Concentrated Stock Positions: Considerations and Strategies

In
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by Steve Caltagirone
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October 18, 2023
Concentrated Stock Positions Considerations and Strategies

Whether you inherited a large holding, exercised options to buy your company’s stock, sold a private business, hold restricted stock, or have benefited from repeated stock splits over the years, having a large position in a single stock carries unique challenges. Even if the stock has done well, you may want more diversification, or have new financial goals that require a shift in strategy.

Understanding the Challenge: What is Concentrated Stock?

Concentrated stock refers to a situation where a significant portion of an individual’s investment portfolio is comprised of shares from a single company or a small number of companies. In other words, it’s a scenario where a substantial percentage of one’s wealth is tied up in a particular stock or a limited group of stocks.

When a single stock dominates your portfolio, various factors can complicate the decision to sell. These include not just tax implications but also legal constraints, contractual obligations (like lock-up agreements), and practical considerations, such as the impact of a large sale on thinly traded stocks. The appropriate choice depends on your specific situation and tax considerations. Here’s an overview of some options:

1. Sell Your Shares
Selling your shares provides liquidity for diversification. However, if you have a low-cost basis, capital gains taxes may be a concern. You might consider selling shares over time, which can help you manage the tax bite in any one year yet allow you to participate in any future growth.

If you hold restricted shares, you might set up a 10b5-1 plan, which spells out a predetermined schedule for selling shares over time. Such written plans specify in advance the dates, prices, and amounts of each sale, and comply with Securities and Exchange Commission Rule 144, which governs the sale of restricted stock.

2. Hedge Your Position
You may want to help protect yourself in the short term against the risk of a substantial drop in price. There are multiple ways to try to manage that risk by using options. However, bear in mind that the use of options is not appropriate for all investors.

Buying a protective put essentially puts a floor under the value of your shares by giving you the right to sell your shares at a predetermined price. Buying put options that can be exercised at a price below your stock’s current market value can help limit potential losses on the underlying equity while allowing you to continue to participate in any potential appreciation. However, you also would lose money on the option itself if the stock’s price remained above the put’s strike price.

Selling covered calls with a strike price above the market price can provide additional income from your holdings that could help offset potential losses if the stock’s price drops. However, the call limits the extent to which you can benefit from any price appreciation. And if the share price reaches the call’s strike price, you must be prepared to meet that call.

A collar involves buying protective puts and selling call options whose premiums offset the cost of buying the puts. However, as with a covered call, the upside appreciation for your holding is then limited to the call’s strike price. If that price is reached before the collar’s expiration date, you would lose not only the premium you paid for the put but also face capital gains on any shares you sold. Be careful about closing one side of the collar while the other side of the trade remains outstanding.

3. Exchange Your Shares
Another possibility is to trade some of your stock for shares in an exchange fund (a private placement limited partnership that pools your shares with those contributed by other investors who also may have concentrated stock positions). After a set period each of the exchange fund’s shareholders is entitled to a prorated portion of its portfolio. Taxes are postponed (potentially indefinitely) until you decide to sell those shares; you pay taxes on the difference between the value of the stock you contributed, and the price received for your exchange fund shares.

4. Monetize the Position
If you want immediate liquidity, you might be able to use a prepaid variable forward (PVF) agreement. With a PVF, you contract to sell your shares later at a minimum specified price. You receive most of the payment for those shares — typically 80% to 90% of their value — when the agreement is signed. However, you are not obligated to turn over the shares or pay taxes on the sale until the PVF’s maturity date. When that date is reached, you must either settle the agreement by making a cash payment or turn over the appropriate number of shares, which will vary depending on the stock’s price at that time. In the meantime, your stock is held as collateral, and you can use the up-front payment to buy other securities that can help diversify your portfolio. In addition, a PVF still allows you to benefit to some extent from any price appreciation during that time, though there may be a cap on that amount.

PVF agreements are complicated, and the IRS warns that care must be taken when using them. Consult a tax professional before using this strategy.

5. Borrow to Diversify
If you want to keep your stock but need money to build a more diversified portfolio, you could use your stock as collateral to buy other securities on margin. However, trading securities in a margin account involves risks. You can lose more funds than you deposit in the margin account.

6. Donate Shares to a Trust
If you want income rather than growth from your stock, you might transfer shares to a trust. If you have highly appreciated stock, consider donating it to a charitable remainder trust (CRT). You may also qualify for an income tax deduction on the estimated present value of the remainder interest that will eventually go to charity. Typically, the trust can sell the stock without paying capital gains taxes and reinvest the proceeds to provide an income stream for you as the donor. When the trust is terminated, the charity retains the remaining assets.

Another option is a charitable lead trust (CLT), which in many ways is a mirror image of a CRT. With a typical CLT, the charity receives the income stream for a specified time. At the end of the trust period, the remaining assets are paid to the grantor or the grantor’s heirs. This can help reduce, or in some cases even eliminate, estate taxes on appreciated assets that eventually go to the grantor’s heirs. There are costs associated with creating and maintaining trusts. You receive no tax deduction for transferring assets unless you name yourself the trust’s owner, in which case you will pay taxes on the annual income. Other philanthropic options include donating directly to a charity or private foundation and taking a tax deduction.

Timing Matters

When dealing with a large stock holding, think about your time frame. Some strategies, such as hedging, might be most suitable in the short term or if you are restricted from selling. Others, such as donating to a trust, may be more cost-effective over a longer time period, though your charitable intentions obviously play a role as well.

Managing a concentrated stock position is a complex task that may involve investment, tax, and legal issues. Consult financial professionals who can help you navigate the maze. While there are no guarantees in investing, informed decision-making can help you unlock the full potential of your wealth.

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