option grants have been losing ground to restricted stock recently, a growing number of companies require top managers to keep a specified portion of their compensation tied up in company stock. To shareholders, "it's wise to get top executives heavily burdened with company stock for reliably long periods," says Jeff Lancaster, a principal and financial planner with California-based Bingham, Osborn & Scarborough LLC.
Of course, heavy exposure in any one stock is not prudent investment strategy, which is one reason forward sales caught on so quickly. Studies show that most top executives sell rather than buy their firm's stock when they exercise their options. That's smart, as long as their holdings don't fall below any holding requirements. "Even Bill Gates sells [Microsoft] stock," says Rhine. "Is diversification a sign of disloyalty? Not if you adequately explain it."
No Solid Alternative
No matter how executives explain them, prepaid forward sales may not be a diversification option much longer. In Willens's view, the IRS ruling essentially signals the death knell for such contracts.
So what should executives with large concentrations of one stock do to diversify and avoid, or at least defer, taxes? Personal-finance experts recommend the following alternatives, though each, as Lancaster notes, has its drawbacks:
Exchange funds. These funds allow you to defer tax by exchanging a position in a single stock with one in a basket of others. Buyers may find the basket insufficiently diverse, simply because there aren't enough shares available except in the largest firms. The annual fees required can also be steep, typically running about 2 percent of assets every year (despite very little if any ongoing portfolio management).
Equity collars. The use of an equity collar compensates a stock owner for a decline in price beneath a specified level. The cost can be high if the collar must be kept in place for long, so they may be ineffective for anything but maintaining a position in a stock long enough (that is, less than 12 months) to convert the proceeds of a sale from ordinary income to a capital gain.
Another consideration is that the owner gives up any right to appreciation above a specified level. As a result, notes Lancaster, "many executives simply hope the price goes sideways for quite some time." Thanks to a 1997 IRS ruling, this device may also not defer tax if you give up "substantially" all of any subsequent gain or have "substantially" nothing at risk. The IRS has promised for years to define what "substantially" means here, but has failed to issue formal guidance. In response, tax experts recommend that the strike price for the puts and calls involved in the collar be set at least 10 percent above and below the price of the stock at the time of the transaction. The IRS has told tax practitioners that such a strike price for "out of the money" puts and calls is acceptable, but there's no assurance that the agency won't change its mind, as it seems to have done with prepaid forward sales.
Charitable remainder annuity trusts. With such a trust, you donate stock to a charity and get a stream of income based on its value, potentially for as long as you live. While you get a deduction for the donation, based on the amount that the charity is estimated to end up with when you die, the money you receive from the trust before then is generally taxable as current income, and that must represent at least 5 percent of the assets' initial value. Since the gift is irrevocable, such a trust isn't appropriate if you can't afford large donations.
There is one other alternative, of course: sell and pay the taxes.
Ronald Fink is a deputy editor of CFO.
Passing the Sell Test
The IRS's attack on prepaid variable forward contracts underscores a quandary facing CFOs: how to act in shareholders' best interest without harming their own portfolios.
The standard advice is to set up a formal plan to sell a specified number of shares at regular intervals. As with any insider sale, that requires a number of Securities and Exchange Commission disclosures. Jeff Lancaster, a principal and financial planner with California-based Bingham, Osborn & Scarborough LLC, notes that those disclosures provide ample opportunity to explain one's reasons for selling and the circumstances under which the transactions will take place. There are a number of restrictions on such sales, however, so it's necessary to consult a securities lawyer when establishing such a plan.
As for the tax consequences, Lancaster says that most of his clients have come around to the view that capital gains rates have nowhere to go but up. But while he notes that those with heavy exposure to a single company know they should diversify, he has difficulty convincing them to do so, partly because of the lack of alternatives. David S. Rhine, regional director of family wealth planning for Sagemark Consulting, recommends life insurance, because tax deferral adds smartly to its return and that benefit has long survived challenges from political opponents in Washington, D.C. — R.F.