2 Creative Ways of Hedging Your Concentrated Stock Positions

If you were asked to make a list of your favorite charities, one name you’re not likely to write down is the IRS. Regardless of your preferred investment strategies, most of us have a similar objective when it comes to our tax bill: to pay every dime we legally owe, but not a penny more.

While there are many more techniques you could deploy, what follows are just two “out of the box” strategies to potentially mitigate capital gains taxes – and in years like 2022 – “pre-market” values of concentrated stock positions. As always, this is not to be interpreted as tax advice or legal advice. Please consult your tax professional and legal professional.

What is a Concentrated Stock position?

As the name implies, having a concentrated stock position is simply having too much of a single stock in your investment portfolio. For many folks out there, this concentrated position can happen through employer stock options where part of your total compensation package is derived in company stock. In other cases, it can stem from a rapid increase in the value of stock you already own.

Using IRC § 101 to Maximize the After Tax and Pre-Market Value of Concentrated Stock Positions

When it comes to tax laws, a basic tenet of IRC § 101 is that “gross income does not include amounts received under a life insurance contract if such amounts are received by reason of the death of the insured1” – an not-so easy way of saying death benefit proceeds from life insurance are generally tax free.

For clients who qualify from a health perspective and also have inheritance goals for their heirs, using this basic feature of life insurance can help maximize the after tax proceeds and preserve (or sometimes improve) investment values in the face of a volatile market.

Sample Case Study

To better understand the mechanics involved, let’s assume the following fact pattern and hypothetical case study.

• Mr. and Mrs. Client, both age 62

• Own an investment of 5,520 shares of Disney* with an average cost of $18.12 per share

• Are not in need of dividend income throughout their lifetime.

• Plan to hold the investment until their passing and transfer it to heirs using a stepped-up basis.
  *Stock of The Walt Disney Company is chosen for illustrative purposes only and not meant to be an opinion or representation of the company nor to be treated as investment advice.

Scenario 1: Hold Shares

Without specialized planning, holding the investment until their passing would entitle the client to dividend income throughout their lifetime and, upon their passing, allow them to transfer shares on a stepped-up basis for income tax purposes.

As demonstrated in the figure below, a possible drawback of the “hold” strategy (as 2022 has shown us) is that a wildly fluctuating market can reduce both share and estate valuation 2.

Scenario 2: Sell and Convert Net Proceeds to a Paid Up Policy

As an alternative, if we create a plan using “after tax” values we can attempt to alter the tax implications of the outcome. Assuming a 25% tax rate, liquidating the shares would net proceeds of approximately $775,000 (after paying capital gains taxes).

Using the proceeds to purchase a single premium “paid up” life insurance policy could net the client’s heirs a death benefit just north of $2,500,000 3.

If we translate these values on a “price per share” basis, we start to see a big difference in valuations. The price of the shares would need to grow to about $466 per share throughout the life of the client to obtain similar valuations. See figure below:

Preserving Estate Valuation

If we extrapolate this one step further, in the face of a bear market that saw a 52% devaluation in the share price of Disney stock (across the two year time period ending 12/30/2022), this strategy can not only preserve, but also maximize the “price-per-share” of the transaction.

As previously noted, the share price equivalent of a paid up policy equates to more than a 2.5x increase in the value of the company’s stock 4. If the shares were subject to a 40% estate tax, the required rate of return would be even greater.

While this helps to account for the opportunity cost of selling the shares, it also helps preserve estate values against a downshift in prices.

Using Exchange Funds to Defer Taxation and Maximize the Pre-Market Value of Concentrated Stock Positions

Exchange funds provide us with a second strategy for mitigating taxes and potentially preserving the value of a concentrated stock position.

A Brief Background on Exchange Funds

In using an exchange fund, a client transfers a portion (or all) of their concentrated stock position in exchange for shares of a limited partnership that mimics a diversified portfolio.

Typically, the limited partnership will be an investment fund that represents a broad index such as the S&P 500, Russell 3000 etc. However, it is important to note that this is not a pure exchange of “stock for more stock.”

One important caveat is that 20% of the exchange fund being received is to be invested in illiquid assets. Traditionally, this 20% allocation is invested in physical real estate, commodities, or other illiquid securities.

Concentrated Stock vs. Exchange Fund

It can be helpful to visualize the notional values of the exchange as follows (out of convenience we’ll continue to use Disney stock as an example):

This exchange is not subject to capital gains taxes and is generally a non-taxable event.

An enhanced benefit of the 20% carve-out (in this case real estate) is that the illiquid asset can have a lower correlation to traditional equity markets and therefore alter the return profile and volatility investors may experience through a standalone index (much like a traditional diversified portfolio) – more on that later.

There are two distinct advantages of conducting this transaction:

• immediate diversification through the representative index

• tax deferral opportunity

The attained diversification is self explanatory – putting your eggs in 3,000 baskets can be better than putting them all in one. However, the tax deferral requires further explanation.

It should be noted that this investment strategy is most suitable for investors with a longer time horizon, as exchange rules require a seven year hold of the limited partnership in order to qualify for the tax deferral.

After the seven year commitment period, an investor can begin to liquidate (partially or in full) their ownership of the exchange fund in order to better control the amount of gains and subsequent taxes paid across several years.

A liquidation after the seven year commitment is conducted through a second exchange. This time, a basket of randomly selected stock is received in exchange for shares of the limited partnership.

The “basket” will have an average cost basis equal to the original shares deposited in the first exchange, which can then be sold in the open market and taxed at long term capital gains taxes.

Should the exchange fund still be held at the time of the clients passing, shares of the limited partnership qualify for a step-up in basis.

While the future values of any investment can be largely unpredictable (it is possible for a single stock to outperform an index), the benefits of diversification can still persist even in down markets.

Diversified Portfolio in Down Markets

This is where we circle back to the altering of the return profile. Once again using Disney as a representation of a single stock example, you’ll notice that while 2021 was relatively mild when compared to 2022, the representative index fared much better.

However, add in the 20% asset allocation to real estate, and the exchange fund outperformed the index – helping to improve estate valuations even when the “down year” was relatively mild.

Is a Concentrated Portfolio better than a Diversified Portfolio?

To be fair, it is quite possible for a single stock position to outperform an index (value stocks fared better than most in 2022). It’s also possible that the 20% carve-out from an exchange fund performs worse than both the stock and the index, and you can find yourself wishing you never tried to mitigate things altogether.

That said, in the world of investments we often find ourselves looking at the probability of a successful outcome. With the majority of individual positions under-performing their respective index9, it’s hard to argue against spreading out the risk.

Conclusion

The above are only two tactics you can use to diversify a concentrated stock position and help reduce the respective tax due. More important than strategies or investment decisions are your overall objectives with respect to your finances.

In many cases, a much simpler approach could be to create a “tax budget” and liquidate in piecemeal fashion (followed by diversifying the position with the proceeds).

Of course, that assumes that you are willing to part with the stock in question to begin with. Sentimental attachments (or an overly bullish outlook) can sometimes supersede the desire to defer and reduce taxes, rendering tactical approaches less helpful. As with any client-facing profession, how easy we find the answer is usually tied to how well we listen.

Sources:

1. https://www.irs.gov/pub/irs-drop/rr-07-13.pdf

2. https://finance.yahoo.com/quote/DIS/history?period1=1577836800&period2=1672358400&interval=1d&filter=history&frequency=1d&includeAdjustedClose=true

3. Assumes the clients are underwritten as standard plus nonsmoker for Prudential’s PruLife SVUL Protector designed with the initial face amount guaranteed to age 120. Guarantees are based on the claims-paying ability of the issuing company and required premiums being paid on time when due. The policy as illustrated is a Modified Endowment Contract which affects the taxation of disbursements from the cash value during the insured’s life.

4. Share price equivalent divides the death benefit received by the hypothetical policy by the amount of shares. Does not take into account additional shares purchased through reinvestment of dividends.

5. https://finance.yahoo.com/quote/DIS/history?period1=1640995200&period2=1672444800&interval=1d&filter=history&frequency=1d&includeAdjustedClose=true

6. https://finance.yahoo.com/quote/DIS/history?period1=1609459200&period2=1640908800&interval=1mo&filter=history&frequency=1mo&includeAdjustedClose=true

7. https://research.ftserussell.com/Analytics/FactSheets/Home/DownloadSingleIssue?issueName=US3000USD&isManual=True

8. Exchange fund performance being quoted is the Goldman Sachs Exchange Place: All Cap LP Performance

9. https://news.yahoo.com/one-stat-shows-how-hard-it-is-to-pick-market-beating-stocks-231312491.html