There are many strategies for concentrated stock positions. Many of these strategies will either enhance or hedge those positions or your overall portfolio, and many involve options. Here are some excellent strategies to consider when you have a concentrated stock position that a client wants to hold and/or that has a low tax basis. However, you may want to consider some of these strategies as you develop your asset allocation plan aligned with your financial plan.
Investing Strategies to Hedge or Enhance a Concentrated Stock Position
- Covered Calls: Write out-of-the-money covered call options (above current price – it is covered call as you also own the underlying stock) until the calls are exercised or until the stock is sold in the future. The extra income from the calls can offset a portion of the impact of capital gains taxes paid. If a client is committed to keeping a position, this is a way for advisors to add value and enhance the stock’s total return but requires consistent monitoring to avoid an inadvertent sale. Monthly covered calls are recommended if return enhancement is the goal.
- Married Put: Purchase out-of-the-money put as a down-side “insurance policy” that lasts for the duration of the option. If long-term holding is intended, this could become costly. See equity collar as an alternative.
- Equity Collar: Purchase long-dated put option and sell long-dated call option (potentially zeroing out the cost of put with a premium of call, or even creating some income). The collar must leave some room for gains and losses to avoid being deemed a constructive sale by the IRS.
- One way to enhance return is by purchasing long-dated puts and selling monthly covered calls. The calls can offset the cost of the put while generating ongoing additional income monthly. As expiry approaches on the puts, they could be sold (get a little money back if OTM), and new puts will be purchased.
- In a bear market scenario, your client may not have to part with the stock or exercise the put option. With proper management, they may realize the same level of “hedge” by simply selling the put for a gain (albeit at higher tax rates – ST gain). A new put could then be purchased further out-of-the-money, and call writing could continue.
- Bear Put Spread: Purchase an out-of-the-money put option (strike price below stock price), and sell another put option that is further out-of-the-money (to offset some of the cost of the long put). This provides limited downside protection (but only to the extent of the short put strike price).
- Variable Prepaid Forward: Sell the promise that you will sell enough shares to satisfy a claim on the stock at a specific date in the future. You define “when” you want to sell. You also defer the gain until the date of sale. If the stock appreciates before that date, fewer shares must be sold to satisfy the claim. If the stock goes down in price, more shares would have to be sold to fulfill the contract, but some of the loss would be offset by the initial payment received.
- Exchange Fund: Shares can be contributed to an “exchange fund partnership” where you receive a pro-rata interest in a diversified portfolio that is equal in value to your shares. Drawback: there is typically a seven-year lock-up period to satisfy the requirements to defer the gains.
- Gradual Diversification: Sell and diversify segments of the holdings over time, perhaps 10-20% each year, to avoid taking all of the additional capital gains (and the ensuing higher tax brackets) in a single year. Note that if a client has minimal other income, taking long-term capital gains over a shorter period may be less of a concern. There is, however, a market risk associated with diversification all-at-once (i.e., tax paid all at once, and complete reinvestment followed by a market decline could be poorly received by clients who paid the tax “at the top”).
- Stock Protection Plans: There is a relatively new idea that pools the risk like insurance, where some amount (2% upfront and 2% per year or so) is paid annually to a fund for several years (5 years, etc.). At that point, the stock is sold. If it declined, the fund compensates participants for their losses. The downside: if there is a broad market decline, the fund may run out of contributed assets. This can get fairly expensive.
- Borrow to Diversify: The concentrated stock position could be used as collateral for a loan to purchase additional, more diversified securities or options. Downside: margin risk.
- Short the Stock: Shorting the concentrated stock (at least to some extent) could offset some of the risk of loss from lack of diversification.
Charitable Planning Strategies to be “Tax Smart” with your planned giving
- Donor-Advised Fund: For the charitably inclined, stock can be donated to the donor-advised fund (we have used ones at our custodians, Charles Schwab or Fidelity, or even outside funds like the National Christian Foundation), then sold and diversified without capital gains taxation.
- Charitable Remainder Trust: Appreciated stock could be donated to a trust with an “annuity” (not necessarily the product, but a payment stream) back from the trust to the client. Payments could be made for a set number of years (up to 20) or the life of the client(s). There has to be a projected “remainder” in the trust of at least 10% of the assets for charity. The client gets an immediate charitable deduction with income paid back to them. There is a common misconception that this “eliminates” capital gains; it does not. It simply defers taxation over the prolonged period of repayments (the trust pays annuity payments: first from any ordinary income and dividends generated by trust investment assets, then from capital gains, then from tax-free income, and finally as a return of principal). The charitable value is less attractive in lower interest rate environments.
- Charitable Gift Annuity: Some charities will take donations and agree to pay an annuity amount to the donor for a certain period of time. Any remaining funds after that would go to charity. The donor would get an immediate income tax deduction based on the value of the donation (less the actuarial value of the annuity stream). Market conditions, such as low yields, can make these harder to offer.
Life Insurance and Estate Strategies Aligned with your Financial Plan
- Insure the Stock Value for Your Family: Sell a fraction of the stock (and pay any capital gains) to purchase a life insurance death benefit equal to the total value of the concentrated position. The policy could be indexed to the market and have a floor limiting losses. If the stock declines, the death benefit plus the value of the remaining stock can provide more than the original value to your family. If the stock appreciates, your family will get both the value of the stock and the tax-free death benefit. At death, the stock will get a step-up in basis, eliminating the capital gain—immediate sale and diversification after that would incur no taxation!
- Gift Shares to Family: This transfers the concentrated stock (with embedded capital gains intact) to children. The problem shifts from parent to child. Life insurance on transferring clients could be purchased to help offset the expected capital gain taxation to the family members.
- Gift Shares to an Irrevocable Trust: An irrevocable grantor trust would remove the stock from your client’s estate, but not allow the stock to get a step-up in basis upon your client’s death (children would have the same capital gains problem that parents had at death). This removes assets from the estate for estate tax purposes but does not eliminate the problem of gains. In some cases, if death is near, it might make sense for the parents to “swap” the stock with cash from their estate or to buy back the low-basis stock before their death. That would allow for an at-death basis step-up (potentially eliminating the capital gains problem).