A prepaid variable forward contract lets you receive a large cash payment today in exchange for agreeing to deliver a variable number of shares, or their cash value, at a future date. Done correctly, it gives you liquidity and downside protection now while the taxable sale is deferred until the contract settles.
How the contract works
You agree with a bank dealer to deliver shares at maturity, often two to five years out. In return the dealer pays you a substantial portion of the shares’ current value up front. You pledge the shares to the dealer as collateral for the term.
The number of shares you deliver at maturity depends on the stock price then. That variable delivery is what gives the contract its name and most of its economics.
- Below a floor price, you deliver all the pledged shares. Your downside below the floor belongs to the dealer.
- Between the floor and a cap, you deliver fewer shares as the price rises, keeping the appreciation in that range.
- Above the cap, you keep only a fixed slice of shares and give up further gains.
Economically, this is a collar plus a loan wrapped into one contract. The equity collar structure sets the floor and cap, and the prepayment is roughly the discounted value of the floor.
Why the up-front payment is less than the stock’s value
The prepayment is not the market value of the shares. It reflects the floor price, discounted for the time until maturity at the dealer’s financing rate, and reduced further for the dealer’s hedging costs and spread.
Dividends matter too. If the stock pays them, the contract usually either passes them through or prices them in, which changes the prepayment. Ask each dealer to show how the advance is built so offers can be compared on the same terms.
The width of the band matters as well. A higher cap lets you keep more upside but generally reduces the advance, because the dealer is giving away more. A lower floor raises your exposure to a decline but can be traded for a wider band. These are the same trade-offs as in any collar, with the prepayment added on top.
A worked illustration
Suppose you hold shares worth $10 million at today’s price, with a very low basis. You enter a three-year contract with a floor at today’s price and a cap meaningfully above it. The dealer prepays a large share of the floor value in cash at signing, after discounting for three years of financing and its spread.
At maturity, three outcomes are possible. If the stock has fallen below the floor, you deliver all the pledged shares and keep the cash, so the decline is the dealer’s problem. If it has risen into the band, you deliver fewer shares and keep the rest. If it has risen above the cap, you keep a fixed number of shares and the dealer takes the gains beyond it.
In every case, you had the cash for three years, and the taxable sale happened at maturity rather than at signing. The numbers are illustrative only; actual advances depend on rates, volatility and dividends at the time.
Why it is not a sale for tax purposes
The tax case for these contracts rests largely on Revenue Ruling 2003-7. The IRS concluded there that a prepaid forward with a pledge of shares was not a current sale and not a constructive sale, because the number of shares to be delivered varied significantly and the shareholder kept the right to settle with cash or other shares.
The ruling is narrow. Its conclusions depend on the facts it described, and departures from those facts invite a different answer. Contracts are therefore drafted to track the ruling closely, and tax counsel should review the final terms against it.
When the contract settles, the sale is recognized. The gain is measured using your basis in the delivered shares and the amount realized, which generally includes the original prepayment. Whether that gain is long-term depends on your holding period, which the straddle rules can affect, as covered in the article on collar taxation and holding periods.
Where these contracts have gone wrong
Lending the pledged shares
In the Anschutz litigation, the contract was paired with a share lending arrangement that gave the dealer use of the pledged stock. The courts treated the combination as a current sale of the shares, and the deferral was lost. The lesson is that the pledge must be a pledge, not a transfer of the shares’ benefits and burdens.
Extending the contract
In the McKelvey estate case, a federal appeals court held that extending existing contracts was itself a taxable event. Extending maturity is a natural thing to want when the stock moves, so any extension or restructuring should be treated as a new tax decision.
Who uses them, and what to check first
These contracts suit holders of large, liquid public positions who want cash now and are willing to defer the sale. Common uses include funding a diversified portfolio, paying for a home, or seeding other investments while waiting for a better tax year.
Before engaging a dealer, confirm the basics:
- Your company’s insider policy allows hedging and pledging. Many prohibit both for officers and directors.
- The shares are freely tradable or can be delivered in compliance with Rule 144.
- You have a plan for the cash. The advance is not taxable income, but losing it to poor investments still leaves the delivery obligation.
- You understand the settlement. If you plan to deliver shares, those shares stay pledged and unavailable for the whole term.
It also helps to compare against simply selling in stages. A tax-budget approach to diversification sometimes gets most of the risk reduction at lower cost and with far less complexity.
The bottom line on the prepaid variable forward contract
A prepaid variable forward contract converts a concentrated position into cash and a hedge today, with the sale and its tax deferred to maturity. That deferral rests on a narrow ruling and on clean execution. Keep the structure close to the ruling, avoid share lending, treat extensions as taxable decisions, and have a CPA and tax counsel model the settlement before you sign.
Is the up-front payment taxable?
Generally not when received. Under the IRS’s published position, a properly structured contract is an open transaction, and the gain is recognized when the contract settles.
How much cash can I get up front?
Usually a substantial share of the current value, but less than all of it. The advance reflects the floor price discounted for time, plus the dealer’s costs and spread.
Can I extend the contract when it matures?
Sometimes, but an extension can be treated as a taxable event in its own right. Treat any extension as a new tax decision and get advice before agreeing to one.
How is this different from a loan against the stock?
A loan leaves you fully exposed to the stock and must be repaid in cash. This contract includes downside protection and is settled by delivering shares or their value, with the upside capped.
This article is for general educational purposes only and is not tax, legal, or investment advice. Equity-compensation and wealth-planning rules are complex and depend on your specific situation; consult a qualified tax professional or financial advisor before acting.
