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US Court Strikes Down Stock Option Scheme

by Mike Godfrey, Tax-News.com, Washington

29 July 2010


A recent United States Tax Court ruling has attacked the basis of a scheme whereby many US company executives have, in the past, deferred the capital gains tax due on share options.

The scheme was based upon prepaid forward sale contracts, usually with a share lending transaction executed at the same time. The Internal Revenue Service has now challenged the whole arrangement, contending that it constitutes an immediate sale of the shares in question and that, therefore, capital gains accrued on the shares are subject to tax in the usual way. That view has now been upheld by the court.

Under the forward sale agreement, the taxpayer would normally receive up to 80% of the market value of shares sold to a bank, with completion of the transaction and physical transfer of the shares to be made at a future date, for example ten years later.

Taxpayers would treat the forward sales as remaining ‘open’, rather than ‘closed’, and therefore not declarable in their tax returns. It was believed that any tax due on capital gains on the shares would be deferred to that later date. This was of great value during the previous bull market when share options were usually of significant mark-to-market value.

Usually, the forward sale contract is accompanied by a simultaneous share lending agreement by which the taxpayer also lends the stock to the bank. The taxpayer thereby receives an additional return, while the bank is able to sell the shares short, or otherwise hedge its risk, over the period of the forward sale.

The case brought before the court involved the well-known US businessman, Philip Anschutz who, it was said, had previously invested in oil exploration and railroad companies, in which he had accrued substantial shareholdings. When he wished to invest in the real estate and entertainment sectors, he used a forward sale and share lending agreements to obtain the necessary funds on a non-taxable basis.

Although Anschutz had used an S corporation to hold the shares in his previous companies, this did not alter the fact that any tax liability would have been for his account. For federal tax purposes, such a corporation acts in a similar fashion to a partnership, in that its income is taxed at shareholder rather than corporate level. A shareholder reports his portion of the corporation’s income or loss on his individual tax return.

In analysing the agreements, the tax court found that the S corporation, and Anschutz, had effectively transferred the benefits and responsibilities of share ownership, including legal title to the shares; all risk of loss from falls in market value; a major portion of the opportunity to take advantage of future capital gains; the right to vote the shares; and their physical possession.

The court therefore decided that the two transactions taken together represented a closed sale of shares, and that the consequent capital gains should have been declared in Anschutz’s 2000 and 2001 tax returns.

While it is believed that Anschutz intends to make an appeal against the tax court’s ruling, the extent of the capital gains at risk from the ruling is currently unquantifiable. It is, however, known that the use of this scheme has been widespread, and the capital gains in question could run into billions of dollars.

There also remains some doubt whether a forward sale of shares, but without the share lending arrangement, would produce a similar court decision. It would appear to be the latter arrangement that triggered the court’s opinion that the scheme constituted a complete disposal of the shares, and there have been comments that a forward sale of shares by itself could remain, under the federal tax laws, an open transaction.

TAGS: individuals | court | capital gains tax (CGT) | compliance | tax | investment | tax compliance | law | equity investment | United States | individual income tax

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