3 Hedging Strategies for Concentrated Stock Positions
Taxpayers often have a large percentage of their wealth tied up in a single stock, but a single stock portfolio is unfavorable for two reasons. First, it is risky to bet your financial future on the performance of a single company, and second, the volatility associated with a concentrated portfolio could be expected to substantially reduce returns.
In the research report The Enviable Dilemma: Hold, Sell or Hedge Stock, for example, the authors found that from 1984 to 2003, the annualized compounded return on the S&P 500 was 13%, while the annualized compounded return for the average stock was only 9.9%, nearly a 24% reduction.
Some financial planners may think the solution is as simple as selling the stock and reinvesting the proceeds in a diversified portfolio. This would lock in the gain on the stock, eliminate the concentrated portfolio risk and increase the expected return on the new portfolio; however, there would be one important tradeoff: the investor typically has a low basis in the stock and would incur substantial capital gains tax if the shares were sold.
Keeping the stock or selling it and reinvesting in a diversified portfolio are not the only options. It may be possible to get the best of both worlds by enabling the taxpayer to achieve all of the following at a reasonable cost:
- deferral or elimination of capital gains tax
- hedging against downside risk
- monetization and diversification
- retention of the upside potential on the stock
Here are three strategies designed to accomplish these objectives.
#1: Protective Put Option. A put option gives the investor the right to sell the underlying security at a stated price during a stated period of time.
Example. Tom owns 10,000 shares of XYZ stock with a basis of $10/share and fair market value of $100/share. For $3/share, Tom buys put options on the stock with a strike price of $93/share. No matter how low the stock price drops, Tom can sell for $93/share.
- No immediate gain recognition.
- Locks in gain of at least $80/share ($93 sale price -$10 basis) - $3 cost of put option).
- Enables Tom to borrow against the stock (typically 90% of its value, or $900,000).
- Tom can use the $900,000 to reinvest in a diversified portfolio.
- Tom retains all upside potential above the current price of $100/share.
Disadvantage: Cost of put.
#2: Cashless Collar. This strategy addresses the cost disadvantage of buying a put. Suppose that Tom can sell a call option with a strike price of $110 for $3/share, netting out the cost of the put. The call option gives the buyer the right to buy XYZ stock from T for $110/share.
Advantage: Pays for put.
Disadvantage: Tom loses upside potential above $110/share.
#3: Charitable Remainder Trust. A charitable remainder trust is a trust in which the grantor or another non-charitable beneficiary receives a lead annuity or unitrust interest, with the remainder interest passing to charity. Tom would contribute the XYZ stock to the charitable remainder trust and the trust could sell it with no gain recognition because the charitable remainder trust is a tax-exempt entity.
- Sale locks in gain on stock.
- No gain recognized on sale.
- Full value of stock can be reinvested without capital gain tax (100% monetization to reinvest).
- No tax until Tom receives annuity or unitrust payments.
- Income stream for Tom.
- Charitable deduction for present value of remainder interest.
- Irrevocable transfer of assets.
- 10% minimum value for charitable remainder interest.
- Must avoid unrelated business taxable income.
- No prearranged sale before stock is contributed or gain taxed to T.
While every client situation is different, chances are you can help them by following one of these three strategies. Overall, be flexible and plan to change your course of action when needed.
Want to learn more? I discussed the concepts described in this article and much more during my session, “Tax Preferenced Retirement Savings for High-Income Individuals” at the 2015 AICPA Advanced PFP Conference. To obtain a recording of this session, visit the AICPA Conference Materials website. Conference attendees may download any session’s handouts and recordings at no cost; non-conference attendees may download for a fee. For more resources from the AICPA PFP Section on these and other financial planning strategies, visit aicpa.org/PFP.
Robert S. Keebler, CPA/PFS, MST, AEP (Distinguished), Keebler & Associates, LLP, Green Bay, Wisconsin. Robert is a 2007 recipient of the prestigious Distinguished Accredited Estate Planners award from the National Association of Estate Planners & Counsels.
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