A Clever Tax Strategy May Backfire - New York Times is an impressive reporting job by Flloyd Norris. I can only vaguely understand this tax-avoidance strategy but, regardless, who could possibly symphathize with the hunters as opposed to the hunted?
The Strategy as Norris presents it:
An investor with a large block of stock does an options collar transaction, in which he buys a put option, giving him the right to sell the stock, and sells a call option, giving someone else the right to buy the stock from him. That protects him from major price declines, in return for giving up possible additional gains.
As long as there is a decent spread between the put and call exercise prices, leaving the investor with a chance for losses or profits, that is legal under the rules. Investors can get cash out by borrowing money secured by the stock. Then they can put the cash into other investments, like hedge funds, the current trendy investment for the wealthy.
In Wall Street jargon, the investor buys something called a prepaid variable forward contract that puts the whole transaction together.
This is popular because there are a lot of rich people with concentrated investments, including people who sold their family-run company to a publicly traded one and received stock. In many such cases, the tax basis of the stock is close to zero, so selling shares would mean paying tax on nearly all the proceeds. And you don’t get richer by paying taxes.
The strategy as described above is not challenged by the I.R.S. memorandum. The catch comes from the fact that the brokerage firm needs to hedge its exposure to a big drop in the price of the stock. It can do that by selling the stock short, but that means finding some stock to borrow, preferably from a lender who will not recall the shares at an inopportune time. So the contract may call for the customer to lend his shares. It makes things much easier.
But that, the I.R.S. memorandum states, is where the problem lies. As far as it is concerned, an investor who has given up most of the profit and loss potential and then lends out the shares has also given up the right to get the actual dividends, and risks losing the votes on the shares.
