Entrepreneurs, heir, senior corporate executives and other high-net-worth investors often own large and risky positions in a single company’s stock. What can they do about it?
These concentrated equity positions, as investment professionals call them, often are made more difficult to manage because the investor has a low cost basis in the stock. An outright sale of low-basis stock will trigger substantial capital gains taxes. This may not be a terrible outcome now that the top federal tax on long-term capital gains has been cut to 15 percent, but reluctance to incur this tax can still lead the investor to take an imprudent gamble on the fate of a single company.
Generally, the goal in managing a concentrated equity position is to hedge against price declines in the stock, and ultimately to get money out of the position and diversify the portfolio. Here we will compare outright sales, protective puts, equity collars and variable prepaid forward contracts as methods of hedging large stock positions. Exchange funds, another vehicle that can achieve both goals of price protection and diversification, were discussed in Jonathan Bergman’s article “Spreading Risk Without Triggering Taxes” in the January 2000 issue of Sentinel.
The most obvious way to reduce the risks of a concentrated position in a single stock is to sell most or all of the shares and reinvest in a safer, more diversified portfolio.
The major impediment to this strategy is the capital gains taxes that will be triggered upon sale. By holding the concentrated position one can defer tax. That tax deferral represents leverage, because the deferred taxes can be viewed as money borrowed from the government without interest. However, the analogy of an interest-free loan holds true only if one assumes that capital gains tax rates will not increase in the future. Future rate increases represent a cost of deferring taxes that could have been paid at lower rates today.
Also, many times an outright sale is not feasible because the investor has restrictions against selling the stock. An additional concern for very large blocks of stock is the potential price- depressing effect of large sales over a short time. This is a greater consideration for smaller or more illiquid companies than for larger companies.
A protective put strategy buys protection against a price decrease with the purchase of a put option on the stock. A put option allows the holder to sell a specified number of shares at or before a certain date for a fixed price, known as the strike price. The investor is able to decide how much protection he or she wants by naming the strike price.
This strategy limits the downside risk of the stock, while still allowing the investor to participate in any appreciation. Protective puts are often preferred by those who remain bullish on the stock, but want protection against a price decline.
A protective put strategy is considered a straddle for tax purposes. A straddle occurs when an investor owns offsetting positions in a stock. Once a straddle begins, the holding periods on the offsetting positions are suspended. When one of the offsetting positions is sold or expires, the holding period clock begins again for the remaining position.
If the taxpayer has implemented a straddle, dividends received from the appreciated position will not qualify for the lower 15 percent dividend tax rate. For dividends to be considered qualified, one must hold the stock for at least 61 days within a 121-day window around the ex-dividend date, without owning any offsetting positions that diminish risk.
At expiration, if the stock price is lower than the strike price, the put options can be sold for approximately the difference. By selling the options instead of delivering the shares, one can continue to hold the appreciated position and defer what may be a large long-term capital gains tax. However, the proceeds from the sale of put options will always be taxed at short-term capital gains rates, because the holding period clock is frozen as a result of the straddle rules. If the stock’s price is above the strike price, the options expire worthless, and the investor can recognize a short-term capital loss. If the investor chooses to exercise the put option, shares are delivered. The cost of the put option is added to the stock’s cost basis.
One of the drawbacks of the protective put strategy is that it can be very expensive to maintain over a long period of time because new puts must be purchased as old ones expire. Also, the investor’s portfolio remains undiversified.
An equity collar is a strategy where the investor purchases a put option and also sells a call option on the same stock. Call options allow the holder to buy a specified number of shares at or before a certain date for a fixed price. A collar provides the same protection against price depreciation as a protective put strategy, but is less costly as the result of income from sale of call options.
Dealers generally create collars, but the investor can still decide on put and call strike prices. Therefore, the investor can decide how much protection vs. appreciation he or she wants.
An equity collar is also considered a straddle for tax purposes. Therefore, the holding period clock stops as soon as the collar is entered. Income received from the sale of call options is not taxed until the options either expire or are exercised. At this point, the income is taxed at short-term capital gains rates. Again, because the collar is considered a straddle, dividends received will be non-qualified and taxed at a higher rate.
If a collar’s band (the difference between the put and call strike prices) is too tight, it may be considered an “abusive collar” and can be treated as a constructive sale. A constructive sale occurs when transactions take place attempting to neutralize gain and loss in a current stock holding. Examples include a short against the box, or a future or forward contract.
If a transaction is deemed to be a constructive sale, the taxpayer is considered to have sold the appreciated position as of the date of the constructive sale, with one exception. If the taxpayer closes the transaction that would be deemed a constructive sale by the 30th day following the end of the tax year, and then holds the appreciated position for 60 days without hedging, the taxpayer is not required to report a constructive sale.
While there is no formula to calculate when a collar is abusive, tax experts have generally agreed that the band should be at least 15 percent to 20 percent from the put strike to the call strike.
A collar strategy where the cost of purchasing the put option is exactly equal to the income from writing the call option is known as a zero cost, or cashless, collar. The strategy benefits those who want to protect against a price decline, but are willing to forgo upside appreciation beyond the call strike price to minimize the cost of implementing the hedge.
Variable Prepaid Forward Contracts
In a variable prepaid forward (VPF) strategy, the investor agrees to sell a variable number of shares at some point in the future, typically between one and five years, in return for receiving an up-front cash advance. The cash advance is usually between 75 percent and 90 percent of the stock’s current value, and does not have to be repaid. Thus, the investor can immediately put these funds to work in a diversified portfolio. The VPF is settled at expiration by delivery of a portion or all of the shares pledged in the contract, to be determined by the stock price at expiration.
The VPF is structured similarly to a collar in that the downside is protected by a floor amount and the appreciation potential is capped by a ceiling. The investor retains ownership of the underlying shares and thus the voting rights and the dividend, although the dividend also is non-qualified.
The VPF strategy is not treated as a constructive sale as long as the band is maintained (15 percent to 20 percent). Taxes are deferred until the expiration of the contract, at which time the shares are delivered, and taxes are paid on the difference between the proceeds from the cash advance and the cost basis.
In summary, several techniques are available to investors who hold appreciated concentrated stock positions. These techniques allow such investors to hedge the risk of these positions and/or diversify their portfolios. The ultimate decision of which hedge, if any, is best to implement depends on the facts and circumstances specific to each investor. Some factors to consider include how much price depreciation of the stock the investor can tolerate, how much appreciation potential he or she wants to retain, the costs he or she is willing to incur to hedge the position, and whether the investor wishes to extract cash from the position to diversify or provide liquidity.