An Introduction to the Variable Prepaid Forward Contract
Stockholders may utilize a variable prepaid advance contract to cash in some or all of their shares while delaying paying capital gains taxes. The shareholder collects the money, but the selling deal needs to be formalized.
Investors who possess many shares in a single firm and want to raise money while deferring taxes sometimes use this method.
A Comprehensive Overview of Variable Prepaid Forward Contracts
An individual who has amassed a substantial quantity of business shares, such as a founder or senior executive, may need a variable prepaid forward contract. That individual may choose to raise a large sum of money, lock in gains in the stock, or diversify their concentrated assets.
This individual may sell the shares to a brokerage firm using a variable prepaid forward contract. Between 75% and 90% of the stock’s current value is given to the investor immediately, but the deal still needs to be completed. The capital gains tax is only owed once it is settled. At that point, the investor surrenders the shares or their cash equivalent at a predetermined price range to guard against a significant loss.
The practice is beneficial in several situations. For example, after receiving stock options, certain executives are not allowed to sell them for a predetermined time. Additionally, investors get uneasy if a corporate insider engages in a significant stock transaction. The variable prepaid forward contract skillfully avoids these difficulties.
The investor is also shielded against a significant loss if the stock increases significantly in value before the transaction is completed since the contract sets a floor and ceiling price for the ultimate transaction.
Undoubtedly, there is controversy around this practice, with some believing it ought to be outlawed.
Technically speaking, a collar strategy—a packaged long put and short call option on security—is what a prepaid variable forward contract is. However, it includes a third component: the transaction’s monetization via a loan secured by the underlying security. These tactics were initially highly complicated, but advances in financial engineering have made them more prevalent.
Of course, the IRS and financial media also take notice of them. The heir to Estée Lauder, Ronald Lauder, was “artfully sheltering” his remuneration via a prepaid variable forward contract, according to a 2011 front-page story in The New York Times. These tactics are often criticized since the CEO’s salary is sometimes higher than typical employee compensation.
Conclusion
- By using this tactic, a significant shareholder may profit while delaying paying capital gains taxes.
- The deal has yet to be sealed. For owners of stock options with a later exercise date, that is a benefit.
- The tactic is divisive and often attracts IRS attention.
