What are 'Variable Prepaid Forward Contracts'

Variable prepaid forward contracts are investment strategies that allow a shareholder with a concentrated stock position to generate liquidity for diversification or other risk management purposes.

BREAKING DOWN 'Variable Prepaid Forward Contracts'

Variable prepaid forward contracts are often used by investors to lock in their profits and defer their taxes. In return for giving the stock to a brokerage company, the investor usually gets between 75% and 90% of the current value. So the investor receives cash now but doesn't actually have to account for the income until the official transfer is complete. Some think this should not be allowed because technically a transfer has occurred, and should, therefore, be recognized for tax and regulatory reasons.

Prepaid variable forward contracts are popular with corporate executives who often accumulate a substantial position in a company they've founded or led. Because a concentrated position posses risk to an executive, they often lack effective ways to diversify their wealth. Often they are prohibited from selling their shares, or at a minimum, it doesn't look good when they do. Especially during volatile periods.

The prepaid variable forward contract is an effective method to synthetically add diversification or pass the financial risk to another party. Technically, a prepaid variable forward contract is a collar strategy, which is a bundled long put option and short call option on a security, with a third element: the monetization of the transaction in the form of the loan against the underlying security. While once fairly sophisticated, these types of strategies are commonplace thanks to advancements in financial engineering.

Naturally, these types of strategies draw the attention of the IRS as well as financial journalists. The New York Times in 2011 ran a front-page feature highlighting how Ronald Lauder, the Estée Lauder cosmetics heir, was "artfully sheltering" his compensation through a prepaid variable forward contract. With executive pay at many multiples of the average employees' compensation level, these sort of strategies are popular targets for scrutiny.

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