Owning enough stock in a single company that the value eclipses your other assets might sound enticing. Although significant wealth has been created for those fortunate enough to hitch their wagon to the right company’s stock, that’s only half the story. To properly manage risk and avoid unnecessary tax liabilities, you must also understand the implications associated with holding or selling these positions.
How Much Stock in One Company Is Too Much?
A common rule of thumb is to pare down stock positions that exceed 10% of one’s net worth. Like all rules of thumb, it is important to consider your own situation and circumstances. Be aware of your own biases when considering whether to pare down your position. Ask yourself, “If I had x dollars today to invest, would I be buying this stock?”
Another great question is to ask how you would feel if the stock dropped 20%…or 50%? While we never like to imagine a situation where our biggest holding freefalls, the reality is that there are countless examples of “great” companies that had major declines.
If taxes were not an issue, then scaling back a concentrated position would be a no-brainer. You would simply sell enough shares to reduce the concentration to a manageable amount and diversify thereafter.
In practice, it is more complicated. An appreciating stock usually will have increased potential tax liability associated with it. Fortunately, there are some creative ways to reduce or limit one’s exposure, while keeping tax liability in check. We will examine some of the more common ways.
How Should You Sell Your Stock?
The short answer is, it depends.
If you have a large position with little or no tax liability – usually from an inherited position with “stepped-up basis” – then selling outright is straightforward. But what about other scenarios?
Large Positions with High-Embedded Gains
If the positions have large, embedded gains, this is where a strategy becomes paramount. It is important to work with your tax and financial advisors to optimize this strategy from both a risk and capital gain perspective.
One approach is to stagger the sales over multiple tax years. Alternatively, if you’ve managed to accumulate north of $1,000,000 in one or a few stocks, then an Exchange Fund may be an option. An Exchange Fund is a tax mitigation strategy reserved for wealthy individuals who are considered Qualified Purchasers (QPs). For simplicity, QPs are those with investments (not including primary residence) of $5,000,000 or more.
The concept is as follows:
- One contributes their highly appreciated position(s) valued at least $1mm to the exchange fund.
- In exchange, your investment is diversified into hundreds of positions including some illiquid holdings (probably real estate) within the fund.
- After a seven-year period, you can take possession of a diversified “basket” of stocks with the cost basis spread among them.
- Because of the complexity, limited number of providers, and fees/rules associated with Exchange Funds, it’s critical that you work with an advisor with experience in this strategy.
Selling Stock in a Qualified Plan
If the stock is held in a company retirement account, such as a 401k, there are additional factors to take into consideration. While there is no tax liability when qualified plan stock is sold, at some point, you will begin taking distributions from the plan, which are taxed as ordinary income (higher rate than long-term capital gains).
One way to mitigate this tax liability is a special technique that utilizes Net Unrealized Appreciation (NUA). In this scenario, appreciated company stock (only) would be distributed out of the plan at age 59 ½ and older (to avoid penalties). The pre-tax amount (basis) is taxed as ordinary income, while the remaining appreciation (NUA) would be taxed at long-term capital gains rate when sold. Since the shares are not being rolled into an IRA, but rather a taxable account, no required minimum distributions will be needed from these funds. This technique is complex, so working with your advisors is recommended.
Hedging Against Your Concentrated Stock
There are circumstances where you may want to continue holding a concentrated stock position. In this case, it may make sense to also protect against the downside.
An option strategy, such as using a “zero-cost collar” is one approach that may make sense for you. While option strategies are complex, and a collar is no exception, the concept is straightforward. In a collar strategy, you simultaneously buy a “put” option, which gives you the right to sell a position at an agreed-upon price, while at the same time selling a “call” option, which gives someone the right to buy the stock at an agreed-upon price.
For example, let’s assume you have a position in XYZ company that comprised a large percentage of your net worth. While you believe that XYZ’s prospects for the future are excellent, a large decline in the stock’s value would severely impact your financial picture.
If XYZ is trading at $100/share, and you have 10,000 shares, you could buy the right to sell a certain number of shares of XYZ at $90/sh. You would only execute this right if XYZ dropped below $90. At the same time, you sell a call option to someone who would like to buy XYZ at a price of $110. If XYZ went above $110, then the owner of this contract could take advantage by “calling” those shares, meaning you would need to deliver XYZ stock at $110/share.
If structured properly, selling the call will pay for the buying of the put. Roughly speaking, you have protected your downside below $90, and limited your upside above $110. If your head is spinning now, you are not alone. There are other options and strategies that may make sense for your situation as well. Getting this wrong can be a very expensive proposition. Finding someone who is knowledgeable about options strategies and hedging is key to getting this right.
Wrapping it Up
While we all would love to have bought Amazon the day after its IPO, the reality is that there are many regular investors who will end up with concentrated stock positions. Being realistic about the implications of an outsized hit to your net worth in the event of a major downturn should help navigate your course of action. Thanks to the complexity of IRS regulations combined with myriad alternatives, partnering with a professional can make all the difference.