The proposition of ending up with such a large amount of a single stock that it eclipses your other assets most likely sounds enticing to the average person. Indeed, much wealth has been created by those fortunate enough to hitch their wagon to companies whose stock has continued to climb for years on end, such as what happens with some companies’ equity compensation plans. The reality is that for these lucky souls who have benefited from this appreciation and now have a concentrated stock position, there are major tax implications for holding or selling these positions going forward.
How much of a single stock is too much? A common rule of thumb is to pare down concentrated stock positions that exceed 10% of one’s net worth. Like all rules of thumb, it is important to consider your own situation and circumstances.
Questions to Ask Yourself
Be aware of your own biases when considering whether to pare down your position. Ask yourself, “If I had X dollars today to invest, would I be buying this stock?” Another great question is to ask how you would feel if the stock dropped 20% … or 50% … While we never like to imagine a situation where our biggest holding free-falls, the reality is that there are countless examples of “great” companies that had major declines.
If taxes were not an issue, then scaling back a concentrated stock position would be a no-brainer. One would simply sell the amount that would reduce the concentration to a manageable amount and diversify. In practice, however, it is more complicated. By definition, an appreciating stock usually will have increasing potential tax liability associated with it.
Fortunately, there are some creative ways to reduce or limit one’s exposure, while keeping tax liability in check. We will examine some of the more common ways.
Spreading Tax Liability Over Multiple Years
Selling stock. If one has a large position with little or no tax liability (usually from an inherited position with “stepped-up basis”), then selling outright is straightforward. If the positions have large embedded gains, this is where a strategy becomes paramount. One strategy is to stagger the sales over multiple tax years.
It is important to work with your tax and financial advisers to optimize this strategy from both a risk and capital gains perspective.
Selling stock held in a qualified plan. If the stock is held in a company retirement account, such as a 401(k), then there are additional factors. While there is no tax liability within the plan when stock is sold, at some point the employee will take distributions from the plan, which will be taxed as ordinary income (a higher rate than long-term capital gains). There is a way to mitigate this future tax liability using a special technique that utilizes net unrealized appreciation (NUA).
In this scenario, appreciated company stock (only) would be distributed out of the plan at age 59½ and older (to avoid penalties). The pre-tax amount (basis) is taxed as ordinary income, while the remaining appreciation (NUA) would be taxed at the long-term capital gains rate when sold. Since the shares are not being rolled into an IRA, but rather a taxable account, no required minimum distributions (RMDs) will be needed from these funds. This technique is complex, so working with your advisers is recommended.
Large positions with high embedded gains. If one has managed to accumulate north of $1 million in one or a few stocks, then an exchange fund may be an option. Like many of the great loopholes, this one is reserved for wealthy individuals who are considered qualified purchasers (QPs) — for simplicity, those with investments (not including primary residence) of $5 million or more.
The concept is as follows: One contributes their highly appreciated position(s) valued at at least $1 million to an exchange fund. In exchange, your investment is diversified into hundreds of positions, including some illiquid holdings (probably real estate) within a fund. After a seven-year period, you can take possession of a diversified “basket” of stocks with the cost basis spread among them.
Because of the complexity of this strategy, it is a must to work with an adviser who is experienced in using them. There are only a couple of providers of this strategy. There are fees and rules associated with exchange funds that must be well understood before utilizing.
Hedging. There are circumstances where one may want to hold on to a concentrated stock position, but also protect on the downside. An option strategy, such as using a “zero-cost collar,” may make sense. While option strategies are complex, and a collar is no exception, the concept is straightforward.
You would simultaneously buy an option to “put” or sell a position at an agreed-upon price, while selling (writing) an option with the right for someone to buy (call) at an agreed-upon price.
For example, suppose I have a position of XYZ Company that comprises a large percentage of my net worth. While I believe that XYZ’s prospects for the future are excellent, I worry that a large decline in value would severely impact my future lifestyle. If XYZ is trading at $100 per share, and I have 10,000 shares, I might utilize a collar. I could buy the right to sell a certain amount of shares of XYZ at $90 per share. Of course, I would execute this right only if XYZ dropped below $90.
At the same time, I could sell (write) a call option to someone who would like to buy XYZ at a price of $110. If XYZ went above $110, then the owner of this contract would want to take advantage of “calling” those shares, which you would need to deliver at $110 per share. If structured properly, the selling of the call will pay for the buying of the put. Roughly speaking, you have protected your downside below $90 and limited your upside above $110.
Be Careful: Getting It Wrong Can Cost You
If your head is spinning now, you are not alone. There are other options strategies that may make sense for your particular situation as well. Getting this wrong can be a very expensive proposition. Finding a financial adviser who is knowledgeable about options strategies and hedging is key to getting this right.
While we all would love to have bought Amazon the day after its IPO, the reality is that there are many regular investors who will end up with concentrated stock positions. Being realistic about the implications of an outsized hit to your net worth in the event of a major downturn should help navigate your course of action. Thanks to the complexity of IRS regulations combined with myriad alternatives, partnering with a professional can make all the difference.
Chris Creed is a Senior Lead Adviser for Venturi Wealth Management. Chris partners with new clients to organize, plan and manage all aspects of their family's financial life. As a Certified Financial Planner® professional and a Certified Private Wealth Advisor®, Chris creates customized wealth planning strategies unique to highly affluent clients.
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