This article was updated on April 10, 2019 to reflect current tax laws and limits.
There’s an old investment saying, “Concentrated wealth makes people wealthy, but diversified wealth keeps them wealthy.” One of the most common concentrations of wealth people have are large or concentrated stock holdings in a single company. Publicly traded companies often compensate employees with stock or stock options, especially upper-level executives. Others may have large holdings from investing early in an initial public offering (IPO) or inheriting a large holding. No matter how it was obtained, owning a large stock position creates investment and planning challenges.
DEFINING A CONCENTRATED STOCK Position
The definition of a concentrated stock position varies. Some define it as any position greater than 10% or 20% of a portfolio. A more individual metric is to define it as the size of an individual position that can negatively affect an investor's financial plan. That can be a position that is 5% of a portfolio or 50%, depending on the investor’s goals.
Why is concentrated stock a risk?
The worst-case scenario of having a large amount of wealth in one stock is that the company goes bankrupt and the stock value goes to zero. That would destroy or severely impair the financial future for many. A less obvious and more common risk is that the company under performs for a prolonged period. This can be due to the company’s sector falling out of favor, heavy regulation, or mismanagement of the company. In this case, the stock holding becomes a liability as opposed to the value generating asset it was in the past.
There is usually more volatility in owning a single stock. The volatility risk is especially acute if cash is needed and the stock must be sold to raise funds. Volatility increases the chance that the stock sells at a lower value.
EMOTIONAL Attachment TO A COMPANY CAN BE STRONG
There is often a strong emotional attachment to large stock holdings. It can be difficult to sell shares of a company that you put so much of your effort, energy, and life into. For those who inherited the position, the loyalty can be strong for the company that has been the source of the family wealth. Also, the stock usually has become a large portfolio position because it’s been profitable. It is difficult to let go of a high performing stock that has outperformed the overall market.
But relying on one company to achieve your financial goals generally risks the overall portfolio valuation, increases volatility, reduces liquidity, and leaves the portfolio vulnerable to sector slowdowns or adverse regulations. Large setbacks by the company could jeopardize long-term financial plans. If you still work for the company of the concentrated position, your job could be at risk at the same time the stock loses value. Having your income and wealth in one company puts a lot of eggs in one basket. As such, investors generally should reduce their holding in a concentrated stock position to lessen these risks.
Even if you want to diversify from a large stock position, there are often challenges to do so. But there are a number of strategies that can lessen exposure to a single stock, diversify a portfolio, and possibly fulfill other financial goals.
SEVEn STRATEGIES FOR DEALING WITH CONCENTRATED STOCK
- Structured Stock Selling
- Using a Trust When Selling Stock
- Exchange Funds
- Using Options for Value Protection
- Stock Protection Plans
- Gifting Stock to Charity
- Gifting Stock to Family
One option is to sell the stock or a portion of the stock outright. But long-term capital gains taxes can be as high as 23.8% for Federal taxes and any state taxes will be in addition to that. Long-term gains are when an investment is held for at least one year. Any investment sold for a gain and held less than one year is considered income for tax purposes and is taxed at higher ordinary income tax rates.
One way to mitigate the tax bite is to schedule to sell a set amount of stock over time such as on a quarterly basis. The time frame can vary, but the goal is to make significant progress reducing the position. After all, reducing exposure is the goal. A 3-5-year time frame usually works well for many.
But opportunities may arise to sell more. For example, if there is a year when income is less due to reduced bonuses or being between jobs, for example, it could be an opportunity to sell stock and take less of a tax hit. No one wants to earn less than usual, but if it happens, make lemonade out of lemons. Proceeds from the stock sale can also supplement the shortfall in income if needed.
For executives still employed by the company, scheduled selling of stock may need to take place within the approved selling open window and may be subject to required approvals.
For those who live in high tax states, using a trust has the potential to reduce state taxes. In law, the situs is the location of the trust property and its location for legal purposes1. Funding a trust with low basis stock and using a situs in a low tax state, such as New Hampshire, can reduce capital gains taxes when selling securities. This is because the gains are subject to the law, and tax laws, of the situs state. This is true whether the trust was created with the state as situs or an old trust that changes situs to a different state.
Many high tax states have long-term capital gain tax rates of 5% or higher. If owners are selling significant positions of low-cost basis stock, the tax hit can be large. Using trusts with situs in favorable tax states can lower or eliminate the state tax bite. Federal taxes are generally not affected by the trust situs, but savings on state taxes can still be significant.
Using a trust for selling stock usually works best for larger positions of a few million dollars or more. This is because the savings need to offset legal and administrative fees. But for positions large enough, the reduction in taxes can far outweigh the additional costs.
Trust laws can be complex, and the investor could lose full access to the stock depending on the trust language and state laws. If considering using a trust for selling shares, it is imperative to work with experts. Find an attorney and trust company knowledgeable about trust situs, regulations, and state tax and estate tax laws. Some resources are: Concord Trust Company 2 and Journal of Financial Service Professionals3.
Exchange Funds, or “Swap Funds,” are private placement limited partnerships or LLCs. These vehicles allow an investor to “exchange” an individual stock for shares in a pooled fund of many stocks. The funds are managed, so the stocks are from different sectors and industries to provide immediate diversification. If your original stock should drop in value, you hold the value of the diversified fund. Using an Exchange Fund also allows the original amount of the stock to be invested without first selling, paying taxes, then investing the remainder.
There are key constraints to using Exchange Funds. Individuals must be a Qualified Purchaser which is defined as having $5M in investable assets. And there are lock-up periods of seven years, potential loss of dividends, fund management fees, and other considerations. Also, if the original stock exchanged should outperform the fund, the investor is stuck with the fund value – you can’t have your cake and eat it too. Lastly, the investor still keeps the original cost basis of the stock with the new fund position, though the need to sell is less due to diversification. Still, for investors who qualify, Exchange Funds are a viable option for diversifying a large stock position. Here is an article on Exchange Funds if you would like to learn more.
There is the potential of controlling downside risk by buying a put option. A put option is a contract that gives the buyer the right to sell a security at a specified price for a fixed period. For example, if you own a stock trading at $50 and buy a $45 put option, it gives you the ability to sell the shares at $45. It doesn’t matter if the stock goes to $0, the owner of the contract will still receive $45 per share from whoever sold the contract. The put option only has a given amount of time that it is in force. The contract time can range from 30 days to two years. A put option strategy is expensive for long-term protection but is more attractive for shorter periods of time. Using put options may be a good short-term strategy, but costs make it difficult to use long-term.
You can reduce or eliminate the cost by selling a call option at the same time. A call option is the opposite of a put option - it allows the holder to buy a stock from someone at a certain price no matter how high the stock rises. So, if you own a stock trading at $50 you can buy a put option at a price of $45 and sell a call option at $55 with matching expiration dates. If the costs of the contracts are the same, they offset, and it costs the stock owner nothing but the transaction fees. This strategy is called a “collar.” If the stock stays at $50 during the period, the options will expire worthless, and the stock owner can do it again. If the stock value drops, the put protects the selling price of $45. If the stock goes above $55, the stock will probably be “called” away and sold to the call option holder. Option traders can work the put and call contracts to match up time periods and pricing and create a “zero-cost collar.” If the shareholder does not have a need for the stock, they can create one zero cost collar after another for as long as they want – as long as there are contracts available and the market pricing cooperates.
Lastly, if an executive is still employed at the company where they earned the stock, more than likely the employee will be prohibited from buying options and will have to rely on other strategies.
Very new to the scene are Stock Protection Plans (SPPs). These act more like insurance than diversifiers. In a typical SPP, investors holding stock from diversified industries pool together cash representing 10% of their stock values for the securities they want to protect. The investors pay a 2% upfront fee and 2% annual fee for a five-year holding period. Most of the cash is invested in 5-year Treasury Notes. After five years, if a stock has gone down in value the stock holder is compensated by the fund. The challenge is if recession hits and most of the stocks go down in value. If that happens, there generally won’t be enough assets in the fund to compensate everyone, and it doesn’t fully protect the owners.
These funds are very new and need to be fully vetted. But it may work for an investor with a matching time frame for protecting a stock value. And since the stock is not exchanged or pledged, the owner retains the stock, dividends, and voting rights.
One of the obstacles of an SPP are the fees. Paying 12% for five years of protection is expensive given that it may not work in a market downturn. Another drawback is if the stock goes up in value after five years you could end up having a bigger diversification issue than when you started with larger embedded gains. With Stock Purchase Plans, kick the tires thoroughly and make sure your situation is one that would benefit from participating.
Direct Gift of Stock
Gifting is a great strategy for reducing stock holdings with capital gains. A popular choice is gifting stock directly to non-profit charities. By donating stock instead of cash, you reduce your stock position and are likely to receive a tax deduction. Donors are eligible for an income tax deduction for the full market value of the stock, up to 30% of adjusted gross income. You benefit by reducing your position and capital gain exposure, and the charity benefits by selling the stock while paying no tax because it is a non-profit. Everyone wins!
Donor-advised funds (DAFs) are a flexible vehicle for gifting. An investor can fund the DAF with stock and potentially receive tax deductions for the value of the stock at the time of funding. The stock is sold, and the proceeds are deposited in investment pools which the investor controls. The investment choices are diversified pools of stocks, bonds and money markets, which gives the account potential to grow. When the investor is ready, they direct the DAF to liquidate funds from the investment pools to charities of their choice. With donor-advised funds, the investor is "banking" future charitable gifts while receiving a tax benefit now. To learn more about Donor-Advised Funds, visit: Charitable Giving Made Easy with Donor-Advised Funds 4.
Charitable Gift Annuities
For those needing income, a charitable gift annuity may be attractive. The charity accepts donated stock and sets up an annuity stream of income for the donor using the proceeds. The donor receives a partial tax deduction plus income for life. When the donor dies, the charity keeps the remaining funds. Visit American Council on Gift Annuities 5 for more info .
Trusts are more complex but can be structured with different gifting strategies and can be funded with appreciated stock. The trusts provide opportunities for gifting while creating tax benefits and can even create income for the donor. An example is a Charitable Remainder Trust (CRT). The investor can receive a tax deduction along with annual income and name a charity to receive the "Remainder" in the future. The opposite type of trust is a Charitable Lead Trust (CLT). With a CLT, the charity “leads off” by receiving annual income for a specified period, and the remainder goes back to the trust, family or heirs. There are other “flavors” in the charitable trust landscape and appreciated stock could be used to fund many of them. Work with an experienced estate attorney to review the available choices that best meet your needs and wishes.
Gifting stock to family members or children is a popular gifting strategy. This works especially well if the children are now adults and the stock owner is currently providing financial help. Examples are helping children with a down payment on a house, buying a car, or funding a trip overseas. The kids can then sell the stock and use the proceeds. Since the kids are likely to be in a much lower tax bracket the capital gains taxes may be lower or even eliminated. For 2019, the Federal government allows each person to gift up to $15,000 per year to an individual without filing a gift tax return. Therefore, a couple can gift a combined $30,000 every year to each child.
A large concentrated stock position can be a challenge when trying to diversify and reduce risk. An investor can incur irreparable financial harm in a worst-case scenario by not diversifying. There are strategies that can reduce those risks, lessen the tax burden of reducing the position, and even fulfill other goals at the same time. They are worth pursuing, but be sure to work with a financial advisor, accountant, and attorney that have experience with concentrated wealth and can walk you through the strategies that best fit your personal situation.
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