Managing a Concentrated Stock Position

In the city of Houston, we are blessed to have more than our fair share of successful businesses. Because of that, at Avidian Wealth, we work with a lot of business owners and executives where a large holding of a single stock dominates their portfolio. With that concentration, challenges in terms of helping them create and manage their comprehensive financial plan.

On the one hand, it may represent a large portion of their portfolio because it has done well in the past. On the other hand, clients (and we as advisors) at times feel that there is a need for more diversification. If this is true in your situation, over time you may find that you have new financial goals that require a shift in strategy. Here are some examples:

1. You are nearing retirement and are worried that having all of your eggs in one basket is too risky.
2. Your company stock may have grown in the past, but now it is slowing down and maybe you now want to diversify additional income.
3. Now that you are in retirement, you are no longer associated in the company and are worried and would rather shift toward protecting what you’ve accumulated.
4. You have most of your stock in your company 401(k) Plan and in retirement, you want to consider strategies that use the stock’s Net Unrealized Appreciation (NUA) as a strategy to reduce your tax bill (capital gains vs. ordinary income) in retirement.

Regardless of the reason, when you have well over 10% of your portfolio in any one stock, even your company stock, it is important to consider your options.

How much is too much?

There’s no firm, universal answer to this. It depends in part on your ability to withstand volatility, your level of wealth, your desired investment return from your portfolio, and your overall asset allocation. Even the best stocks can suffer serious reversals on occasion, and that volatility can affect the power of your assets to compound over time. If your current income depends on the same company as your portfolio–for example, if you hold a large amount of your current employer’s stock–you’re doubly exposed. Though diversification doesn’t guarantee a profit or ensure against a loss, it’s still the best way to limit the overall impact of a single stock. Benjamin Graham, legendary author of The Intelligent Investor, argued that a diversified portfolio required anywhere from 10 to 30 stocks. Other researchers have subsequently held that at least 50 stocks are needed; still others argue the benefits of several hundred stocks. If you accept Graham’s definition, you might start to consider whether your position is too large once it represents more than 10 percent of the stock portion of your portfolio. A financial professional can analyze the potential impact of a single holding on your overall financial situation, and help you assess whether and how to address the issue.

The challenges of a concentrated stock position

A large stock holding can come about in many different ways, and your approach to managing it may depend in part on how you arrived at it. For example, you may have:

• Inherited a large holding
• Exercised options to buy your company’s stock
• Sold a private business, or founded a company that subsequently went public
• Benefitted from price appreciation or repeated stock splits over the years
• Accumulated restricted or common stock as part of your compensation

Just as there are many different reasons for accumulating a concentrated stock position, there are many challenges involved in the decision about how to address it. Some of the most common hurdles investors face are:

• Reluctance to sell because of adverse tax consequences. Investors sometimes take no action on a large stock holding because they do not want to pay the capital gains taxes they will owe upon selling, especially if the stock has a relatively low cost basis.
• Legal constraints on your ability to sell. For example, when a privately-held company is acquired, its executives and/or shareholders may receive restricted securities (those acquired in private transactions rather than through the public markets). SEC Rule 144 limits when restricted shares can be sold and how much can be sold at any one time. Corporate insiders are also subject to legal restrictions on how they trade their company’s shares.
• Contractual obligations that prevent selling, such as lock-up agreements. Executives of a company that has recently gone public may be subject to an agreement with the stock’s underwriter that prohibits their selling within a given time period after the IPO. Companies may also impose so-called blackout periods during which some employees, particularly officers and directors, are not allowed to sell stock. Such blackout periods are designed to comply with Rule 10b-5 of the Securities Exchange Act of 1934, which prohibits sales of stock that are based on material, non-public information (commonly known as insider trading).
• Practical considerations. In the case of a thinly-traded stock, a large sale could overwhelm the market and potentially depress the price.
• Emotional attachments to a stock. If you inherited a large position, or if it has been a major factor in increasing your net worth over the years, you may be reluctant to sell.
• Desire to participate in potential future price gains. If you feel a stock still has plenty of growth potential, it can be difficult to contemplate a trade, even for another stock with equal potential.
• Concerns about possible perception of market manipulation or insider trading. Trading scandals in recent years have caused some corporate officers and directors to be concerned that circumstances might cause regulators to view a large sale with suspicion, even if the trade complies with all regulations.

Fortunately, there are a variety of strategies that can help you address these issues. One of them–or a combination–might suit your unique situation. The choices are complex and will depend on your own circumstances and tax considerations, but here is an overview of some of your options.

Tip: When dealing with a large stock holding, think about your time frame. Some strategies, such as hedging, might be most suitable in the short term or if you are restricted from selling. Others, such as charitable remainder trusts, may be more cost effective over a longer time period, though your charitable intentions obviously play a role as well.

Selling your shares

Selling frees up funds that can be used to purchase other securities that will help diversify a portfolio. The benefits of diversification have been demonstrated repeatedly; multiple studies have shown that the risk-adjusted returns of a single-stock portfolio have generally not outweighed the benefits of diversification. Even if a stock has done well in the past, there’s no guarantee it will continue to do so–and if it does, it could represent an even larger percentage of your portfolio, thus compounding the risk. And the more volatile the stock, the lower its risk-adjusted return relative to the broader market tends to be over time.

The biggest tradeoff is that you’ll owe capital gains taxes on the difference between your cost basis and the sale price. If you have a highly appreciated stock, that may be no small consideration.

Tip: If you’re in poor health or have reached an advanced age, remember that if the stock is part of your estate, the cost basis may be stepped up after your death. That could reduce or eliminate the capital gains tax for your heirs, though the value of the stock would be included in determining if estate tax was due and the amount of that estate tax.

Example(s): John bought a stock for $25 twenty years ago. On the date of his death, it sold for $76 a share. His heirs are able to use $76 as their cost basis for those shares. John’s estate is not large enough to trigger the estate tax. After the estate is settled, John’s heirs decide to sell the stock, which is now trading at $78 a share. They will owe capital gains taxes on the $2 per-share difference.

Obviously, you’ll need to weigh the tax impact and trading costs against any additional potential return you might gain or potential losses on your concentrated holding that you might avert by diversifying. In some cases, the long-term benefits of diversification may offset your tax bill. Remember that selling doesn’t have to be an all-or-nothing proposition. If you want to continue to participate in any upside potential, you could sell only a portion of your position, or consider selling over time. Selling in stages can help you better manage the tax bite in any one year, yet allow you to participate in any future growth. If your stock is one that is thinly traded, a phased approach also could help the market absorb the impact of your sale. However, it could take several years to reposition your portfolio so that your risk is more diversified. You’ll need to balance the potential benefits of phased selling with the possible consequences of prolonging your exposure to the downside risks of your concentrated position.

Restricted shares

If you hold restricted shares or want to avoid the perception of insider trading or market manipulation, you can sell shares over time by using a 10b5-1 plan. So-called because they are spelled out in SEC Rule 10b5-1, such plans can provide a documented defense against any allegations that your trades were made to take advantage of insider knowledge. They must be set up through an independent third party, such as a financial advisor, broker, or trustee, and the decisions about when and how much to sell cannot be based on any material knowledge about the company that is not public.

A 10b5-1 plan can function in several ways. It may spell out a predetermined schedule for selling shares over time, specifying in advance the dates, prices, and amounts (either a specified number of shares or a specified dollar amount) of each sale. It could also set out a formula, algorithm, or computerized program for automating the trades. Or, it may set up a mechanism that eliminates the investor from any decision-making about the sales–for example, allowing a third party who has no insider knowledge to make all selling decisions.

By making clear in advance your plans to sell your stock, a 10b5-1 plan is designed to demonstrate you are complying with SEC Rule 144, which governs public resale of restricted securities and was designed to prevent insider trading, and that trading decisions were not based on any material, nonpublic knowledge about the company’s prospects.

Example(s): Jane is an officer of XYZ Corp. Her daughter will be entering college next fall, and she also plans to buy a second home the following year. Jane would like to sell some of her XYZ stock and use the proceeds for both tuition and the home purchase. However, the stock is a volatile one, and Jane wants to avoid any appearance of impropriety if she sells just before the stock’s price plunges. Jane sets up a 10b5-1 plan that instructs her broker to sell 5,000 of her XYZ shares on the first day of each quarter over the next 2 years at a price no lower than $40 a share.

Caution: Make sure that when you adopt a 10b5-1 plan you intend to carry it through. The selling decisions are considered irrevocable, and attempting to change them or terminating the plan early could raise questions about the plan’s legitimacy, thus potentially bringing on precisely the problems you established the plan to avoid.

You might also be able to avoid some of the Rule 144 restrictions on how much and when you can sell by selling shares privately rather than on the public market. However, you would likely have to sell at less than the market value, and would still face possible capital gains taxes.

Hedging your position with options

Selling is by no means your only way to deal with a concentrated stock position. For example, you may want to retain your stock, but also need to protect yourself short-term against the risk of a substantial drop in its value. There are multiple ways to try to manage that risk by using options.

However, bear in mind that options also can involve substantial risk and are not suitable for all investors. Prior to buying or selling an option, a person must receive a copy of “Characteristics and Risks of Standardized Options.” Copies of this document may be obtained from your financial professional and are also available at http://www.theocc.com.

Protective puts

Buying a protective put essentially puts a floor under the value of your shares by giving you the right to sell your shares at a predetermined price. Buying put options that can be exercised at a price below your stock’s current market value can help limit potential losses on the underlying equity while allowing you to continue to participate in any potential appreciation or dividends paid. However, you also would lose money on the option itself if the stock’s price remains above the put’s strike price.

Example(s): Jim owns 50,000 shares in ABC Corp. He bought them at $50, and they are now trading at $75. Because ABC represents so much of his net worth, Jim wants to protect at least some of his $1.25 million in gains, but does not want to sell. He decides to buy long-term put options for all 50,000 shares. The puts expire in 2 years, have a strike price of $68, and are selling for $3.45. Since each option contract covers 100 shares, Jim pays a premium of $172,500 for his puts (500 contracts x 100 shares per contract x $3.45 per share). Eighteen months later, one of ABC’s major factories burns down and the stock price plummets to $55. Jim can exercise the put and sell his shares for $68; his shares are still worth $900,000 more than he paid for them (not counting the $172,500 he paid for his options). Without the puts, his $1.25 million paper profit at the time he bought the options would have shrunk to only $250,000.

You’ll need to balance the cost of the premium you will pay for the option contract against the potential losses you could incur on your concentrated position. In effect, you’re paying to have the put function as partial insurance for your shares. Bear in mind that over-the-counter option contracts may be thinly traded; if you want to sell your put, there is no guarantee you’ll find a buyer.

Caution: If you buy a put and sell your shares, you’ll likely have a capital gain or loss on the shares. In considering this strategy, also think about whether you would be prepared to sell your shares and face any possible adverse tax consequences.

Covered calls

Selling covered calls with a strike price above the market price can provide additional income from your holdings that could help offset potential losses if the stock’s price drops. By selling the calls, you’re agreeing to sell your shares to another investor at the call’s strike price, which is almost certain to happen if the stock’s price rises above the strike price. This strategy is known as a covered call; because you already own the stock, you’re covered in case you are obligated to turn over shares. However, if the stock price never reaches that point, you’ll retain the premium you were paid for the call.

The tradeoffs with covered calls include:

• Selling a covered call limits the extent to which you can benefit from any further price appreciation.
• You are still exposed to downside risk on the stock holding, which could exceed any gain from selling the calls.
• If the price reaches the call’s strike price, you would have to sell shares to meet the call (unless you were able to buy back the call contract). Depending on how much you paid, this could trigger capital gains taxes.
• Sales of restricted stock are still subject to SEC rules that govern the timing and volume of such sales.

Caution: If you decide you want to sell shares before the call option expires, you’ll have to close out the call contract before you can sell your shares. However, there is no guarantee you’ll be able to do so, and you could pay more to unwind the position than you were paid for the option originally (though that loss also might be offset by profit on the sale of the shares themselves).

Collars

A collar involves buying not only protective puts to limit your losses on the underlying stock, but also selling call options whose premiums offset the cost of the puts. A collar can be a very flexible strategy in terms of the maturity dates and strike prices it involves. However, as with a covered call, the upside appreciation on your concentrated position is then limited to the call’s strike price. If that price is reached before the collar’s expiration date, you would not only lose the premium you paid, but unless you could unwind the position by buying back the calls–and there is no guarantee that you would be able to do so–you might also face capital gains taxes on shares you were required to sell. And be careful about closing one side of the collar while the other side of the trade remains outstanding. For example, if you exercised the put but the shares you sell are later called away prior to the expiration date, you could find yourself with an uncovered call. You could potentially suffer a loss if you had to repurchase the shares at a higher price to fulfill the call.

Caution: The prices set for a collar must not violate the rules against a so-called constructive sale. Under the Taxpayer Relief Act of 1997, a hedging strategy that eliminates all risk is effectively a sale and thus subject to capital gains taxes. With a collar, this can happen if the strike prices of the put and call are too close together, or too close to the market price of the stock holding. Seek expert advice on selecting strike prices that avoid triggering the constructive sale rules.

Caution: Remember that transaction costs in multiple-leg options strategies, such as a collar, can be significant and should be considered as these strategies involve multiple commissions, fees, and charges.

Example(s): In the example above, if in addition to buying puts, Jim had also sold calls with an $83 strike price on his 50,000 shares of ABC Corp. stock, he would have established a collar. The calls would have expired worthless when the stock price dropped to $55, since no investor would have exercised the option to pay $83 for shares that had a market price of $55, and Jim would have retained the premium. That income from selling the calls would also have blunted the impact of the price drop on his ABC position.

Technical Note: Prior to the Taxpayer Relief Act of 1997, a popular way to manage concentrated stock positions was a hedging strategy known as being “short against the box”–a reference to the days when stock certificates were often held in a safe deposit box. To hedge the long position, the same number of shares were borrowed and sold short. If the price went down, the investor would benefit from the short position; if it went up, the gains on the long position would theoretically offset losses on the short position. No capital gains taxes were owed unless and until the shares were actually delivered, and an investor could borrow against the hedged position. However, after the Taxpayer Relief Act of 1997, a “short against the box” position was deemed to be a “constructive sale” and therefore taxable as if the shares had actually been sold. As a result, the equity collar is now used more frequently as a strategy for concentrated positions.

Monetizing the position

Monetizing means deriving immediate cash from an asset, which does not necessarily mean selling the asset. For example, a home equity loan is a way of monetizing the value of your house without selling it.

Prepaid variable forward (PVF) agreements

If you want immediate liquidity, you might be able to use a prepaid variable forward (PVF) agreement. With a PVF, you contract to sell your shares later at a minimum specified price. You receive most of the payment for those shares–typically 80 to 90 percent of their value–when the agreement is signed. However, you’re not obligated to relinquish ownership of the shares or pay taxes on the sale until the PVF’s maturity date, which might be years in the future. In the meantime, your stock is held as collateral, and you can use the upfront payment in any way you choose. For example, you could use the proceeds to purchase other securities that can help diversify your portfolio. When the expiration date is reached, you must either settle the agreement by making a cash payment, or turn over the appropriate number of shares, which will vary depending on the stock’s price at the time of delivery.

If you turn over the shares, your capital gain or loss will be recognized at that time, and you’ll owe tax on the difference between your cost basis in those shares and the amount you received when you signed the PVF. If you choose to settle the PVF with cash, you’ll postpone capital gains taxes on your stock holding. However, any gains or losses from the hedge itself (i.e., the difference between the share price you received upfront and the share price you pay to settle the agreement) are subject to immediate taxation when the PVF is settled.

Caution: Cash settlement can bring on a problem known as straddle taxation. Any gains that result from the hedge itself may be taxable at short-term capital gains rates. That could turn a long-term gain on the underlying shares into a short-term gain taxed at higher rates. Also, you may not be able to deduct losses on the hedge until the stock itself is sold. A tax professional can help you compare the tax consequences of a cash settlement to the potential savings from deferring the capital gains tax on your shares.

Caution: Restricted securities that underlie over-the-counter option contracts are still subject to Rule 144 provisions governing the timing and volume of sales. Options contracts based on restricted securities may need to be settled with cash rather than the securities themselves.

A PVF typically sets a minimum price at which the stock will be valued, but the final value is dependent on the price of the stock when the contract matures. Because you retain legal ownership of the shares, a PVF allows you to benefit to some extent from any price appreciation until the shares must be turned over. However, there may be a cap on that amount. When the PVF matures, if the stock is below the minimum price specified, you must deliver all shares covered by the contract (or settle in cash). If the price is somewhere between the minimum and the cap price, you owe an equivalent number of shares based on that price. If the price is above the cap, the number of shares you owe will be based on the minimum price specified by the contract plus the difference between that floor price and the capped price.

A PVF can be very flexible, allowing you to tailor to your needs the contract’s minimum and cap prices as well as the prepayment amount, maturity date, and whether you settle in shares or cash. Because a PVF is not a loan, you’ll owe no interest on the upfront payment you receive. However, you’ll give up any price appreciation above the cap price, and you won’t know in advance the exact number of shares you’ll turn over. Also, if you own restricted shares and are subject to Rule 144, you’ll still need to follow SEC regulations disclosing the prepaid variable forward contract to the SEC.

Caution: PVFs must be carefully structured. The IRS has issued a warning that questioned so-called “share lending,” which occurs if a financial firm involved in a PVF attempts to hedge the position by, for example, selling the shares short. The IRS opinion said PVFs must be structured so that is clear that the investor still retains ownership of the shares. Though it involved only one specific case, the opinion suggests that care needs to be taken with PVFs to avoid triggering an audit or immediate capital gains taxes.

Borrowing to diversify

If you want to hold onto your stock but need money to build a more diversified portfolio, you could use your stock as collateral to buy other securities on margin. Typical initial margin requirements specify that you have at least 50 percent of the value of your margin purchases in stock or cash. If you have $50,000 worth of shares, you could use them as collateral to purchase an additional $50,000 worth of securities on margin. You’ll owe interest on that $50,000, which you’re borrowing from the broker, though the interest may be deductible. Though buying on margin can help you diversify, you’re still exposed to the downside risk of your original stock holding.

Exchanging your shares

Another possibility is to trade highly-appreciated stock for shares in an exchange fund–a private placement limited partnership that pools your shares with those contributed by other investors who may also have concentrated stock positions. After a set period, generally seven years, each of the exchange fund’s shareholders is entitled to a prorated portion of its portfolio. Taxes are postponed until you sell those new portfolio’s shares; you pay taxes on the difference between the value of the stock you contributed and the price received for your exchange-fund shares.

Though it provides no liquidity and typically little or no income during the seven-year holding period, an exchange fund may help minimize taxes while providing greater diversification (though diversification alone does not guarantee a profit or ensure against a loss). Be sure to check on the costs involved with an exchange fund–there may be a sales load and other fees–as well as what other securities it holds. At least 20 percent of an exchange fund’s holdings must be in non-publicly traded assets, commodity interests, or real estate. Also, you want to ensure that you aren’t exchanging your shares for a portfolio of low-quality stocks. Exchange funds are sometimes known as swap funds.

Donating your shares

Another possibility for dealing with a concentrated stock position is to donate your shares, which eliminates your capital gains tax liability. Depending on your objective, there are many ways to do so. Some methods provide an immediate tax deduction, some offer ongoing income, some enable you to avoid paying capital gains or estate taxes on highly appreciated shares, and some offer a combination of benefits.

Figuring out the ramifications of a concentrated stock position is a complex task that may involve investment, tax, and legal issues. Consult professionals who can help you navigate the maze.

Donating to a charitable remainder trust

If you’re philanthropically minded and have highly appreciated stock, consider donating shares to a charitable remainder trust (CRT). You receive a tax deduction when you make the contribution. Typically, the trust can sell the stock without paying capital gains taxes, and reinvest the proceeds to provide an income stream for you as the donor. When the trust is terminated, the designated charity retains the remaining assets. You can set a payout rate that meets both your financial objectives and your philanthropic goals, and because the principal is not reduced by taxes, the income generated may be greater than if you had sold the asset yourself. However, your donation is irrevocable, and the income payments are fixed, which means their value will be affected over time by inflation.

Donating to a charitable lead trust

Another option is a charitable lead trust (CLT), which in many ways is a mirror image of a CRT. With a typical CLT, the charity receives the income stream for a specified time; the rest goes to your beneficiaries. You receive no tax deduction for transferring assets to it unless you name yourself the trust’s owner, in which case you’ll pay taxes on the income it generates each year. A charitable lead trust can be an excellent vehicle if you believe your stock has a bright future and want your heirs to benefit from it, but also want to reduce the potential tax liability to your estate.

Donate to a charity

By donating stock directly to a qualified charity rather than selling it and donating the proceeds, you will not only remove it from your taxable estate but avoid paying capital gains taxes. In effect, the donation costs you less because of the tax benefit you receive.

A charity must qualify as a 501(c)(3) nonprofit organization as defined by the IRS in order for you to receive an tax deduction for the donation. Although most tax-exempt organizations qualify, some do not. A charity will know its status, and you can verify it by using IRS Publication 78, a version of which is searchable online at www.irs.gov. Also, there may be limitations on the amount you can donate in any one year and still receive the deduction; the limits are based on a percentage of your adjusted gross income and how long you have held the stock.

Donate to a private foundation

You also can receive an immediate tax deduction for the market value of your stock by setting up a private foundation, which then make grants to qualified 501(c)(3) nonprofit organizations. A private foundation provides you with the most control over how your contribution is invested and used; for example, you can name family members to the foundation’s board of directors. A private foundation can accept a wide range of assets, including restricted stock and hedge fund interests, though there is a limit on your yearly contribution that is based on a percentage of your adjusted gross income (AGI).

However, the costs of setting up and administering a private foundation can be substantial, so they typically are used for relatively large charitable contributions. Also, there are legal constraints on contributions in order for it to qualify for a tax deduction. The foundation cannot be involved in so-called self-dealing; for example, family members or their employees cannot borrow money from, buy from, or sell to the foundation. Finally, grants made by a private foundation are public records, so this is not the best choice if you prefer anonymity.

Donate to a donor-advised fund

Another option is a donor-advised fund, which also enables you to take the immediate tax deduction in the year of your donation and avoid capital gains taxes on a stock sale. A donor-advised fund can be set up as part of a larger charitable organization–for example, a community foundation in your home town. A donor-advised fund enables you to track your own contributions and suggest specific grants and philanthropic causes you would like the money to support. Though the charity is not legally obliged to follow your recommendations, in practice they typically do so (subject to legal constraints, such as making sure the grants go to a 501(c)(3) nonprofit organization). You may have a limited amount of ability to determine how your contributions are invested, and any returns on your stock are added to the money available in your charitable account for grantmaking.

Unlike a private foundation, your grant recommendations can be made anonymously. Also, the percentage of AGI that you can contribute in any one year and still qualify for a tax deduction is higher than that of a private foundation (though again, you should consult a tax professional who can review your own situation). You can donate your stock and take your time to decide how you would like to support specific charitable efforts. In addition to donating publicly traded stock, you may also be able to donate restricted stock and LLC or other limited-partnership interests.

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