How should I manage my concentrated stock position and avoid unnecessary taxes?
A few weeks ago, we wrote about executive compensation and the ways companies reward their employees with stock, option grants, RSUs, and other long-term incentive awards. Whatever the compensation vehicle, we highlighted the common theme that all these renumeration schemes trend toward the accrual of outsized or concentrated company exposure if left unmanaged. We also looked at some helpful ways to thin exposures and manage risk by understanding how the compensation vehicles work, their taxation implications, and how to manage exposure over time.
Understanding your compensation structure and high-level strategy is incredibly important, especially for proactive planning. Sometimes it’s not so easy, however, at least with the proactive aspect. For many folks, they may already have a concentrated position in place, or they might receive one through an unexpected buyout, corporate action, or sudden price appreciation in their company shares. Other times, investors simply hold large stock positions by virtue of inheritance, an investment idea that turned into a home run. Whatever the reason, if you built a lot of wealth from one stock or one career, you may be questioning what to do with it. This week we’re going a layer deeper to discuss some strategies we use to help answer that question, and as we do so – we tip our hat to your success. We recognize that your years spent building and investing mean a lot from a personal perspective, and that gives a certain weight to any decision about how to handle your investment. The good news, you can have your cake and (mostly) eat it too. There are tradeoffs with anything, of course, but depending on your preferences there are more excellent options available today than ever before.
A first strategy to consider is hedging with options. Option-based strategies offer flexibility to add downside protection, while preserving some or all upside without an immediate outright sale of shares[i]. Leveraging our background in derivatives trading, a few options (no pun intended) that we think are worth utilizing are:
Another strategy to consider is an Exchange Fund. Exchange funds are useful when a single stock is comprised of millions of dollars and pushes your concentration past the 10-20% of portfolio threshold. Like the name implies, an exchange fund receives your shares (and the shares of other investors with concentrated equity exposure) to pool risk, in exchange for an interest in a diversified portfolio. When properly structured, the contribution can defer recognition of capital gains while reducing single-stock exposure, while providing immediate diversification that maintains investment and market exposure. The rub: exchange funds must be held for seven years with no or only limited liquidity, at which point the investor receives a diversified basket of securities and their original cost basis.[ii]
Completion portfolios are another way another way to improve diversification of concentrated stock portfolios. These are customized investment strategies designed to "wrap around" an investor’s existing concentrated position so that their combined holdings mimic the risk and return profile of a more diversified allocation. Instead of buying a standard index or an equity fund, which might inadvertently add more exposure to the sector you are already over-invested in, a completion portfolio intentionally underweights or excludes your concentrated holding and its highly correlated peers. A completion portfolio can be created with a careful selection of asset classes and managers or customized direct indexing. In many applications the customized indexing approach is advantageous because it fine tunes underlying portfolio exposures while gradually generating tax losses that can be used to offset the gains on your eventual sale of shares.
A final tool, and one that may be combined with any of the above, is strategic selling. This involves spreading stock sales over multiple tax years to control timing and tax impacts. This is done in conjunction with long-term planning goals, gifting appreciated shares to charity you care about or a Donor Advised Fund (DAF), utilizing charitable remainder trusts (CRTs) which can reduce taxes while providing income, or considering intra-family basis planning, taking advantage of step-ups to eliminate capital gains.[iii][iv]
There’s no one-size-fits-all solution to managing a concentrated stock position. The right approach, or combination of these tools, depends on your goals, tax situation, time horizon, and comfort with risk. Most important is having a plan. Ignoring your concentrated stock position won’t provide a solution and rapidly evolving market dynamics may even complicate or increase the risk over time. Having a thoughtful strategy in place puts you in control, so you can move forward with confidence and focus holistically on your financial life, not just on a single aspect.
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