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
donating to a trust, may
be more cost effective
over a longer time
period, though your
obviously play a role as
Make sure your
collar's not too tight
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. Also, the prices set for a
collar must not violate
the rules against a
sale. A strategy that
eliminates all risk is
effectively a sale and
thus subject to capital
gains taxes. The
strike prices of a collar
should not be too close
to your stock's market
Options involve risk and are not suitable for all investors, and investors may lose the entire amount of invested principal in a relatively short period of time. 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.
Concentrated Stock Positions: Considerations and Strategies
Whether you inherited a large holding, exercised options
to buy your company's stock, sold a private business, hold restricted stock,
or have benefitted from repeated stock splits over the years, having a large
position in a single stock carries unique challenges. Even if the stock
has done well, you may want more diversification, or have new financial
goals that require a shift in strategy.
When a single stock dominates your portfolio, however, selling the stock
may be complicated by more than just the associated tax consequences. There
also may be legal constraints on your ability to sell, contractual obligations
such as lock-up agreements, or practical considerations, such as the possibility
that a large sale could overwhelm the market for a thinly traded stock.
The choices appropriate for you are complex and will depend on your own
situation and tax considerations, but here is a brief overview of some of
Sell your shares
Selling obviously frees up funds that can be used to diversify a portfolio.
However, if you have a low cost basis, you may be concerned about capital
gains taxes. Or you may want to avoid any perception of market manipulation
or insider trading. You might consider selling shares over time, which
can help you manage the tax bite in any one year, yet allow you to
participate in any future growth.
You'll need to consider the tax consequences of any sale. Long-term capital gains are generally taxed at special capital gains tax rates of 0%, 15%,
and 20% depending on your taxable income. By contrast, because short-term capital gains are taxed as ordinary income, the top
short-term capital gains tax rate can be 37%. Higher-income taxpayers should be aware that they may be subject to an additional
3.8% Medicare unearned income tax on net investment income (unearned income includes capital gains) if their adjusted gross
income exceeds $200,000 (single filers) or $250,000 (married joint filers).
If you hold restricted shares, you might set up a 10b5-1 plan, which
spells out a predetermined schedule for selling shares over time. Such
written plans specify in advance the dates, prices and amounts of each
sale, and comply with SEC Rule 144, which governs the sale of restricted
stock and was designed to prevent insider trading. A 10b5-1 plan demonstrates
that your selling decisions were made prior to your having any insider
knowledge that could influence specific transactions. (However, terminating
the plan early or selling too much too quickly could raise questions
about the plan's legitimacy.)
You might also be able to avoid some of the 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 capital gains taxes.
Hedge your position
You may want to try to protect yourself in the short term against the
risk of a substantial drop in price. There are multiple ways to try to
manage that risk by using options. However, bear in
mind that the use of options is not appropriate for all investors.
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. However, you also would lose money on the option itself
if the stock's price remains above the put's strike price.
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. However, the call limits the extent
to which you can benefit from any price appreciation. And if the share
price reaches the call's strike price, you would have to be prepared
to meet that call.
A collar involves buying protective puts and selling call
options whose premiums offset the cost of buying the puts. However, as
with a covered call, the upside appreciation for your holding 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
for the put, but would also face capital gains on any shares you sold. 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 call's expiration date, you could be left 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.
Monetize the position
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% of their value — when the agreement
is signed. However, you are not obligated to turn over the shares or
pay taxes on the sale until the PVF's maturity date, which might be years
in the future. When that 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 that time. In the meantime, your stock is held as collateral, and you
can use the upfront payment to buy other securities that can diversify your portfolio. In addition, a PVF still allows you to benefit
to some extent from any price appreciation during that time, though there
may be a cap on that amount.
PVF agreements are complicated, and the IRS warns that care must be taken when using them. Consult a tax professional
before using this strategy.
Borrow to diversify
If you want to keep your stock but need money to build a more diversified
portfolio, you could use your stock as collateral to buy other securities
on margin. However, trading securities in a margin account involves risks. You can lose more funds than you deposit in the margin account.
Consider speaking with a financial professional before considering
Exchange your shares
Another possibility is to trade some of your stock for shares in an exchange
fund (a private placement limited partnership
that pools your shares
with those contributed by other investors who also may 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 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, 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 as well as what other securities it holds. At least
20% must be in nonpublicly traded assets or real estate, and the more
overlap between your shares and those already in the fund, the less diversification
Donate shares to a trust
If you want income rather than growth from your stock, you might transfer
shares to a trust. If you have highly appreciated stock, consider
donating it 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 charity retains the remaining assets. You can set
a payout rate that meets both your financial objectives and your philanthropic
goals; however, the donation is irrevocable.
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.
There are costs associated with creating and maintaining trusts. You receive no tax deduction for transferring assets unless you name
yourself the trust's owner, in which case you will pay taxes on the annual
income. Other philanthropic options include donating directly to a charity
or private foundation and taking a tax deduction.
Managing 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.