By: Garrett Wells, CFP®
Diversification is a foundational concept in financial planning and asset management. The objective of diversification is to spread out proverbial eggs across several baskets to increase the odds of successfully achieving long-term investment goals while reducing the chances of sharp and permanent losses of capital.
During pronounced equity market gyrations like we have experienced recently, planning for your financial future becomes incredibly difficult. This magnifies the importance of diversification — especially when stock positions become concentrated.
What is a Concentrated Stock Position?
A concentrated single-stock position occurs when a single stock holding constitutes a relatively large percentage of an investment portfolio. Common scenarios when this may occur include the following:
- An employee receives stock or stock options as part of compensation.
- An individual inherits a sizeable single stock position.
- A long-held stock appreciates substantially over time.
- A business owner sells his or her company and receives stock in a publicly traded company as part of the proceeds.
Diversifying: Why It’s Necessary and Your Options
Regardless of how the concentrated stock position occurs, the result is a disproportionate allocation of wealth that exposes individuals to undue financial risk. One way to reduce this risk is to simply sell out of the concentrated position. However, this may result in a large capital gains tax bill.
Keep in mind, everyone’s financial situation is unique and you should consult a financial professional to determine if any of the following strategies are appropriate for you.
Fortunately, there are other ways to diversify an investment portfolio and reduce or eliminate the risk of a concentrated stock position. Here are 6 strategies to consider in addition to simply selling a position.
Pros: Tax-free transfer of stock or assets, potential reduction of gift value from income taxes, simple process.
Cons: The gifting party gives up ownership of the asset.
Perhaps the simplest and most efficient way to manage large gains in stock value is through the process of gifting to charitable organizations. If a stock or other asset is donated to a charity, no tax is paid at the time the gift is given. You can also deduct the current market value of the gift from your income taxes up to certain limits as long as the stock or asset has been held for one year or longer.
For charitable organizations that may not have the ability to take donations in forms other than cash, Simon Quick can help you establish a donor advised fund. These allow you to make regular or one-time contributions of cash or stock that can be granted to your designated charities over time while still receiving the tax advantages immediately at the time of contribution. Assets within donor advised funds are able to grow and be sold tax-free, making them a preferred tool in helping efficiently maximize the amount you can give to charitable causes.
Alternatively, you may choose to gift stock or assets to a family member. As long as the gift is below the annual exclusion amount ($17,000 per individual for 2023), the gifting party will pay no tax, but basis will transfer with positions and the receiving party will still need to pay tax should there be a sale in the future. In many instances, there are still benefits as the gifting could shift the capital gains into a lower tax bracket of the receiver. Of course, the downside of gifting to charity or others is that the stock or assets gifted no longer remain the property of the original holder.
2. Tax Managed Strategies
Pros: Wind down a concentrated position by using tax losses from other assets, retain market exposure.
Cons: Additional cash is needed on top of the appreciated stock, multi-year process.
The IRS generally allows investors to offset realized gains with realized losses for tax purposes. Typically, a process known as tax loss harvesting occurs around year end, during which time investors and advisors will look through portfolios to see which positions should be realized at a loss to offset taxable gains and income from other profitable investments. While this is a useful technique, in many instances investors may not have enough losses to offset the potential tax consequences of the full sale of an appreciated position. In such a situation, utilization of an active tax management strategy may be advantageous.
Active tax management strategies overlay index-tracking portfolios with tax loss harvesting. You would provide a manager with an appreciated stock position as well as cash. The cash contribution is then used to purchase additional stocks with the goal of replicating an index. As certain stocks within the replicated index lose value, they are sold and replaced with stocks that have similar characteristics. The sales generate tax losses that can be used to offset taxable gains as portions of the appreciated stock are subsequently sold over time. Being able to fully liquidate out of a position can take several years and the exact amount of time needed will vary depending on the amount of stock contributed relative to cash, the basis of the contributed stock, and how flexible you want to be in tracking error versus a benchmark index.
3. Option-based Liquidation
Pros: Highly liquid, modest downside protection to the security, no lock up of capital, customization to best suit investor situations.
Cons: Multi-year process to liquidation, limits further stock appreciation.
Options give holders the right, but not the obligation, to buy or sell specific securities. The option seller benefits from receiving a premium to offer that right to the holder. This is not too dissimilar from an insurance policy or pre-purchasing tickets for a future event at a discount. We don’t recommend individuals trade options on their own unless they are experts and actively monitoring their positions. If executed conservatively and thoughtfully by a professional manager, however, an option strategy can be a useful tool in the context of tax-efficiently liquidating positions and reducing risk.
A simple approach to this strategy is to sell call options on a stock an investor wishes to liquidate over time. Depending on the direction the underlying stock moves, the options will either make or lose money. If the call options are profitable, the stockholder can sell a portion of the underlying position and use the premiums earned from writing the call options to pay the tax bill associated with the stock sale. If the options lose money, those losses can be used to offset the tax bill resulting from an unwinding sale of the underlying security.
4. Equity Collar
Pros: Offers downside protection, generates income and cash flow, maintains concentrated stock’s value, can be done “costless.”
Cons: Might be considered a constructed sale and subject to taxation.
With this strategy, you will purchase a long-dated put option on the concentrated stock while selling a long-dated call option. The put option will give you the right to sell your concentrated stock position at a certain price in the future, thus offering downside protection. The call option, meanwhile, will provide income you can use to finance the put option. An equity collar will keep the value of the concentrated stock between a lower and upper limit over the collar’s timeframe.
With a costless equity collar, the sale premium will cover the cost of the put option so there is zero cash outflow. Or you could sell a call option with a higher premium to create net cash flow if you want to generate additional income. Be sure to leave enough room for potential gains and losses so the transaction is not considered a constructed sale by the IRS, which would subject it to taxes.
5. Exchange Funds
Pros: Transfer of single name risk into market risk, receive back a diversified basket of holdings after seven years.
Cons: No tax benefits or improvement in cost-basis, moderately illiquid.
Exchange funds are special investment vehicles that allow investors to contribute appreciated stock holdings into a large, diversified pool of other stocks in exchange for a proportional interest in that pool. After the contribution of owned shares to the fund, the tax basis will not change, but risk is immediately diversified. The two primary benefits of this type of investment solution are risk reduction through diversification and deferral of tax payments. After an investment is held within an exchange fund for seven years, the investor becomes eligible to redeem a basket of shares from the fund rather than only the stock that was contributed.
These baskets usually consist of between 10 and 30 names and are diversified by sector and distributed in-kind to investors. Like the contribution, the redemption is not a taxable event; however, it is worth noting that through this strategy you are merely deferring the payment of taxes, not eliminating them. The redeemed stocks will maintain a basis similar to that from when the concentrated stock was originally contributed. In many situations, investors have also found exchange funds to be great estate planning tools as a step-up in basis will occur upon death.
6. Opportunity Zone Funds
Pros: Reduction and deferral of taxes, profits on fund gains are tax-free if partnership interest is held for 10 years.
Cons: Does not fully eliminate realized taxes, limited window to reinvest gains, long fund lockup period, investment-related risks.
The Tax Cuts and Jobs Act of 2017 allows investors to take advantage of the opportunity zone investment program. This program incentivizes investors with unrealized capital gains to realize those gains and subsequently roll them into investments in real estate or businesses located in underdeveloped areas by offering attractive tax benefits. There are two primary benefits to investing in an opportunity zone fund.
- Investors can defer their tax bill until their 2026 tax filing
- Any profits generated by the opportunity zone fund are tax-free as long as certain criteria are met and the investment is held for at least 10 years.
Opportunity zone funds can be great options for those with appreciated stock that the holder no longer wants. Additionally, they can provide compelling after-tax return potential when compared to traditional real estate investments not utilizing the program. For a more in depth look at opportunity zone investing, please see our whitepaper entitled Making Good Become Great: Investing in Opportunity Zones.
How a Financial Advisor Can Help
Deciding which of these solutions is most appropriate should be done on a case-by-case basis and within the context of your total portfolio. You could also benefit from a combination of these solutions, particularly when managing for future liquidity needs. If your stock position has become too concentrated, we welcome the opportunity to discuss the various options available to you in further detail. Visit us online, call us at (973) 525-1000 or send an email to firstname.lastname@example.org to discuss your situation in detail.
About Garrett Wells
Mr. Wells joined Simon Quick in December of 2017. He is currently a vice president on the client advisory team. He is responsible for supporting the Partners and Client Advisors in assisting with financial planning for clients, implementing investment plans, preparing investment performance reports, and coordinating client communications. Mr. Wells is a member of the Hiring Committee, where he helps to identify and interview new talent for the firm. Garrett completed the Financial Planning Certificate Program at Fairleigh Dickinson University and became a CERTIFIED FINANCIAL PLANNER™ practitioner in October 2020. Prior to joining the firm, Garrett worked as a consultant for First Derivatives focusing on Regulatory Reform for investment banks. There he gained experience in the implementation of financial regulation across the front, middle, and back offices of large banks. Learn more about Garrett on LinkedIn.
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