U.S. News

U.S. Wonders if Stock Deal Is Tax Abuse

Lynnley Browning|The New York Times

A strategy that corporate executives routinely use to turn their stockholdings into cash while delaying payment of taxes is coming under increased scrutiny by the Internal Revenue Service.

The agency, in a technical paper issued last week, said the strategy, which has the goal of deferring the payment of federal income tax for many years, might have some features of a questionable tax shelter.

While the I.R.S. stopped short of labeling the strategy an abusive tax shelter, it instructed its field agents, appeals officers, examiners and lawyers to pay close attention to the returns of wealthy people who use it.

It also said that if it found tax violations, it would consider levying the same hefty penalties that now apply to buyers of abusive shelters. Those penalties are 20 to 30 percent of the underreported tax.

The strategy, known as a variable prepaid forward contract, is one of the most widely used in corporate America. The unpaid taxes associated with it are likely to total billions of dollars a year, according to Robert Willens, a corporate tax consultant in New York.

The strategy comes into play when an executive holding a large amount of publicly traded stock that has gained in value wants to turn that stock into cash, but not immediately pay the capital gains taxes that apply when the stock is sold.

Instead, the executive agrees at a future date to sell a chunk of the stock to an investment bank, in exchange for an immediate cash payout. The executive pays the taxes on the stock when he actually turns over the shares to the bank, typically many years later.

To protect itself against potential losses should the pledged stock fall in value, the bank then hedges its bet by borrowing the pledged shares from the executive and selling them short, betting that they will fall in price.

The executives and banks argue that the shares are technically borrowed by the bank, not sold to it, and that the transaction is thus not a sale resulting in a cash payment that is immediately subject to taxation..

The I.R.S. disagrees.

The bank gets “all the benefits and burdens of ownership in the pledged shares,” making it a true sale and thus taxable to the executive, according to the technical paper, which is dated Feb. 6 and was published by Tax Analysts, a trade publication, on Friday.

The I.R.S. paper also instructs agency employees to determine if the strategies are “reportable transactions,” technical language that can refer to an abusive tax shelter.

Reportable transactions are characterized by, among other things, confidentiality agreements between the taxpayer and the bank or accounting firm that carried out the transaction, and by fees based on the amount of tax to be saved or deferred. Unlike “listed transactions,” they can be legal, but under stiffer 2004 rules aimed at combating tax shelter abuses, taxpayers still have to disclose their use to the I.R.S.

The matter does not appear to involve any violations of securities laws or any of the offshore tax components that are under heightened I.R.S. scrutiny.

Wall Street banks entered into scores of the transactions with executives in recent years, according to Mark H. Leeds, a tax lawyer at Greenberg Traurig in New York.

Mr. Willens, the corporate tax consultant, said executives liked the strategy because it allowed them to diversify their investments by taking large quantities of stock in a single company, converting the shares to cash and then buying other stocks, while delaying payment of taxes associated with the sale. “This is the most popular deferral technique that exists,” he said.

But some users are able to reduce taxes as well as defer them, and that may be upsetting the I.R.S. Mr. Leeds said that some executives, by carrying out the transactions through partnerships and the like, could be avoiding payment of ordinary income tax, at rates of 35 percent.

In 2003, apparently unaware that an increasing number of the prepaid forward contracts involved share lending, the I.R.S. declared them valid.

But by 2006, when it had started to figure out how the transactions work, it issued a memorandum saying that they were not.

“I think that it is fair to say that the I.R.S. has had buyer’s remorse over its original ruling for some time,” Mr. Leeds said. He said the agency was asking banks about how the transactions worked, though he would not identify the banks.

The I.R.S. declined to comment.