Viewpoints on Financial Planning
Investors with large holdings of a single stock or concentrated position face unique challenges. There have been several instances where once-popular stocks have seen their share prices plummet due to market, specific industry, or unexpected company events.
Though they recognize the risk, some investors express a reluctance to sell because of emotional connections to a particular company, belief in future share appreciation, potential tax consequences, or loss of a strong dividend. Other investors might wish to diversify but feel limited by a fear of how the market would perceive a sale of some or all of the position.
Most professional investment advisors counsel that holding more than 10% to 15% of investable assets in one position is not prudent. In fact, the added risk and volatility of a concentrated portfolio often does not result in superior investment returns and can potentially be catastrophic to one’s current and future financial security.
Fortunately, there are a variety of strategies that an investor can use to manage the inherent risks of a concentrated portfolio. These include outright sales, charitable gifts (outright or through a charitable remainder trust), as well as one or more investment solutions.
FREQUENTLY ASKED QUESTIONS
1. What is the impact to today’s investor, of the outright sale of a concentrated equity position?
An outright sale of a concentrated equity position should be viewed as a risk reduction and diversification tool. The advantage of an outright sale is that it affords the investor the opportunity to lessen overall portfolio risk and potentially build a more diversified asset mix. Certainly, the taxes payable and the lost appreciation potential in the underlying stock as well as the loss of dividends and voting power is a negative consequence of an outright sale and should be considered.
Currently, long-term capital gains are taxed at an historically low 15% federal rate (plus applicable state tax, if any) for most taxpayers (20% for those in the 39.6% federal income tax bracket and 0% for taxpayers who would otherwise be in the 10% or 15% marginal income tax brackets). The cash that is generated from the stock sale can be utilized in many ways, but for many it affords the chance to create a more diversified portfolio.
2. What opportunities exist for charitably inclined investors who hold concentrated equity positions?
An outright charitable gift of appreciated securities held for at least the long-term capital gain holding period (one year and a day) to most public charities is income tax deductible up to 30% of a taxpayer’s adjusted gross income (AGI) for the calendar year (with a five-year carry forward of any excess) with no payment due for the capital gains tax that would otherwise be payable on sale.
Example: Karen purchased a stock for $100,000 more than one year ago and the stock is now worth $500,000. If she sold the stock today and gave the charity the $500,000 sale proceeds, she would have to report the $400,000 capital gain and pay tax thereon. Alternatively, if Karen gifted the $500,000 of stock directly to a public charity, she would qualify for a charitable tax deduction (subject to annual deduction limits) equal to the fair market value of the stock, and avoid paying the capital gains taxes on the $400,000 of appreciation—a much better result.
Another alternative for philanthropic taxpayers is a Charitable Remainder Trust (CRT). A CRT allows a donor to gift the appreciated securities and have the trust sell the stock with no immediate capital gains tax liability. In this way, 100% of the sale proceeds are potentially available for re-allocation into a diversified portfolio. The non-charitable beneficiary of the CRT (generally the donor) receives a stream of income (fixed amount or a percentage of trust value) for life, or a stated period of time—not to exceed 20 years.
When the CRT terminates, the trust assets would pass to the charitable beneficiaries named in the trust document. In exchange for the gift to the CRT, the donor receives an immediate charitable income tax deduction for the future gift to the charity. The amount of this deduction is based upon a variety of factors, including the type of CRT, the term of the trust, when payments begin and the life expectancy of the non-charitable beneficiary, as well as an appropriate discount factor set by the US Treasury on a monthly basis (§7520 rate).
3. What investment solutions might be applicable for managing a concentrated equity position?
There are customized investment solutions that are designed to reduce the risk of a concentrated position. Depending upon the unique needs of the investor and current market conditions they might include one or more of the following:
- Covered calls
- Protective puts
- Equity collars
- Prepaid variable forwards
- Exchange funds
4. What is a covered call and when is it an appropriate tool to manage a concentrated equity position?
A covered call is utilized when an investor holds a stock and writes (sells) a call option for a set period of time (expiration date) on the stock to generate increased cash flow from the position. The sale of the call option places a ceiling on the potential share appreciation; however, the upfront option premium received offsets some of this lost opportunity cost. A covered call provides the investor with an increase in immediate cash flow but the downside protection on share price is limited to the option premium received on the front-end of the transaction. Accordingly, it is not a strategy designed to protect against more significant market losses.
5. What is a protective put and when is it an appropriate tool to manage a concentrated equity position?
A protective put is designed to protect against the loss of unrealized gains. In many ways, it can be viewed like an insurance policy: it requires an upfront cash payment and reduces the risk of losing money when a security declines in value below the agreed upon floor price of the put. An investor can limit losses up to the floor price on the put (through its expiration date) while retaining his or her right to share in price appreciation. In this way, the risk in the share price below the floor value is transferred to a third party.
A protective put is deemed to be a straddle for income tax purposes. This means that dividends paid on the stock will no longer qualify for the 15% maximum federal tax on qualified dividend income. Also, the underlying holding period of the security is suspended and does not re-start until the put is sold or expired. The latter should not be an issue where the security had been held for the long-term capital gain holding period prior to the purchase of the protective put.
6. What is an equity collar and when is it an appropriate tool to manage a concentrated equity position?
An equity collar is a risk reduction tool that combines a covered call strategy with a protective put. In doing so, the investor limits share price appreciation to the ceiling price established by the covered call, in exchange for full share protection below the floor price created by the protective put. In this way, it can reduce downside risk by locking in a guaranteed share price. A well-structured collar can also allow an investor to retain limited participation in future appreciation along with voting rights and dividends on the underlying position.
Because of the income from the sale of the call, the equity collar is less expensive than a protective put and can be designed to potentially result in a zero cost to an investor when the cost of purchasing the put exactly equals the income from writing the call. This is known as a zero cost or cashless collar. In any event, collars may be customized to properly reflect the shareholder’s needs. IRS guidelines mandate that there must be a minimum spread (the difference between the put and call strike price) and many experts recommend at least 15% to 20% to avoid a taxable event.
Example: Jackson owns 15,000 shares of JKJ Inc., which is currently trading at $20/share. He is concerned about the position dropping in value but is not willing to sell the shares today. He enters a one-year equity collar transaction with an $18 floor price and a $22 cap. His position is protected should the share price fall below the $18 put strike and would continue to benefit from share appreciation up to the $22 call strike.
7. What is a prepaid variable forward and when is it an appropriate tool to manage a concentrated equity position?
A prepaid variable forward is designed for an investor who is generally bullish on the position but wants to monetize the portfolio with no immediate income tax consequences. It essentially combines an equity collar with a significant cash advance that can be used to create a diversified portfolio. The components of the transaction are generally as follows:
- A protective “floor” price is set for the hedged shares through the purchase of a protective put option
- The cost of the protective put is partially funded through the sale of a covered call option, which sets a “ceiling” on the hedged shares
- The investor receives a cash advance that reflects the floor value discounted by the net cost (after the covered call proceeds are factored in) of the protective put option as well as the cost of funding for the advance itself
- At maturity, the investor returns some variable amount of cash (or the equivalent value of hedged shares—a taxable event), depending on the structure terms and the final price of the hedged shares.
Like any hedging transaction, the prepaid variable forward means there is an opportunity cost if the stock appreciates above the call strike. Prepaid variable forwards can be adjusted to meet the needs of most investors (relative to risk tolerance, level of optimism on the hedged shares and cost).
Adjustments in the floor and cap price as well as the volatility of the hedged stock, dividend yield and current interest rates all will impact the cash advance paid. At maturity of the contract, the investor fulfills the terms utilizing either cash or shares of the concentrated position—the latter would trigger capital gains consequences at that point in time.
Example: Jim owns 232,558 shares of ABC Corporation which is currently trading at $43 per share—or $10 million. He is leveraged and is looking to pay down some of his debt and diversify out of ABC. He enters a three-year prepaid variable forward with a 100% floor, 130% cap and an advance rate of 76%. He has 100% of the share risk removed, enjoys appreciation up to 130%, and is provided with significant current liquidity and no immediate tax consequences.
8. What is an exchange fund and when is it an appropriate tool to manage a concentrated equity position?
An exchange fund is a private placement usually structured as a limited partnership that is available only to qualified purchasers. It affords investors the ability to exchange the risk and benefits of a concentrated position for that of a diversified equity portfolio along with some illiquid investments (usually real estate) with no tax consequences. The value of the investor’s interest in the partnership fluctuates with the change in the value of the partnership, not the contributed shares. To fully effectuate the exchange, an investor must be in the exchange fund for seven years.
At the expiration of the term, an investor would receive an in-kind stock distribution consisting of his or her share of the diversified portfolio. While earlier withdrawals are possible—they are limited. Investors in exchange funds also lose the right to dividends on contributed shares and run the risk that the value of the partnership may fall. Capital gains tax is deferred and is only paid when the investor sells shares received from the fund.
The goal in managing a concentrated equity position is generally to hedge against price declines and diversify the portfolio in a tax-effective manner. To best accomplish this objective, it is necessary to match the goals and objectives of the investor with one or more of the tools and techniques described herein and weigh the benefits and drawbacks of each against the risk associated with the concentrated position. Expressed another way, the question to an investor could best be framed as follows: If you were starting to build a portfolio today equal to the value of your current investments, what percentage would you prudently hold in that single position?