There are some investors who feel that you have to “bet big” in the stock market to become rich. They are willing to put all their eggs in one basket by investing a large percentage of their investable assets in one particular stock. Others may not intentionally have made this “big bet”, but it just happens that they have accumulated a significant amount of their company’s stock over a 30- to 40-year career through various stock awards. Irrespective of how you may have accumulated the large stock position, you are taking on significant unsystematic risk in your investment portfolio. Unsystematic risk refers to company or industry specific risk that is inherent in every investment.

Yes, it is true that stocks such as Microsoft, Google, Amazon and Apple have made many people very rich. However, there are just as many stocks (of very well-known companies), such as General Motors, Enron, Kodak and Worldcom that have caused people to lose everything.

Most financial advisors will agree that a single stock position that accounts for more than 20% to 25% of your overall investment portfolio would be considered a concentrated stock position. If you are approaching retirement and will need to start living off your investment portfolio, a concentrated stock position can create a problem because it makes your long-term financial security dependent on the movement of one particular stock. Furthermore, if the stock position is highly appreciated, you may be faced with significant tax issues. Simply put, concentrated stock exposes you to greater volatility, possible liquidity constraints and much higher risk than ownership of a well-diversified investment portfolio that reduces unsystematic risk.

The only way to reduce unsystematic risk is to diversify your portfolio. There are several strategies for divesting concentrated stock positions.

Selling outright and using tax efficient share selection – This strategy involves liquidating a large portion of your concentrated stock position and taking advantage of the low 15% to 20% long-term capital gains rate (depending on your adjusted gross income). By selecting shares with the highest cost basis to sell first, you will minimize your tax liability. This strategy will leave you with a smaller position in the stock with a lower cost basis and potentially exposed in the future to higher capital gains rates.

Gifting – If, like most people, you hate to pay taxes and are concerned about the tax liability generated from capital gains on the sale of your stock, you may want to consider gifting the stock to either your children/grandchildren or your favorite charity. An individual can gift $14,000 per year to any family member free of gift taxes. A charitable gift of any amount can provide you with an additional itemized deduction to help reduce your overall income tax liability. Gifting appreciated assets such as stock is considered more tax effective than gifts of outright cash since neither you nor the charity pay capital gains tax on the appreciated stock when it is sold by the charity. When gifting to your children or grandchildren, they will not receive a step up in cost basis of the stock, unfortunately; however, if the person receiving the gift is in a lower tax bracket (such as the 10% or 15% marginal tax bracket), he or she will not pay long-term capital gains tax on the sale of the stock. Furthermore, if you are subject to the new 3.8% Medicare surtax, but your children or grandchildren are not, there would be an additional tax savings realized with the gift.

A charitable remainder trust (CRT) may be an appropriate strategy if you are charitably inclined and your concentrated stock position has significant embedded capital gains. This strategy allows for the transfer of highly appreciated stock into a charitable trust, allowing you to receive both a charitable deduction and an annual income stream from the trust. You would transfer the appreciated stock to the trust, and in return, receive an annual income stream from it. The trust can diversify the portfolio, but any taxes on the gain are deferred until the income stream is passed to the donor. At the trust’s termination (after a certain number of years or the donor’s death), the remaining assets pass to a charity(ies) the donor chooses. This strategy would also help reduce your taxable estate as the CRT is outside of your estate.

Using a Limited Partnership (LP) or Limited Liability Company (LLC) – You can diversify your concentrated stock position by placing the stock in an LP or LLC in exchange for an interest in an LP or LLC. The LP or LLC could hold other stocks, ef­fectively providing you with an interest in a more diversified investment portfolio. This strategy would also capitalize on a number of estate-planning benefits stemming from this type of exchange, since interests in the LP or LLC may be transferred between generations of family members without the realization of capital gains. Furthermore, due to the marketability constraints that such a structure may impose, you may be able to transfer interests in the LP or LLC at a discount to the actual market value of the stocks held in the LP or LLC.

Hedging Your Position – Certain hedging strategies can achieve a number of favorable outcomes: they can protect wealth, delay income taxes and diversify the unsystematic risk of a concentrated stock position. Below are a few examples of several hedging strategies:

  • Purchasing a Put Option – You have a means of purchasing “insurance” against a significant decline in the value of your concentrated stock position by buying an option that gives you the right, at a time in the future, to sell the stock at a specific price, thereby taking away the downside risk of the individual stock. This transaction would be the pur­chase of a put option.
  • Collaring a Stock – This is a two-part strategy whereby part one involves purchasing a put option as detailed above, and simultaneously—part two—selling the right to another investor to buy the stock at a specific price in the future. Part two is referred to as a call option. The sale of the call option generates income that is used to purchase the put option. The combination of the purchase of the put option and the subsequent sale of the call option is known as a collar and it provides you with a guarantee that the concentrated stock position will have a value within the minimum and maximum price for the time period of the options.

Keep in mind that these hedging strategies do not provide any means to reduce or eliminate the income tax liability that would be associated with a highly appreciated concentrated stock position. They would only minimize the volatility that is associated with the concentrated stock position.

Although many investors have created significant amounts of wealth from accumulating and retaining large quantities of one particular stock, it is important to understand the risk and the exposure to volatility associated with owning a concentrated single stock. It is understandable that companies would like their executives to hold meaningful amounts of their company stock to prove to other investors that they believe in their company. Over the years, however, the SEC has realized the risks of forcing employees to hold concentrated stock positions and rules are now in place to regulate this issue.

A longer investment time horizon may help reduce the short-term volatility of a concentrated stock position, but no time in the world will protect your investment portfolio from a poorly managed company that is headed for bankruptcy. If you are reaching retirement age and will need to replace your earned income with distributions from your investment portfolio, you need to seri­ously consider the strategies discussed to effectively manage your concentrated stock position.

An original article authored by the advisors of Wescott Financial Advisory Group LLC
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