In our primary markets, Seattle and Silicon Valley, we often see clients with significant concentrated positions in a single stock. These concentrated positions often come from exercising and holding stock obtained through options or restricted stock units from their employer. Concentrated equity positions can be a great way to build wealth. But when things go wrong, they can also be a way to lose a great deal of wealth very quickly. We help our clients’ hedge risk and begin to diversify in a prudent, tax-efficient manner. Below are several strategies and vehicles to consider for hedging and diversifying concentrated stock positions.
One thing to keep in mind in considering these various strategies is that most of them are designed to defer capital gains taxes into future periods. While future tax policy is always uncertain, most observers believe that capital gains rates will most likely increase in coming years. The long-term capital gains rate at the Federal level is 20% as of now. So, if you are considering diversifying, there is an argument to be made for selling now and paying the capital gains tax at the current low rate. This could of course change if Congress passes a bill that increases the capital gains tax rate immediately or even retroactively, which was part of the September 13, 2021 proposed legislation.
Puts are a type of option that allows the holder of the put option to sell a stock at a specific price at a future date. To hedge the risk of a large position, the owner could buy puts on the stock at an exercise price somewhere below the current price. Typically, around 10% below. If the stock declines to the strike price or below, the profit on the put would offset the loss in the stock. The biggest challenge with this strategy is to buy enough puts to hedge a very large position, which can require a large cash outlay.
The cashless collar is a strategy that partially solves the problem of the upfront cost required to buy puts. The collar combines the purchase of puts, as above, will the sale of an equal number of call options. The seller of a call option is required to sell the stock to the call owner at the listed strike price if exercised. In a cashless collar, the call strike price is usually 5 to 10% higher than the current stock price. So, there is generally a 10-15% spread between the call and put options. With this strategy, the owner of the stock retains some upside potential, up to the exercise price of the call. The proceeds from selling the call will completely or partially offset the price of buying the put. An additional feature is that the owner of the stock can then usually borrow money against the minimum value of the collar, thus monetizing the position.
Variable Prepaid Forward
The VPF is a transaction similar to the Cashless Collar. Instead of using options, the investor enters into a forward sale agreement with a counterparty, usually an Investment Bank. The investor agrees to sell their stock at a certain date in the future but at a variable price. A maximum and minimum price is set, usually with a 15% or larger range. This establishes a minimum price the investor will receive, but also allows them to retain some upside potential. When the date of the forward sale arrives, the investor delivers some or all of their shares based on the stock price. Also similar to the loan against the cashless collar, part of this transaction is that the buyer prepays the seller a portion of the eventual proceeds. But the taxable gain is deferred to the future date of the forward sale.
With both the Collar and the Prepaid Forward, the investor retains beneficial ownership of the stock. With the collar, you will retain dividend rights. With a Prepaid Forward, the terms of the contract will declare which party gets to collect the dividends.
An Exchange Fund is a pooled investment vehicle. Instead of investing cash as in a mutual fund, individual investors contribute shares of stock that they own. Each investor then owns a percentage of a diversified portfolio of all of the stocks that are contributed to the fund. The managers of the fund will decide if and how much of each stock to accept into the fund, thus creating a diversified portfolio. Participants in the Exchange Fund will need to stay invested in the fund for a certain period, usually 7 years. If they want to exit the fund before that time, they would be required to take back the shares they contributed. Capital gains on the original stock contributed would be deferred until the investor exits the Exchange Fund. There are several other technicalities related to this strategy, but it can be an interesting way to diversify a concentrated position.
Charitable Remainder Trusts
A Charitable Remainder Trust (CRT) is a split-interest trust. An investor can establish this type of trust and then contribute shares of stock, usually shares that are highly appreciated. The Trust is a charitable entity, so it can then sell the shares of stock without paying capital gains tax. The donor retains an income stream from the CRT for either a certain period or the rest of their lives if they are over 50. The remainder of the principal of the Trust will go to a charity or charities of the donor’s choice.
How much the distribution payment can be is based on a calculation outlined by the IRS. The Trust needs to be structured so the charity will receive at least 10% of the present value of the amount contributed to the Trust. The donor to the CRT will also receive a charitable deduction in the year they donate. How much that deduction will be is based on this calculation. To comply with the tax rules, it will be at least 10% of the fair market value of the amount contributed.
Each of these strategies has unique features, benefits, and complexities. There are tax rules related to each of them that must be followed. Making sure each of these transactions is structured correctly is very important to achieve your goals. Understanding the benefits and technicalities can help you decide which vehicle or strategy best fits your situation.
To learn more about hedging and diversification strategies, visit www.bordeauxwealthadvisors.com or call 650-289-1105. We manage the complexities of wealth so you don’t have to.
Author: Jon Snare CFA, CFP®