Prepaid Variable Forward Contracts: McKelvey Postmortem, Common Misunderstandings, and Guidelines for Avoiding Issues

Concentrated equity hedging solutions like collars and prepaid variable forwards have gained in popularity in recent years, in part due to rising equity markets. These solutions create downside protection, allow for some upside appreciation, and, in the case of a prepaid forward, allow the investor to borrow against the hedged position at relatively low fixed rates all while potentially deferring taxes on the low-basis stock. Tax risk can be created if the investor removes too much of the risk of loss and opportunity for gain. Although the IRS never created a bright-line test, tax professionals often look at case law surrounding these solutions. One series of cases involves the estate of Andrew McKelvey. In tax circles, these cases are well known; however, the results are often misinterpreted. This paper seeks to clarify the implications of this case and offer guidelines and formulas to avoid tax issues.