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.

  1. Prepaid Credit Card

    A prepaid credit card is a secured card issued by a financial ...
  2. Current Index Value

    Current index value is the most current value for the underlying ...
  3. Short Date Forward

    A short date forward is an exchange contract involving parties ...
  4. Variable Cost-Plus Pricing

    Variable cost-plus pricing is a pricing method in which the selling ...
  5. Sensitivity Analysis

    Sensitivity analysis is a technique used to determine how different ...
  6. Forward Market

    A forward market is an over-the-counter marketplace that sets ...
Related Articles
  1. Personal Finance

    Prepaid 'Credit' Cards: Convenience at a Cost

    These cards offer convenience and security, but are they worth it?
  2. Personal Finance

    The Last States With Prepaid Tuition Plans

    Prepaid tuition could save you thousands of dollars and unwanted stress. Find out where you can still find them.
  3. Managing Wealth

    Variable Annuities: The Pros and Cons

    Variable annuities are one of the most complicated financial instruments—weighing the pros and cons.
  4. Investing

    4 Ways to Diversify a Concentrated Stock Position

    Owning too much stock concentrated in one company exposes an investor to significant risk. Learn four strategies to diversify and protect your portfolio.
  5. Investing

    Consider These Facts Before Choosing a Variable Annuity

    Variable annuities do have some benefits, but there are some disadvantages and misconceptions to take into account as well.
  6. Retirement

    Update Your Variable Annuity With Section 1035

    Thanks to a special tax code clause, you can surrender a variable annuity without paying income tax.
  7. Financial Advisor

    Life Insurance: Variable Vs. Variable Universal

    Do you know why you might need one policy versus the other? Read on to find out the difference between Variable and Variable Universal life insurance.
  8. Retirement

    How a Variable Annuity Works After Retirement

    These investments can provide extra income after you retire. Here’s a guide to when and how you will receive the payout.
  9. Retirement

    Variable Annuities: The Do-It-Yourself Pension Plan

    Variable annuities can cost more than mutual funds, but that might be worth the protection they can add to your retirement.
  1. How are prepaid expenses recorded on an income statement?

    Understand how prepaid expenses are recorded on a company's financial statements. Learn why a prepaid expense would be considered ... Read Answer >>
  2. Do production costs include all fixed and variable costs?

    Learn more about fixed and variable costs and how they affect production costs. Understanding how to graph these costs can ... Read Answer >>
  3. How do fixed costs and variable costs affect gross profit?

    Learn about the differences between fixed and variable costs and find out how they affect the calculation of gross profit ... Read Answer >>
  4. What is the Difference Between Variable Cost and Fixed Cost in Economics?

    Learn what total costs are comprised of, what variable costs and fixed costs are, and the main difference between them. Read Answer >>
Trading Center