If your uncle, best friend, or bank lends you money, is it taxable? No, not if it’s a real loan. But the distinction between loan and income puts many people in trouble with the IRS. Also, interest rates on subprime loans such as litigation finance and pre-IPOs are high, and you may not be able to deduct the interest. Worse yet, if a loan is canceled, even a non-recourse loan, it is called Debt Income Cancellation (COD). The tax code says not having to pay off a loan is like cash. How about a sale? If you receive money for selling your shares or awarding half of your expected collection in court, that is income. Can you get money up front that is not a loan, but also is not income when you receive it? The answer to this conundrum is yes, with a variable prepaid futures contract. Since the transaction is a sale, you can assume that it is taxed now.
However, a variable contract leaves open how much money (proceeds of sale of shares, proceeds of lawsuit, etc.) the seller owes later remit to the funder. The amount is uncertain because the calculation formula usually depends on facts that will not be known until the proceeds have actually been paid. When you sign a prepaid futures contract and receive money, you are entering into a contract to sell a portion of the proceeds from your sale of shares. or receivership later. A futures contract requires a to come up to sell. During the time between signing and closing of the sale, the initial money is like a tax free deposit. If a prepaid futures contract meets certain requirements, it provides liquidity to the seller without immediate tax, just like a loan. However, getting the right documentation is essential. You don’t want to enter into a futures contract, pay a high return to a funder and find out you have to pay taxes now.
You also don’t want to learn later that you can’t deduct a large product payment to the funder, or somehow offset it with the income from the transaction that generated the product. A prepaid futures contract can involve the sale of stocks or other assets. It may involve the assignment of part or all of a lawsuit or its proceeds. Many models of fact are possible with share sales or litigation financing. But tax issues are nuanced and can be confusing. A traditional futures contract says that the buyer agrees to buy a fixed amount of goods at a fixed price, with payment and delivery to take place on a fixed future date. A “prepaid” futures contract requires the buyer to pay when the parties enter into the contract (as opposed to the date of delivery). Taxpayers who sign a futures contract to sell property in the future are generally not considered to have sold the property. The contract remains open, as an option, until it is sold, settled or expires.
The money changes hands, but there should be no immediate taxable event for the seller if the future sale involves a variable amount of revenue. Until closing, it is not possible to determine how the down payments should be reported. The primary tax authority for the IRS is Revenue Ruling 2003-7, 2003-5 IRB 1, where the IRS approved open trade processing for a prepaid variable futures contract involving the sale of shares. The IRS said no pending sale took place when a shareholder (1) received a fixed amount of cash, (2) simultaneously entered into an agreement to deliver a number of shares at a future date. which varied considerably depending on the value of the shares on the date of delivery, (3) pledged the maximum number of shares whose delivery could be required under the agreement, (4) was entitled unlimited legal right to deliver the pledged shares or to substitute cash or other shares for the pledged shares on the delivery date, and (5) was not economically compelled to deliver the pledged shares.
Sale of shares? Suppose Sam enters into a prepaid futures contract to sell stock, receiving $ 100 as an advance. Later, Sam must deliver shares in a variable formula, or cash equivalent value. If Sam is physically delivering shares upon settlement, Sam will recognize the gain or loss based on the difference between $ 100 and the basis of the shares Sam is delivering. If Sam delivers cash, Sam’s gain or loss is based on the difference between $ 100 and the payment made to settle the contract.
Proceeds of the trial? Suppose the plaintiff in a lawsuit enters into a contract to sell to F, a funder of the litigation, 50% of any proceeds he recovers in the case. F pays the plaintiff the purchase price ($ 100), which could fund legal fees. Two years later, the plaintiff settled his case for $ 500. The plaintiff orders the defendant to pay F $ 250 for his part of the matter under the contract.
Prepaid futures are legitimate ways to generate cash in a tax-efficient manner. They are popular in both litigation financing and stock trading. Transactions that closely follow the model set out in Tax Decision 2003-7 are best where you can. After all, the IRS doesn’t really like open transactions where people get money now but don’t pay taxes until later. This means that you have to be careful with your documents. Ideally, get tax advice before signing and also at tax time.