Clients with one big egg in their basket are exposed to that particular issue, and if the position is highly appreciated, trimming by an outright sale can generate a steep tax bill.
“We are regularly approached by prospective clients, as well as their tax advisors and attorneys, to help reduce exposure to a concentrated stock position,” says Stephen M. Stabile, senior vice president of wealth management, at The Hirsch Stabile Group of Merrill Lynch in New York.
“There is no single solution for a concentrated stock position,” he says. “Usually the solution is multifaceted.”
Nevertheless, some tactics are used regularly.
For example, charitable remainder trusts may appeal to clients who are philanthropically inclined.
“The investor gifts highly appreciated stock to a CRT and typically receives a current income tax deduction,” Stabile says.
“This saves on the capital gains tax the client would owe from cost basis to current market value,” he says. “Then clients can structure a stream of income payable back to themselves or to specific beneficiaries.”
Another way for some clients to trim concentration is to enter into a “zero premium collar,” Stabile says.
With this hedging strategy, the investor simultaneously writes a call option and purchases a put option on issues within the concentrated position. With equal premiums, there is a net zero out-of-pocket cost.
“The investor eliminates risk below the put strike price, participates in appreciation up to the call price and effectively manages risk within specific parameters of the collar,” Stabile says. “A solution to an appreciated concentrated position is usually found in a combination of a CRT and an options strategy.”
Brent Robbs, a tax planning consultant in the wealth management department at Stifel Financial Corp. in St. Louis, mentions using exchange funds for trimming a concentrated position.
“An exchange fund is a limited partnership of numerous partners with highly appreciated concentrated positions,” he says. “In exchange for a contribution of concentrated shares, an investor receives an interest in a partnership that holds a diversified portfolio, comprised of other low-cost-basis equity positions contributed to the fund by other investors.”
This strategy provides diversification without incurring immediate capital gains taxes, Robbs says.
“The downside is that there are generally higher fees associated with exchange funds,” he says. “Regulations require remaining in the fund for at least seven years to maximize tax deferral.”
Robbs gives the example of a client whose $50,000 investment in a stock many years ago is now worth $1 million.
“The client can contribute the $1 million position to an exchange fund and receive exchange fund shares equal in value to $1 million [ignoring any commissions]. “Seven years later, the client redeems the exchange fund position, receiving a diversified basket of stocks equal to the current market value of the client’s exchange fund position,” Robbs says.
“The cost basis of these shares is approximately $50,000, the original cost basis of the contributed concentrated position,” he says. “Here, the client diversified immediately at no tax cost and will not realize capital gains until selling the stocks received from the exchange fund.”
Donald Jay Korn is a New York-based financial writer who contributes to On Wall Street and Financial Planning.