Concentrated Stock Positions

One of the more enviable dilemmas in investing involves deciding how to deal with a large, concentrated stock position.  There are three possible choices – hold, sell, or hedge.  Each method has pros and cons, and determining the best solution depends highly upon the individual circumstances and related goals.  When designing such a strategy, there are several important things to consider – including tax implications, contractual obligations, employer mandates, legal requirements and psychological barriers.  The intricacies of these factors serve to emphasize the importance of consulting a team of advisors, tax-professionals and attorneys to formulate a strategy.

Holding the Position

Holding the position represents the easiest solution, simply because it requires zero action.  This tends to be a common choice, as many people prefer to “leave well enough alone”.  Doing nothing, however, is synonymous with accepting the increased risk that characterizes concentrated wealth, such as the risk of losing some or all due to inherent problems with the stock itself.  Shareholders of Enron, WorldCom, Lehman Brothers, Washington Mutual or General Motors would quickly attest to what a major stock collapse can do to a portfolio.  History has shown us that seemingly stable businesses with long operating histories can vanish overnight.  Investors who opt to retain concentrated positions are wise to be mindful of the potential risk involved.

Selling the Position

Selling the position, while nearly as simple as holding it, often comes with a very large tax bill.  Concentrated positions often result from the growth of a very successful investment; what this also means is that when these positions are sold, very high gains will be realized as well.

In 2013, the new 3.8% Medicare surtax on net investment income went into effect. This additional tax applies to single taxpayers with a Modified Adjusted Gross Income (MAGI) in excess of $200,000 ($250,000 for married filing jointly).  In many states, taxpayers also owe state taxes on realized gains.  Some states, however – such as California – do not have a special tax rate for capital gains and assess taxes at ordinary income rates.  This means that for top earning taxpayers, the top long-term capital gains rate in California may exceed 37%.  A California taxpayer with an income of over $250,000 can expect to pay about 30% in long-term capital gains taxes.  This consideration is further complicated by the step-up in basis that many investors receive at their death.  If an appreciated position is held until death, the spouse or other heirs will likely not pay any tax on the gains.  It is important to have accounts titled correctly and trust documents written to ensure the ability to capitalize upon this benefit.

One method of limiting taxes is to create a divestment plan.  An investor would structure a set amount of shares to sell each year based on current income until the desired amount of diversification is reached.  This strategy intends to keep an investor in the lowest possible tax bracket during the divestment period.  This method is well suited for young taxpayers with a long-term time horizon, as they are not likely to benefit from a step-up in basis.

It is important to remember that selling a position can be a difficult psychological task, especially when a position has been held for a long time.  Many investors choose to keep a small portion of the original investment simply for nostalgia as a result.

Hedging the Position

There are several methods of hedging a concentrated stock position.  They range from straightforward solutions – such as buying put options – to complex strategies involving irrevocable trusts and limited partnerships.  It is crucial to weigh the costs versus the benefits of the various strategies.

Simple Hedges

Simple hedges are created using publicly traded and liquid option contracts.  Custom strategies can limit the amount of money at risk of being lost if the stock declines in value.

One common strategy is called an Option Collar, which involves simultaneously selling a call option that limits the amount you can make should the stock rise rapidly and using the proceeds to buy a put option that limits the amount of money that you can lose should the stock decline rapidly.  The goal of the Option Collar is holding the stock long term without significantly jeopardizing the principal.  If the stock is held until death, then the entire cost basis is stepped up to the current value and the heirs can sell the stock without any capital gain taxes due.

A lesser known strategy is to sell put options against a diverse basket of stocks and use the proceeds to buy the protective put.  A diverse portfolio of stock puts has proven historically less volatile than the stock market.  The goal of such a strategy is to convert an investment with the risk of a concentrated portfolio into an investment with the risk of a diversified portfolio without realizing any taxable gain.  Additionally, this strategy does not limit the amount that can be gained should the stock continue to grow.  This solution is best for clients that believe the stock will continue to appreciate, yet who cannot necessarily afford the loss if the stock collapses.

Certain types of restricted stock may not be eligible for these types of hedging strategies.  These strategies are complex in nature and should only be implemented by professional option investors.

Exchange Funds

An Exchange Fund is an investment that is set up for the sole purpose of helping clients with concentrated portfolios to diversify while avoiding taxation.  The Exchange Fund consists of a private placement investment where shareholders deposit their concentrated stock in exchange for shares of the fund.  The fund is made up of stocks deposited by other investors in similar situations.  Some exchange funds have a date in the future when they will dissolve and distribute to each shareholder their percentage of the fund.  The investor now has a diversified basket of stocks with low cost basis instead of the original single stock.  The drawbacks of these funds are that they are illiquid, have long term commitments, and high fees.  Additionally, in order to maintain their legal status, 20% of their assets must be invested in “qualified” non-stocks or securities.  Most Exchange Funds use leverage to purchase illiquid real estate partnerships in order to satisfy this requirement.  Exchange Funds are typically only available to accredited investors.

Charitable Trusts

Charitable Trusts can be a useful solution for a concentrated stock position.  They offer tax benefits, retirement income and the opportunity to donate to a favorite charity.   In a Remainder Trust, an investor would deposit their concentrated asset, which can include stocks, bonds, real estate and privately held businesses.  The Trust then sells the asset(s) without tax consequence and can invest the proceeds into a diversified portfolio.  Investors receive an immediate income tax deduction and an annual income stream for life; upon death, the remainder goes to the charity or charities of choice.  The income stream can be for up to two people’s lives, such as a husband and wife.

There are two types of Charitable Remainder Trusts – Uni-Trusts and Annuity Trusts.  A Uni-Trust pays a fixed percentage of the year-end balance.  If the assets increase in value, the income will increase.  The corollary is true as well; if the assets decrease in value, the income will also decrease.  In an Annuity Trust, the donor receives a fixed dollar amount of income regardless of investment performance; it can never increase or decrease.  There is a lot of flexibility regarding the income stream and the deduction; it can be structured to favor either a higher income or a higher deduction.  This solution is particularly useful for older clients that prefer a steady stream of retirement income.

Conclusion

There are many ways to reduce the risk of concentrated positions.  It is not only important to weigh the many pros and cons of each solution, but also to work with your investment, legal and tax advisors to make educated and informed decisions.            

Important Disclosure: This content is for informational purposes only. Opinions expressed herein are subject to change without notice. Beacon Pointe has exercised all reasonable professional care in preparing this information. Some information may have been obtained from third-party sources we believe to be reliable; however, Beacon Pointe has not independently verified, or attested to, the accuracy or authenticity of the information. Nothing contained herein should be construed or relied upon as investment, legal or tax advice. Only private legal counsel may recommend the application of this general information to any particular situation or prepare an instrument chosen to implement the design discussed herein. An investor should consult with their financial professional before making any investment decisions.

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