Learn how to limit risk and save taxes when diversifying a concentrated stock position.
- A portfolio that is top-heavy in one security poses tremendous downside risk, so it’s critical to employ diversification strategies.
- These strategies can help an investor hedge, monetize, and diversify out of a concentrated equity position while deferring capital gains tax.
- Each strategy has advantages and disadvantages, and selecting the right one for you should involve careful planning with your financial, tax, and legal advisors.
Many corporate executives, directors, and officers, especially those of fast-growing companies, find themselves in a quandary these days. If they own millions of shares in those companies, their net worth can be substantial. So what’s the downside?
A portfolio that is top-heavy in one security poses tremendous downside risk. How, then, can an executive diversify his or her portfolio in the most effective, tax efficient manner?
Here is a brief look at some single-stock diversification strategies to help an investor achieve three goals – to hedge, monetize, and diversify out of a concentrated equity position while deferring capital gains tax.
Collars are types of hedging strategies used to limit the price risk of a stock and permit the investor to participate in further appreciation, up to a specific price. A collar also allows an investor to monetize— that is, borrow against— a concentrated equity position.
One well-known type of collar is the zero-premium collar, or zero-cost collar. With this approach, “put options” provide protection from a price decline below a specified price, and “call options” provide appreciation potential, up to a specified price. A “put” is a contract that gives an investor the right, but not the obligation, to sell a certain number of shares at a specified price until a certain date. A “call” gives its holder the right, but not the obligation, to buy a specific number of shares of stock at a predetermined price, until a certain date.
For example, if a stock is trading at $100, an investor could simultaneously buy a put option at $90 and sell a call option at $125. The call strike price is set so that the premium received for the call option will match and, therefore, cover, the cost of the premium that the investor must pay to purchase the put option; hence the term “zero-premium collar.” The strike price is the price at which the owner of a call can buy the underlying stock or the owner of a put can sell the underlying stock.
In this scenario, if the collar were to expire, say, after three years, the investor would have a floor price of $90, while enjoying a potential price rise to $125 during a 36-month period.
Another kind of collar is the “income-producing collar.” It is similar to the zero-premium collar, except that it generates income to defray the cost of borrowing against the value of the stock. With an income-producing collar, the net premium received from the sale of a call option after covering the cost of the put option is available for payment to the investor.
Pre-paid forward sale
A pre-paid forward sale may be helpful for investors who wish to create tax-deferred liquidity from a concentrated stock position. Like collars, pre-paid forward sales involve the purchase of a put and the sale of a call. The difference, however, is that the put option is usually set at a higher level to allow for greater monetization of an equity position and, thus, to maximize liquidity.
A pre-paid forward sale is usually a privately negotiated contract with a counter-party in which an investor receives a tax-deferred, interest-free, up-front payment of up to 90 percent of the value of his or her stock, in exchange for selling forward a number of his or her shares. At maturity, the investor will have the option of settling the contract by delivering stock or cash.
Both collars and pre-paid forward sales offer many benefits. In addition to those already mentioned, investors also retain control of their shares, receive dividends, and have the possibility of deferring taxes.
The goal of an exchange fund is to allow an investor to shift from a concentrated position to a diversified position without triggering capital gains tax, as would be the case if the investor simply sold shares.
An exchange fund works in a straight forward way: Investors contribute stock to a limited partnership or limited liability corporation. In return, they receive partnership units in exchange for their contributed shares, which gives them a shared ownership of all securities in the fund. To avoid registration with the Securities and Exchange Commission (SEC), exchange funds are offered only to “qualified purchasers” with a net worth of at least $1 million.
Exchange funds are offered by many major brokerage firms, fund companies, money managers, and banks. Portfolio managers oversee the funds and decide what assets to hold. Hence, not all shares that are offered are accepted.
Portfolio construction is important because the manager will avoid selling contributed shares for the life of the fund in order to preserve the tax deferral. Some funds restrict withdrawals and charge withdrawal fees during the first several years. After seven years, most funds will redeem partnership units with shares of at least 10 different securities contributed to the fund. At this time, the cost basis of the contributed shares will be transferred to these securities.
Like any investment, exchange funds carry risks. Nonetheless, the risks may be outweighed by the key benefit of such funds – the ability to convert a low-basis, single-stock concentration into a well-diversified portfolio, without paying capital gains tax.
Executive Diversification and Investment Trust (EDIT)
This type of trust, also referred to as a Blind Trust, allows executives to diversify their investments through the sale of restricted stock without limiting the timing of the sales to so-called “window periods,” which would otherwise put constraints on when stock can be sold.
Window periods are imposed by publicly held companies. Windows usually begin late each quarter and end a month after a company’s earnings report has been issued. Window periods are designed to keep insiders from running afoul of securities regulations, which prohibit the trading of stock using material, non-public information about companies.
With an EDIT, an investor gives a trustee sole authority to decide on the timing of sales. All sales are made in accordance with the SEC’s Rule 144 and within the parameters of the trust, without the insider’s knowledge or participation. Hence, sales may be made at any time, even if the executive possesses material, nonpublic information about his or her company.
EDITs may be used by corporate executives and insiders, senior officers, directors, and anyone owning 10 percent or more of the company’s outstanding shares.
There are other ways to diversify concentrated holdings of stock, including variations on collars and forwards, investment swaps, and the issuance of exchangeable equity-linked notes for blocks of appreciated stock. Each strategy has advantages and disadvantages. Selecting the right one for you should involve careful planning and consultation with your financial, tax, and legal advisors.
The information in this article has been obtained from sources believed to be reliable, but its accuracy and completeness are not guaranteed. The opinions, estimates, and projections constitute the judgment of Wilmington Trust and are subject to change without notice. This article is for information purposes only and is not intended as an offer, recommendation, or solicitation for the sale of any financial product or service or as a recommendation or determination that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on the investor’s objectives, financial situation, and particular needs. Investing involves risk, and you may incur a profit or loss. Diversification does not ensure a profit or guarantee against a loss. There is no assurance that any investment strategy will be successful. Past performance is no guarantee of future results.