United States: A Ring Around the Collar - IRS Approves Mechanism to Lock in Stock Profits and Obtain Liquidity - All Without Triggering a Taxable Sale

Originally published December 3, 2004

Suppose you sell or exchange your appreciated low basis privately-held company stock for equivalent publicly traded stock in a "tax-free reorganization," but for various reasons you do not want to sell the publicly traded stock in your current tax year. Would you like to be able to obtain cash from the appreciated public stock without borrowing or selling the stock and paying taxes currently, retain the ability to benefit from a range of further appreciation in the stock, and still substantially eliminate the risk of suffering from a decline in stock value? If the publicly traded stock is otherwise freely tradable, you may be able to enter into a hedge transaction allowing you to meet those goals. In order for such a transaction not to be treated as a sale for federal income tax purposes, you must retain voting rights, dividend rights, and participation in the publicly traded stock appreciation. Moreover, you must have the contractual and financial capacity to use assets, other than the stock in question, to repay the cash you receive in the hedging transaction.

The Tax Relief Act of 1997 (the "1997 Tax Act") added Section 1259 to the Internal Revenue Code of 1986 as amended. Section 1259 treats as constructive sales most transactions under which you lock in gain by eliminating both your ability to benefit from an increase in stock value and the possibility of suffering a decline in stock value. A transaction that eliminates only your downside risk or upside potential in stock does not fall within Section 1259. For that reason, a put option to sell stock at a fixed price, for example, the current fair market value, is not treated as a constructive sale. While the put option may eliminate the downside risk, the put option does not eliminate the chance for upside in the stock.

The Senate Committee Report to the 1997 Tax Act provided that:

" It is anticipated that the Treasury regulations, when issued, will provide specific standards for determining whether several common transactions will be treated as constructive sales. One such transaction is a "collar." In a collar, a taxpayer commits to an option requiring him to sell a financial position at a fixed price (the "call strike price") and has the right to have his position purchased at a lower fixed price (the "put strike price"). For example, a shareholder may enter into a collar for a stock currently trading at $100 with a put strike price of $95 and a call strike price of $110. The effect of the transaction is that the seller has transferred the rights to all gain above the $110 call strike price and all loss below the $95 put strike price; the seller has retained all risk of loss and opportunity for gain in the range price between $95 and $110. A collar can be a single contract or can be effected by using a combination of put and call options.

In order to determine whether collars have substantially the same effect as the transactions specified in the provision, it is anticipated that Treasury regulations will provide specific standards that take into account various factors with respect to the appreciated financial position, including its volatility. Similarly, it is expected that several aspects of the collar transaction will be relevant, including the spread between the put and call prices, the period of the transaction, and the extent to which the taxpayer retains the right to periodic payments on the appreciated financial position (e.g., the dividends on collared stock). The Committee expects that the Treasury regulations with respect to collars will be applied prospectively, except in cases to prevent abuse."

The conference report provides that, except in cases to prevent abuse, the regulations with respect to collars will be applied prospectively. Although the Treasury Department has yet to issue regulations regarding collars, substantial guidance regarding collars was provided by the IRS in Revenue Ruling 2003-7, I.R.B. 2003-5.

In that ruling the taxpayer held publicly traded stock with a fair market value of $20. On September 15, 2002, the taxpayer entered into an arms-length agreement with an investment bank, received $z and became obligated to deliver between 80 and 100 shares to the bank on September 15, 2005 (the "Exchange Date"). There was no restriction on the taxpayer’s use of the $z. The exact number of shares to be delivered to the investment bank depended on a formula, and varied between 80 and 100, depending on the stock value on the Exchange Date. For example:

• To the extent the market price of the stock was less than $20 on September 15, 2005, the taxpayer was obligated to deliver 100 share of the stock;
• If the market value of the stock exceeded $25 on the exchange date, the taxpayer was obligated to deliver 80 shares; or
• If the market price was between $20 and $25, the taxpayer was obligated to deliver shares worth $2,000.

To secure the taxpayer’s obligations to the investment bank, the taxpayer pledged to a third party trustee unrelated to the investment bank the maximum amount of shares (i.e., 100) that would have to be delivered under the transaction. The taxpayer retained the voting and dividend rights with respect to the pledged shares. Under the arrangement, the taxpayer had the right on the Exchange Date to deliver the pledged shares, cash or other unpledged shares to satisfy the taxpayer’s obligation to the investment bank. The taxpayer also possessed the resources to satisfy its obligation using any one of those alternatives.

Based on these facts, the IRS concluded that the taxpayer had not made a constructive sale of the pledged shares, despite the taxpayer’s unfettered right to use the $z received in the transaction.

A properly structured borrowing and collar is one mechanism that can provide you with substantial liquidity for your appreciated stock without triggering a gain for income tax purposes. Because of the risks inherent in an improperly structured collar transaction, these transactions require careful planning and document review.

This article is intended to provide information on recent legal developments. It should not be construed as legal advice or legal opinion on specific facts. Pursuant to applicable Rules of Professional Conduct, it may constitute advertising.