Spotlight on BDOWA’s Services: Managing Concentrated Stock Positions
Spotlight on BDOWA’s Services: Managing Concentrated Stock Positions
Concentrated stock positions can arise in various ways. Stock can be passed down from generation to generation, growing in value until it constitutes the bulk of the family’s wealth. Key corporate executives may be paid in stock and end up with a large block of the company’s equity. Company founders may find themselves with all their wealth in one specific business they own.
However it arises, having a large part of your wealth tied up in a single stock a leading example of idiosyncratic risk. It directly contravenes the principle of diversification—a key investment tenet—and makes your net worth more volatile. There is also the chance—as remote as it may seem—that a public company could collapse, as highlighted by recent examples like Enron and Lehman Brothers.
Prudence dictates that you should diversify away some measure of concentrated idiosyncratic risk to make it a more manageable part of your overall portfolio. The BDO Wealth Advisors team has advised many families and individuals on this issue, and we are happy to share our perspectives.
Overcoming a psychological barrier
When investors have a concentrated stock position, the most common barriers to action are often psychological. For example, inaction may be caused by a psychological phenomenon known as “anchoring.” This means that you attach to what you know and base your decisions around an established reference point.
Suppose a stock has been in a family for generations. The current generation may not want to be the ones to sell something their grandparents owned and has served the family well over time. Alternatively, an executive or company founder who has been with a company for decades and has a degree of confidence in that business may find it hard to replicate that feeling elsewhere. “Deworsification” is also a common fear; investors often worry that they won’t be able to find another investment that can outperform a stock that has done so well over time.
It is crucial to view your portfolio in its totality and keep a long-term focus. A diversified portfolio can introduce assets that perform countercyclically to your concentrated stock with less volatility.
Practical strategies for dealing with concentrated stock positions
Capital gains taxes are one key issue when seeking to diversify concentrated stock. Stock held for an extended period of time is likely to have a low basis relative to current market values, and therefore a significant embedded capital gain. We review three common strategies for diversifying concentrated stock.
1. Structured selling
Structured selling is a common diversification strategy that involves selling limited blocks of stock over time to mitigate the tax impact.
Investors can accomplish this strategy with simple sell limit orders that release stock at pre-determined prices. However, using stock options can be more effective. For example, if you plan to sell a stock at $55, you could sell a covered call option with a $53 strike price and receive a $2 premium for the call. (The call option gives the option holder the right to buy the stock from you at the strike price.) The stock only has to get to $53 to trigger a sell, but the economics are the same as a sell limit order at $55 once you include the call premium.
You can enhance this strategy using a collar. You sell a covered call option and simultaneously buy a put option at a lower strike price. (The put option gives you the right to sell the stock should it fall below the strike price.) This strategy protects your downside in the stock and may be costless if the premium income on the call options covers the cost of the puts. There are numerous tax rules around stock options which can lead to unpredictable tax results, so it is advisable to seek the advice of an experienced financial professional when considering options-based strategies.
Another approach is tax-loss harvesting. Suppose the concentrated position is in a taxable account and you have losses on other taxable investments. In that case, you can realize the losses and sell off just enough concentrated stock to use them up. The losses offset the gains in your concentrated stock. Tax-loss harvesting can be a very tax-efficient way of getting out of a large stock position over time.
With a containment strategy, you borrow against your concentrated stock and use that liquidity to build a diversified portfolio around it. One approach is a so-called monetization trade. You put a floor and ceiling around the stock using the collar discussed above and then borrow against this hedged position. You may be able to borrow up to 90% of the floor set by the strike price of your put option. You are effectively monetizing the stock while still owning it. Of course, you must factor in the cost of the loan and the possibility that you may be deferring, rather than solving, your concentration problem.
One of the few sure ways to avoid capital gains tax on appreciated stock is to hold the concentrated stock until death. Whoever inherits the stock will have a step-up in basis to market value at the time of inheritance, and embedded capital gains will be eliminated. This is an effective option, but understandably not always the preferred strategy.
If wealth has a generational aspect to it, another alternative is to gift the stock to the next generation during your lifetime. Those who receive it will keep your basis in the stock, but because recipients are likely to be in a lower tax bracket, they will pay less in total taxes when they sell the position. This effectively mitigates the tax impact at the family level.
You can also make a charitable donation of stock. If you replace a planned cash donation with stock and invest the cash instead, you effectively diversify the position. When donating to a qualified charity, the donor avoids any capital gains issues and can take an income tax deduction equal to the stock’s market value. Of course, not all charities can manage large stock grants. Alternatively, you could gift the stock to a donor-advised fund that you set up and run similarly to a family foundation, making charitable disbursements as you see fit. The same rules apply—the donor pays no capital gains tax on the donation and receives an immediate tax deduction. These funds can be set up with relatively small amounts and are an advantageous way to bunch charitable contributions.
Find the strategy that is right for you and your family
Tackling the problem of concentrated stock can be challenging, and the precise solution you adopt depends on a host of factors specific to you and your family. You should consult with your tax professional to determine the best option for your unique situation. The BDO Wealth team can work with you to think through various strategies and scenarios to help you make an informed decision.
If you are interested in learning more about managing a concentrated stock position or any other portfolio management issue, please do not hesitate to reach out to us.
BDO Wealth Advisors, LLC is a Registered Investment Adviser dedicated to providing clients with unbiased, personal financial advice. Working in partnership with our clients, our wealth management team helps organize, enhance, manage, and preserve wealth through sound financial strategies. This information is provided by BDO Wealth Advisors, LLC for the personal use of our clients and friends. It should not be construed as personal investment, tax, or legal advice. Information compiled from additional third-parties. Please be sure to consult your CPA or attorney before taking any actions that may have tax consequences and contact BDO Wealth Advisors, LLC regarding any investment decisions. Every investment strategy has the potential for profit or loss.