How a prepaid variable forward works
- You sign a contract with a bank to deliver shares of a stock you own on a future date, commonly a few years out.
- The bank pays you cash today, typically about 75–90% of the position’s current value.
- You pledge the shares as collateral, and generally keep voting rights and dividends.
- At maturity you deliver a variable number of shares, or the equivalent cash, depending on the stock price. That is when the sale is taxed.
Terms vary by bank, stock, and market conditions. Prepaid variable forwards are executed by banks and broker-dealers, not by advisors.
The floor and the cap
Every prepaid variable forward sets two prices. Below the floor, you deliver all of the shares; you have already been paid, so a decline below the floor is the bank’s loss, not yours. Between the floor and the cap, you deliver fewer shares and keep the rest. Above the cap, your extra upside stops and the bank keeps the additional gain.
In effect, the contract combines a sale of the shares’ future value with a collar. The cash advance is priced off the floor, the cap, the term, interest rates, expected dividends, and the stock’s volatility.
A worked example
An executive owns 100,000 shares worth $100 each, a $10 million position with a very low cost basis. She enters a three-year prepaid variable forward with a $100 floor and a $130 cap, and receives an $8.5 million cash advance today.
| Stock price at maturity | Shares delivered | Shares she keeps | Value kept |
|---|---|---|---|
| $80 (below the floor) | 100,000 | 0 | $0 |
| $115 (between floor and cap) | 86,957 | 13,043 | about $1.5 million |
| $150 (above the cap) | 80,000 | 20,000 | $3.0 million |
Whatever happens, she keeps the $8.5 million advance. If the stock falls, she is protected below $100. If it rises, she keeps the gain only up to $130, so the most she can retain is $3 million of additional value. The capital gain is recognized when the contract settles, not when she receives the cash.
Hypothetical and simplified for illustration; the advance, floor, and cap are not quotes, and actual terms depend on the stock, term, and market conditions. Ignores dividends and transaction costs.
Why it isn’t taxed as a sale up front
Receiving most of a stock’s value in cash looks a lot like selling it. In Revenue Ruling 2003-7, the IRS concluded that a properly structured prepaid variable forward is not a current sale and is not a “constructive sale” under Section 1259. The arrangement in that ruling had these features:
- The number of shares to be delivered varied meaningfully with the stock price (from 80 to 100 shares per 100 pledged).
- The shareholder had an unrestricted right to settle in cash or with other shares instead of the pledged ones.
- The pledged shares were held by a third party, and the shareholder kept voting and dividend rights.
- The shareholder could use the cash advance without restriction.
The Anschutz trap
In Anschutz Co. v. Commissioner (Tax Court 2010, affirmed by the Tenth Circuit in 2011), prepaid variable forwards were paired with share-lending agreements that let the bank use the pledged shares. The court treated the arrangements as current sales, and the taxpayer had to recognize gain in the years it received the upfront cash. Structure and documentation matter as much as the economics.
Prepaid variable forwards can also be subject to the tax straddle rules, which may require interest and carrying costs to be capitalized rather than deducted. Gain is generally recognized at settlement, and the character of that gain depends on your holding period in the shares delivered.
Sitting on a concentrated position?
We’ll compare a prepaid variable forward against selling, collars, exchange funds, and charitable strategies for your position, and coordinate with your tax counsel and the executing bank.
Schedule a call →Considerations for executives and insiders
- Company policy first. Many public companies prohibit officers and directors from hedging or pledging company stock. Check the insider trading and hedging policy before anything else.
- Securities rules. Insiders typically need to trade in an open window or under a Rule 10b5-1 plan, and directors and officers generally report the transaction publicly on Form 4. Restricted or control stock may involve Rule 144.
- Position size. Banks generally offer these contracts only on liquid stocks and meaningful positions, often several million dollars or more.
Costs and risks
- Embedded cost. There is usually no separate fee; the bank’s compensation is built into the advance, floor, and cap. Comparing quotes from more than one bank helps.
- Capped upside. Gains above the cap belong to the bank.
- Hard to unwind or change. Ending early is possible but can be expensive, and in Estate of McKelvey (2d Cir. 2018) extending existing contracts was treated as triggering tax.
- Counterparty exposure. You rely on the bank to perform at maturity.
- Tax is deferred, not avoided. The gain is recognized at settlement. Plan where that cash and that tax bill will come from.
Alternatives to compare
| Strategy | Cash now | Tax on gain |
|---|---|---|
| Sell shares over time | Gradual | Paid as you sell |
| Prepaid variable forward | Most of the value | Deferred to settlement |
| Collar plus a loan against the shares | Depends on loan size | Deferred while shares are held |
| Exchange fund | None; diversifies instead | Deferred |
| Charitable remainder trust | Income stream | Spread over time; charitable deduction |
See our concentrated stock strategies for a fuller comparison, and lending and liquidity strategies for borrowing against a position.
Frequently asked questions
What is a prepaid variable forward contract?
A prepaid variable forward is a contract in which a shareholder agrees to deliver a variable number of shares, or the equivalent cash, to a bank on a future date in exchange for a cash payment today, typically about 75% to 90% of the shares’ current value. The shareholder is protected below a floor price and keeps upside only up to a cap.
Is a prepaid variable forward taxable when you enter it?
Generally not, if it is structured like the arrangement in IRS Revenue Ruling 2003-7, where the number of shares delivered varied significantly with the stock price and the shareholder could settle in cash or other shares. Gain is then recognized when the contract settles. Pairing the contract with a share-lending agreement caused immediate sale treatment in the Anschutz case.
How much cash do you get from a prepaid variable forward?
Banks typically advance about 75% to 90% of the position’s current value. The exact amount depends on the floor and cap, the term, interest rates, expected dividends, and the stock’s volatility.
What happens when a prepaid variable forward matures?
You deliver shares or cash based on the stock price. Below the floor you deliver all the shares; between the floor and the cap you deliver fewer and keep the rest; above the cap the extra gain goes to the bank. The capital gain on the shares delivered is generally taxed at settlement.
Can corporate executives use a prepaid variable forward?
Sometimes. Many companies prohibit officers and directors from hedging or pledging company stock. Where allowed, insiders usually need to act in an open trading window or under a Rule 10b5-1 plan and report the transaction publicly.