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.