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How to Diversify Concentrated Stock Positions

April 23, 2024.

What is a Concentrated Stock Position?

concentrated single-stock position occurs when a single stock holding constitutes a relatively large percentage of an investment portfolio. Common scenarios when this may occur include the following:

  • An employee receives stock or stock options as part of compensation.
  • An individual inherits a sizeable single stock position.
  • A long-held stock appreciates substantially over time.
  • A business owner sells his or her company and receives stock in a publicly traded company as part of the proceeds.

Regardless of how the concentrated stock position occurs, the result is a disproportionate allocation of wealth that exposes individuals to financial risk. One way to reduce this risk is to simply sell out of the concentrated position. However, this may result in a large capital gains tax bill.

Another method is to gradually sell the concentrated position over time.  This may allow you to employ a concept called tax loss harvesting.  The IRS generally allows investors to offset realized capital gains with realized capital losses for tax purposes. Typically, tax loss harvesting occurs around year end, during which time investors and advisors will look through portfolios to see which positions should be realized at a loss to offset taxable gains and income from other profitable investments. While this is a useful technique, in many instances investors may not have enough losses to offset all of the potential tax consequences of the full sale of an appreciated position. Therefore, this could be done gradually over time to reduce the impact.

Fortunately, there are also other ways to diversify a concentrated stock position besides tax loss harvesting.  Many of these methods are described below:

  1. Gifting

Pros: Tax-free transfer of stock or assets, reduction of taxable estate, simple process.

Cons: The gifting party gives up ownership of the asset.

One of the simplest and most efficient ways to manage large gains in stock value is through the process of gifting to charitable organizations. If a stock or other asset is donated to a charity, no tax is paid at the time the gift is given. You can also deduct the current market value of the gift from your income taxes up to certain limits as long as the stock or asset has been held for one year or longer.

For charitable organizations that may not have the ability to take donations in forms other than cash, you may be able to establish a donor advised fund. These allow you to make regular or one-time contributions of cash or stock that can be granted to your designated charities over time while still receiving the tax advantages immediately at the time of contribution. Assets within donor advised funds are able to grow and be sold tax-free, making them a preferred tool in helping efficiently maximize the amount you can give to charitable causes.

Alternatively, you may choose to gift stock or assets to a family member. As long as the gift is below the annual exclusion amount ($18,000 per individual for 2024), it is not counted against the lifetime exclusion, and the gifting party will pay no tax.  However, basis will transfer with positions and the receiving party will still need to pay tax should there be a sale in the future. In many instances, there are still benefits as the gifting could shift the capital gains into a lower tax bracket of the receiver. Of course, the downside of gifting to charity or others is that the stock or assets gifted no longer remain the property of the original holder.

  1. Option-based Liquidation

Pros: Highly liquid, modest downside protection to the security, no lock up of capital, customization to best suit investor situations.

Cons: Multi-year process to liquidation, limits further stock appreciation.

Options give holders the right, but not the obligation, to buy or sell specific securities. The option seller benefits from receiving a premium to offer that right to the holder. This is not too dissimilar from an insurance policy or pre-purchasing tickets for a future event at a discount.  If executed conservatively and thoughtfully by a professional manager, an option strategy can be a useful tool in the context of tax-efficiently liquidating positions and reducing risk.

A simple approach to this strategy is to sell call options on a stock an investor wishes to liquidate over time. Depending on the direction the underlying stock moves, the options will either make or lose money. If the call options are profitable, the stockholder can sell a portion of the underlying position and use the premiums earned from writing the call options to pay the tax bill associated with the stock sale. If the options lose money, those losses can be used to offset the tax bill resulting from an unwinding sale of the underlying security.

  1. Equity Collar

Pros: Offers downside protection, generates income and cash flow, maintains concentrated stock’s value, can be done “costless.”

Cons: Might be considered a constructed sale and subject to taxation.

With this strategy, you will purchase a long-dated put option on the concentrated stock while selling a long-dated call option. The put option will give you the right to sell your concentrated stock position at a certain price in the future, thus offering downside protection. The call option, meanwhile, will provide income you can use to finance the put option. An equity collar will keep the value of the concentrated stock between a lower and upper limit over the collar’s timeframe.

With a costless equity collar, the sale premium will cover the cost of the put option so there is little to no cash outflow. Or you could sell a call option with a higher premium to create net cash flow if you want to generate additional income. Be sure to leave enough room for potential gains and losses so the transaction is not considered a constructed sale by the IRS, which would subject it to taxes.  Note: this strategy can get complicated and should be implemented by a financial professional.

  1. Exchange Funds

Pros: Transfer of single name risk into market risk, receive back a diversified basket of holdings after seven years.

Cons: No tax benefits or improvement in cost-basis, moderately illiquid.

Exchange funds are special investment vehicles that allow investors to contribute appreciated stock holdings into a large, diversified pool of other stocks in exchange for a proportional interest in that pool. After the contribution of owned shares to the fund, the tax basis will not change, but risk can be diversified. The two primary benefits of this type of investment solution are risk reduction through diversification and deferral of tax payments. After an investment is held within an exchange fund for seven years, the investor becomes eligible to redeem a basket of shares from the fund rather than only the stock that was contributed.

These baskets usually consist of between 10 and 30 names and are diversified by sector and distributed in-kind to investors. Like the contribution, the redemption is not a taxable event; however, it is worth noting that through this strategy you are merely deferring the payment of taxes, not eliminating them. The redeemed stocks will maintain a basis similar to that from when the concentrated stock was originally contributed. In many situations, investors have also found exchange funds to be great estate planning tools as a step-up in basis will occur upon death.

  1. Opportunity Zone Funds

Pros: Reduction and deferral of taxes, profits on fund gains are tax-free if partnership interest is held for 10 years.

Cons: Does not fully eliminate realized taxes, limited window to reinvest gains, long fund lockup period, investment-related risks.

The Tax Cuts and Jobs Act of 2017 allows investors to take advantage of the opportunity zone investment program. This program incentivizes investors with unrealized capital gains to realize those gains and subsequently roll them into investments in real estate or businesses located in underdeveloped areas by offering attractive tax benefits. There are two primary benefits to investing in an opportunity zone fund.

  1. Investors can defer their tax bill until their 2026 tax filing
  2. Any profits generated by the opportunity zone fund are tax-free as long as certain criteria are met and the investment is held for at least 10 years.

Opportunity zone funds can be great options for those with appreciated stock that the holder no longer wants. Additionally, they can provide compelling after-tax return potential when compared to traditional real estate investments not utilizing the program.

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References

Wells, Garrett.  “6 Ways to Diversify a Concentrated Stock Position”.  6 Ways to Diversify a Concentrated Stock Position — Simon Quick Advisors.  April 24, 2023.

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