The very asset responsible for creating significant wealth may eventually become the

biggest risk to financial peace of mind.

Written by: Brian Heithoff, CFP®

STRATEGIES FOR HANDLING

CONCENTRATED STOCK POSITIONS

Many affluent investors have amassed significant personal wealth through an inheritance, an equity compensation structure, a great run in an individual stock investment, or the sale of a closely held business to a publicly traded company.

These situations often result in a high concentration of

assets in a single investment. However, the very asset

responsible for creating significant wealth may eventually

become the biggest risk to financial peace of mind.

Often times, investors develop an emotional attachment to a stock

that may be driven by a sense of loyalty, bullish sentiments regarding

the company’s future, concerns of being a corporate insider or fears of

Uncle Sam and a big tax bill. Sometimes, the investor simply adheres

to a “if it isn’t broke, don’t fix it” philosophy. Unfortunately, some good

things don’t last forever.

Over the last two decades alone, we’ve witnessed many blue chip

stocks go bankrupt, sometimes abruptly, and always at the peril of

overly concentrated investors. These aren’t little-known companies, but

household names like Delta Airlines, United Airlines, Bethlehem Steel,

Kmart, Enron, WorldCom, Federated Department Stores, Lehman

Brothers, Texaco, Circuit City and many more. Very few predict a fast-

growing company or household name will meet its demise; however, it

happens more often than many of us would care to admit.

Sometimes, the

investor simply

adheres to a “if it

isn’t broke, don’t

fix it” philosophy.

Unfortunately, some

good things don’t

last forever.

STRATEGIES FOR HANDLING CONCENTRATED STOCK POSITIONS

That is why it is vital to evaluate stock concentration when markets are positive and sentiment is bullish. Working with an advisor who maintains an objective view can help investors see past their emotional attachment to certain stocks so they can develop a plan to diversify their portfolios and protect their net worth.

Following are several strategies your advisor might employ to help you divest and diversify.

Sell your sharesA sale of stock is often the best and most simplistic means for reducing a concentrated stock position. However, investors with a low-cost basis may be concerned about the capital gains tax associated with selling.

The American Tax Relief Act of 2012 set the maximum tax rate on long-term capital gains at 20 percent for individuals in the 39.6 percent federal income tax bracket. The maximum rate decreases to 15 percent for those in the 25 percent, 28 percent or 33 percent, and to 0 percent for those in the 10-15 percent brackets. Also, an additional 3.8 percent surtax applies to net investment income for taxpayers with adjusted gross income (AGI) over $200,000 (single filers) or $250,000 (married filing jointly).

Low volume stocks will likely require the use of disciplined limit order placement. Rule 144 or restricted shares have their own specific applicable rules and trading windows. You can possibly file for a 10b5-1 plan to demonstrate your selling decisions in advance. This written plan includes a formula that will control the trading of the shares over a specific period of time. Alternatively, you may consider setting up a blind trust and giving the trustee full discretion to determine how much will be sold, at what price and when. A trustee working with a professional money manager may maximize the sale price of the stock in the trust. Blind trust managers often use the same hedging strategies to provide some downside protection during the term of the trust.

Net unrealized appreciation (NUA)The NUA strategy allows investors to pull low basis, highly appreciated stock out of the corporate retirement account and pay ordinary income tax on the basis only. Because the stock is now outside the qualified account, the net unrealized appreciation, or the difference between the basis and the current price, is taxed when it is sold at a long-term capital gain.

STRATEGIES FOR HANDLING CONCENTRATED STOCK POSITIONS

Hedge your positionYou may consider protecting yourself against a significant drop in stock value by using options. A purchased put option is akin to buying insurance against the risk of loss in your stock. If you buy a protective put option, you have the right to sell all or a portion of your shares at a predetermined price. Like insurance, if the price of the stock goes up, then the value of the option will expire worthless. It may make sense to use this strategy for short-term protection, but over the long-term, this option can be quite expensive.

Selling covered call options with a strike price above the current market price can provide additional income and minimal protection against a total loss if the stock drops in value. However, call options limit the upside benefit from price appreciation. One approach is to use covered call options as part of a systematic selling arrangement where you would part with certain shares based on market movements and get paid the premiums while you wait.

A cashless collar combines the two previous strategies of buying protective puts while also writing calls for a premium. The premiums received from selling the call options offset the cost of buying the puts. It works like this:

• Purchasing the put ensures that if the stock’s price drops, the investor can sell it at a predetermined price. At-the-money puts can cost 10 to 20 percent of the value of the stock, annually.

• At the same time, the investor sells a call, giving someone else the right to buy the stock at a predetermined price if the stock value should rise. A call might sell for 15 to 20 percent of the current stock price.

• The premium earned on the call offsets the cost of the put, thus earning the name zero-premium collar.

• Buying a put is designed to provide downside protection, while selling the call may allow you to capture at least some upside appreciation (with the added benefit of offsetting the cost of the put). There are no taxes incurred on the underlying stock however there are some unique tax rules for the options straddle.

• On the downside, if the price of the stock were to soar, the holder would buy the investor’s stock at the agreed-upon price and resell it for an immediate profit. The investor, therefore, has limited his or her participation in the appreciation of the stock.

Be careful not to set the price of the collar too close to avoid triggering a constructive sale under the Taxpayer Relief Act of 1997. To avoid the constructive sale, the spread between the put and the call is usually 20 percent of their strike prices, but always seek the advice of a tax professional. There must be some element of possible loss or gain to avoid the constructive sale rule. Entering into a hedge transaction puts a pause on the capital gain clock.

The one-year holding period for long-term capital gains is interrupted by the duration of the collar. You cannot deduct the losses until all positions have closed-when the collar expires, is exercised, is bought or is sold out. On the other hand, gains are taxed as soon as the call option expires unexercised. If the call closes before the put, you may recognize capital gains without the benefit of the offsetting loss.

Hedging stock optionsYou cannot currently hedge incentive stock options before exercise. Hedging during the first year after exercise may be a disqualifying disposition and trigger ordinary income taxes. It may be possible to hedge nonqualified stock options by opening a collar with a 20 percent spread between the call and the put strike prices. Please consult with your investment professional.

Borrow to diversifyIf you do not want to (or cannot) sell your shares, you may be able to use the shares as collateral for a margin loan. Trading securities in a margin account involves significant risk that should not be taken lightly and should be discussed with you financial professional. Margin loan will be capped at 50 percent of the value of the shares at a variable interest rate priced above the broker call rate.

STRATEGIES FOR HANDLING CONCENTRATED STOCK POSITIONS

Monetize the positionIf you want immediate liquidity, you may be able to use a Prepaid Variable Forward (PVF) contract with an institution. The value of the concentrated position can be concurrently monetized by means of a margin loan. Using a PVF, you contract to sell your shares later at a minimum specified price. You then receive the majority of the payment (75-90 percent) when the agreement is signed. You are obligated to turn over the shares or cash equivalent at the maturity date, which may be years away. The number of shares depends on the stock’s price at the time of delivery. While your shares are being held as collateral by the lender, you can use the cash to diversify your holdings.

There is some counterparty credit risk with this strategy. The PVF still allows for some price appreciation during this time, which may be limited by a cap. These agreements are complicated, and it is wise to consult a tax professional.

Exchange your sharesAnother option is to trade some of your stock for shares in an exchange fund. A private placement limited partnership pools your shares with those contributed by others who may also be in a similar concentrated status. After a set period of time, each shareholder is given a prorated portion of the fund. This action provides no immediate liquidity but does help minimize taxes while providing greater diversification. The trade-off is that the investment lacks liquidity, offers limited or no current income, accrues high fees and gives the investor no control over what is owned within the fund.

Because these are highly regulated private placements, they are limited to only the wealthiest investors who can qualify under the SEC rules. An investment in an exchange fund usually carries a $1 million minimum. They carry no guarantee that the diversified portfolio will do better than the single stock, and, as with any technique, tax laws can change.

Pairs tradingA pairs trading strategy takes like securities and trades them in long-short format. The long concentrated stock position is offset by a short position in a like security or ETF. The intent of the trade is to reduce the idiosyncratic risk of the concentrated holding. There are no guarantees that a pair trade will prove effective in hedging the position. The stock prices could possibly become uncorrelated.

Gifts of stockYou could gift the concentrated stock but it is subject to the gift tax. The following gifts are considered to be taxable gifts when they exceed the annual gift exclusion amount of $14,000 in 2017. Remember, taxable gifts count as part of the $5.49 million in 2017 you are allowed to give away during your lifetime, before you must pay the gift tax.

Donate shares to a trustBy donating highly appreciated stock to a charitable remainder trust (CRT), you are eligible to receive a tax deduction when you make the contribution. You can set a payout rate conducive to your income needs. The trust would get an irrevocable donation that can be sold to diversify and create an income stream for you with no immediate capital gains tax at the time of sale.

Managing a concentrated stock position is a complex task. If an investor desires to retain the concentrated security, a portfolio can be constructed that factors in the concentration. It will add layers of complexity to the capital allocation discussion.

For additional information about managing your concentrated stock position, please contact your wealth advisor. We will work to develop a strategy that takes into account your objective and time horizon, the title of the securities, any restrictions, your liquidity needs, any applicable fees, your need for dividends and your charitable aspirations.

STRATEGIES FOR HANDLING CONCENTRATED STOCK POSITIONS

STRATEGIES FOR HANDLING CONCENTRATED STOCK POSITIONS

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