Sixteen Ways to Manage a Concentrated Position

Warren Buffett, Bill Gates and Jeff Bezos bet on themselves by concentrating most, if not all, their wealth in their company stock. Shares of Berkshire Hathaway, Microsoft, and Amazon have created enormous wealth for these billionaires, and they’re currently the three wealthiest individuals in the United States.

A concentrated equity position is a blessing and a curse. Shareholders of Berkshire Hathaway, Microsoft, and Amazon have enjoyed significant price appreciation and wealth creation from their stock holdings.  Investors in Enron, Lehman Brothers, and WorldCom lost everything.

What is a concentrated equity position? A stock position accounting for more than 25% of your investable assets is considered concentrated. Your definition may vary depending on your appetite for risk. It can be as low as 5% or more than 50%. You may have acquired your stock through incentive stock options, restricted stock grants, an employee stock purchase plan, 401(k) contributions, company bonus, or acquisition. Regardless, protecting your asset should be a primary goal.

Concentration is a great way to create wealth; diversification is the best way to keep it. Dealing with a large stock position presents unique challenges.

Let’s examine a few strategies to help you manage your position. The ideas range from holding your stock to giving it all away. As a note, these strategies assume your shares are free and clear, and you’re not subject to insider information, trade windows, lockups, vesting, or other restrictions. If you’re not sure, please check with your corporate counsel or attorney.

Hold. Retaining your current position may pay dividends, especially if you want to increase your wealth. As we have seen, this strategy has treated Warren Buffett, Bill Gates, and Jeff Bezos well. Your tolerance for risk is a factor if you want to retain your shares as some stocks carry more risk than others. For example, Amazon has a daily standard deviation of 3.7%, Pepsi’s is 1.53%, and Beyond Meat is 8.7%. Holding your stock will also allow you to defer your gains if you own them in a taxable account.

Sell. Selling your shares is the fastest way to reduce your position and diversify your holdings. However, if you sell your shares in a taxable account, it can trigger substantial capital gains.

Direct Gift. A direct gift to your favorite charity is efficient and straightforward. In transferring your shares to a charity, you’ll be able to deduct the fair market value of your gift at the time of the transfer. The charity can sell your shares in their account and avoid capital gains.

Gift to Children. You can gift your shares to your children, but they’ll retain your cost basis. This strategy will reduce your estate while building up theirs. You’re allowed to give away $15,000 per person, per year so donating stock to your kids below this threshold does make sense.

Retirement Account. If you hold your stock in your 401(k) or IRA, you can sell them without tax consequences allowing you to reduce your position and diversify your assets. Distributions from your retirement account are taxed as ordinary income, and you won’t be able to take advantage of more favorable capital gain rates.

Qualified Charitable Deduction (QCD). If you’re older than 70 ½, the government allows you to distribute up to $100,000 to charities directly from your IRA. This type of distribution will satisfy your required minimum distribution (RMD). For example, if your RMD is $100,000 and you donate $40,000 to your favorite charity, then your taxable distribution will be $60,000. You won’t be able to deduct your charitable contribution since it’s being sent directly from your IRA.

Net Unrealized Appreciation (NUA). The net unrealized appreciation allows you to transfer shares of your employer stock from your 401k to your taxable account at a more favorable tax treatment than a distribution. The NUA is the difference between the fair market value and your cost basis.[1] When you receive your shares from your plan, only the cost basis is taxed. The remainder will be taxed as capital gains when you sell your shares. For example, at the time of your distribution, your cost basis is $25 per share, and the fair market value is $60. The $25 is taxed as ordinary income, the remainder, $35, will be taxed at long-term capital gain rates when the shares are sold. If the stock rises to $80 per share, then the $20 gain above $60 will be short or long-term depending on when they are sold.[2] If your shares had been withdrawn from your IRA, without the NUA, your entire $60 position would be taxed as ordinary income.

Put Options. If you want to hold your shares, but you’re concerned about a falling stock price, you can purchase put options. Put options increase in value when stocks fall. It’s a short-term insurance policy against a market decline. This strategy allows you to retain your stock, but at a price. Buying put options to protect your shares is expensive, especially if you repeat the process a few times a year. Let’s look at buying put options to protect 10,000 shares of XYZ Inc. trading at $215 per share. The January 2020 $215 strike price is offered at $15.75 per contract, so protecting your shares will cost you $157,500. One contract equals 100 shares of stock. If XYZ Inc. falls below the $215 strike price at expiration, the option will increase in value. If XYZ Inc. closes above $215 at expiration, you’ll lose 100% of your proceeds on the put purchase. If the put is losing value, your stock is gaining value. Ten thousand shares of XYZ Inc. at $215 per share equals $2.15 million. The put purchase represents 7.3% of your holdings. You can sell your option at any time before it expires in January.

Call Options. A call option replacement strategy allows you to sell your equity shares and purchase a corresponding amount in the form of call options. The ratio is 100 shares to 1 option contract. If you own 10,000 shares, you can buy one hundred contracts. This strategy allows you to sell your stock but maintain a position in the company at a reduced amount through your option contracts. For example, 10,000 shares of ABC Inc. are currently worth $2.2 million at $220 per share. The January 2020 $220 strike price has a current price of $14.25 per contract, so 100 contracts cost $142,500. The contract value represents about 6.5% of your stock holdings. If you sell your shares, you can use a small percentage of the proceeds to buy the option contracts and diversify the remainder. The downside is that you’ll pay taxes when you sell your shares.  Another disadvantage is the call option has a limited life; it will expire on January 17, 2020. If ABC Inc. is trading above $220 at the time of expiration, the call option will finish in the money, and you can take your gains. If ABC Inc. is trading below $220, your option will expire out of the money, and you’ll lose 100% of your investment.

Option Collar. A collar utilizes calls and puts to generate income and protect your equity position. The collar surrounds your stock. For example, If ABC Inc. is trading at $220 per share, you can sell a call option at $220 to generate income and buy a $210 put to protect the downside. If ABC Inc. rises above $220 at expiration, you must sell your shares at $220 regardless of how high the market price rises above the strike price. If ABC Inc. falls below $210, your put option will protect the downside. The ABC Inc. January $220 call strike price is currently selling for $14.25 per contract. If you own 10,000 shares, you will sell 100 contracts to generate $142,500 in income (before fees). The ABC Inc. January $210 put currently costs $13.25, so your cost to purchase the put is $132,500. The call generated $142,500 in income, and the put cost you $132,500, for a credit of $10,000. The collar can be widened or narrowed based on your situation. If the collar expands, you’ll generate less revenue.

10b5-1 Plan. A 10b5-1 plan allows insiders to sell their stock holdings without regard for trade windows, corporate events, or insider activity. You can determine the number of shares, price limit, and duration. If the price of the stock trades at your limit, the shares will be sold regardless of a trade window or other insider activity. For example, if you want to sell your shares at $100, then they’ll be sold at that price or higher.[3]

Donor-Advised Fund (DAF). A Donor Advised Fund allows you to transfer appreciated shares to the fund. Once inside the DAF, you can sell your shares and purchase new investments without realizing a capital gain. You can deduct the contribution from your taxes, and it occurs in the year of your gift, not in the year of distribution. You don’t have to distribute the proceeds immediately, so if you’re not sure which charities to support, you can defer the payment until you identify the organizations. For example, if you transfer $100,000 worth of ABC Inc. stock to your Donor Advised Fund, sell it, reinvest the proceeds, and then send a portion of the funds to your favorite charity. The funds that remain inside your DAF will grow tax-free.

Charitable Remainder Trust (CRT). This trust allows you to transfer your shares to a Charitable Remainder Trust, sell your holdings, diversify your assets, and receive income from the proceeds. At your death, the remainder of the trust assets will be sent to your pre-determined charity. The stock, once transferred, can be sold free of taxation and the proceeds reinvested into a diversified portfolio of stocks, bonds or funds. Your contribution to the trust qualifies for a charitable deduction. The amount of income you can receive from the trust is between 5% and 8% of the portfolio value. You will pay ordinary income tax on the income you receive.

Exchange Fund. As the name implies, you exchange your shares for a basket of stocks allowing you to defer your gains. The minimum is steep, and you’re required to hold the fund for several years.  According to a Forbes article on exchange funds, the minimum investment for some funds is $5 million with a required holding period of seven years.[4]

Private Annuity.  A private annuity works well with colleges and universities. If you donate your stock to your alma mater, they can establish a private annuity for you so that you can receive income for life or a certain number of years. Your alma mater can sell the stock free of taxation and use it to fund their operations. You’ll get a deduction based on the fair market value of your gift.

Pledged Asset Line (Loan). If you’re heavily concentrated in stocks and you need liquidity, consider a pledged asset loan. The amount of your loan is based on the equity of your investment holdings, like a line of credit on your home. The loan will allow you to access capital without selling your investments and realizing capital gains. If your holdings aren’t restricted, this strategy makes sense, and it’s a better option than using margin to access the capital in your account.

The only difference between death and taxes is that death doesn’t get worse every time Congress meets. ~ Will Rogers

August 29, 2019

Bill Parrott is the President and CEO of Parrott Wealth Management firm located in Austin, Texas. Parrott Wealth Management is a fee-only, fiduciary, registered investment advisor firm. Our goal is to remove complexity, confusion, and worry from the investment and financial planning process.

Note: Investments are not guaranteed and do involve risk. Your returns may differ than those posted in this blog. Options involve risk and are not suitable for every investor. Please consult your CPA or tax advisor before implementing any of these strategies to see if it makes sense for your situation.

[1] https://www.investopedia.com/terms/n/netunrealizedappreciation.asp#targetText=The%20net%20unrealized%20appreciation%20(NUA,market%20value%20of%20the%20shares., Reviewed by Alicia Tuovila, July 1, 2019

[2] Cannon Financial Institute: A Complete Library of Essential Financial Concepts, 2008. Net Unrealized Appreciation page 538.

[3] https://www.investopedia.com/terms/r/rule-10b5-1.asp, Reviewed by Will Kenton, updated on April 2, 2019.

[4] https://www.forbes.com/sites/agoodman/2016/01/10/one-way-some-wealthy-investors-can-avoid-big-capital-gains-taxes/#1680ec4f324e, Andrew Goodman, 1/10/2016