In many of my introductory meetings, prospects often approach me in a standoffish state to declare…” I know, I know, you will probably tell me I need to arbitrarily sell my company stock so to make it less than 5% of investment holdings…tell me something new…please…”
With so many financial blogs, investment magazines, financial news media touting the need to diversify; we are left scratching our heads as to why we need to sell this investment that actually put us in a situation to become financially independent?!?! On top of that, the TAXES!!! We are expecting to sell these positions at huge capital gains, only to reinvest into investment “vehicles” that can yield FAT JUICY COMMISSIONS to financial advisors. No wonder advisors are “quick to the draw” in making recommendations to sell concentrated stock positions.
There is an old business adage that you “build fortunes through concentration and you preserve it through diversification”. There is nothing more true about this statement to describe the myriad of multi-millionaires minted in the bay area. Yet, with fortunes come financial quagmire. What do I do with this? How do I protect it? How do I ensure that this will allow me to maintain financial independece? How can I avoid taxes?
This post is by no means a recommendation in any one strategy; nor is it meant to be a comprehensive primer on all of the various strategies available. You will need an entire book! Rather, I would like to paint the landscape on the “tools” available to investors in dealing with concentrated stock positions. I welcome a conversation with you to see what would be most appropriate.
First Question, do we even need to sell it?
In my world, we don’t like to use one size fits all. My definition of risk is different from another, and is different from another’s, and another, should I continue on? At the same time, everyone has a different set of goals, dream and desires towards their financial independence destination, and it’s just ludicrous to me that recommendations should be the same for all. We all have unique human DNA, same goes with our money “DNA”. As such, we need to approach each scenario as a situation on its own.
So even before you decide if you need to sell, you want to be crystal HD clarity clear as to what you are investing for, why you are investing, when and how you would feel upon reaching that destination. Remember, amassing piles of cash is not the end all or be all; rather, it’s what this pile of cash will allow you to do, allow you to feel, that is the heart of financial planning.
With this “end” in mind, at what point to do you reach “critical mass” financially? How much pile of cash will you need to sustain you the rest of your life, using very conservative assumptions? Maybe your magic number is 750K in10 years, but are on track to have $2.5M. That is a surplus of 1.75M which should absolutely factor in to your investment strategy. In a situation like this, you are on the “cat bird” seat as I like to call. You have entire spectrum to work; if you want to maintain aggressiveness…you can; if you decide that you no longer want an investment roller coaster ride…you can! The key is to define the amount of money needed to diversify (take the chips off the table) so that this amount will sustain your financial independence through a ripe old age (not just ripe). This would be the amount to consider selling and diversifying from your stockpile of low cost basis company stock. This first step in the process is KEY.
Magic Elixir to Avoid Taxation
I thought I got your attention with that headline. Everyone is looking for this magical elixir, alas, I am sorry to disappoint you but there is none. Nonetheless, I want to remind you of the end game of investing…what is it? If you guessed income, you are right! The end game of building this pile of cash is not to marvel at the dollar value you’ve amassed; rather to turn it into an income stream to fulfill your dreams and goals established on step 1 (See above). Maybe you can string together a few of these strategies to come up with that elixir that is magical for you. Let’s begin!
The first responsible thing to do is to sell a portion (target to sell enough to secure your financial independence goal) of the stock outright and diversify into other asset classes. In fact, the IRS makes this somewhat easier especially if you are in the lower tax brackets. If you structured your retirement income wisely (in a separate post) and within the 10-15% marginal tax bracket; then your Long Term Capital Gains (held more than 1 year) is 0%. The next level is 15% Long Term Capital Gains Tax rates and the bulk of your sales will be at this level; we want to avoid generating income above $400K (loose number) as this will subject you to a 20% long term capital gains. When you compare this to margin income tax brackets, the federal government is incentivizing you to invest and hold for the long haul. The key is to not sell too much to push you into higher tax brackets
The Charity Card
Remember the name of the game is income for financial independence. If the challenge is creating income streams from a pile of assets with minimal taxation…then you may have hit the motherlode. The IRS (bless their hearts) allow you to gift shares of your company stock to either a Charitable Remainder Trust, or a Pooled Income Fund (can be similar to a Charitable Annuity). If control of the management of assets is the name of the game, and the asset size big enough, you can open a Charitable Remainder Trust. You will get a partial tax deduction of your donated company stock (they will account (deduct) for the present value of your income benefit), and you can sell the stock to diversify within that trust without taxes. You will then generate a fixed dollar or percentage from the Trust to be paid to you as an income stream (taxable- you can’t have everything!). Upon your demise, your charity (ies) will receive remaining assets. The pooled income fund and charitable annuities are similar, main difference being that these are more of a hands off approach when it comes to investment management.
By utilizing this strategy; you can relieve withdrawal pressure from your investment portfolio because you are enjoying the trust’s income stream. This will allow you to grow your estate bigger to replace the money you set aside to your church, University, and other charitable interests.
College was Hazy…I don’t want to Leave Money to Them
Fair enough. Today is July 2015 and interest rates are at all time lows…there has to be arbitrage for that right? Here is a strategy you can consider. You have this pile of low basis company stock, and you don’t want to sell because of taxes. If you have access to margin (make sure you negotiate a low rate-the only way you can justify this), you can borrow against your low basis concentrated stock position, and use the money to diversify into other asset classes. If you read this previous post, you understand the short and long term behavior of different assets and you want to take advantage by actively selling for tax losses (you never invest with the intention to lose money! This is just behavior of investments over short periods of time). As discussed in the previous post, you want to be performance neutral; ensure you re-invest the “sold” positions in something that correlate strongly (if it shoots right back up, your position will also move up). What you are now essentially doing is harvesting losses to use as you pare down your low basis concentrated stock, while being performance neutral. These losses can offset capital gains with no limit dollar for dollar each year. You are not limited to the $3,000 in losses you can take against active income.
If markets go down, you have losses to use! If markets go up, you won’t have too many losses to harvest, but you made profits to use to pay for taxes. Either way, you are putting yourself in a better position.
Big Declines in my Stock
“I am afraid of big declines in my stock, especially if I will be borrowing against it.”
For any positions you don’t sell you can use an options overlay to protect or generate additional income from these concentrated stock positions.
- PROTECT: You can protect the stock by buying “Put” option. By buying a put option, you have the right to sell the stock at an agreed upon price (strike price) for a duration of time. You can view this as portfolio insurance, and could potentially expire worthless if the stock price is stable or moves up. If the price crumbles, then you have the opportunity to sell the underlying stock itself, or the put option (appreciates when stock price decline).
- INCOME: On the other side of the equation, you can generate extra income from the stock by selling call options. When you do this, you are selling the right to an investor your company shares at specified price for a specified time. In return, you get the premium for selling this option. When you do this, you can be exposed to sell your underlying stock if the price really takes off, or buy back the option (closing out the position) you sold which may cost more than the premium you received.
- COLLAR: You can actually put these 2 techniques together. You can sell a call and use the premium to buy the put options. When you do this, you are putting a floor on the value of the stock, but putting a ceiling or a limit to the stock price. Investors who do this like the certainty they receive from executing on this strategy.
Is there another Way?
The answer is yes…if you are a qualified investor. I will not dive into the intricacies of these strategies but it is something available for the Qualified Investor (5M Net worth+).
- Exchange Funds: This is not exchange traded funds, or ETF, rather, they are usually structured as a limited partnership. Limited partners can “swap” or “exchange” their concentrated stock positions with the basket of stocks in the exchange fund. They are instantly diversified without immediate tax consequences. Keep in mind that you don’t avoid taxes indefinitely, rather, you postpone it. Your cost basis carries over to the shares of stock from the exchange fund. There are nuances to this, so let’s set aside a meeting to discuss the details of this strategy.
- Variable Prepaid Forwards: When you have access to capital market, you have the opportunity to use variable prepaid forwards (VPFs). With VPFs, you lock in your profits, usually 75-90% of the value of the stock, while deferring taxes. You get cash upfront to use as you please, and deliver the stock at a future date at which the taxes will be due. This may be useful for investors that can use diversification now to preserve the assets while realizing taxes later (lower brackets). There are some options of keeping additional growth, and cash payouts; this will be determined by the capital markets provider and contract.
There you have it. These are the “tools” in an investment manager’s “tool chest” when it comes down to paring down concentrated stock positions. There are no rules you have to use 1 tool, or one at a time. More often than not, you will use a combination of these strategies.
Keep your financial “end” game at the forefront.. What will take for you to reach financial critical mass? How aggressive or conservative do you want to be? Above all else, make sure the strategy you employ is connected to your “end” goal. If you would like to discuss these strategies in more detail and how it may fit your situation, reach out to me on my contact form.
Rollan E Dizon, CFP(R)