An investor’s guide to highly appreciated stock

As holdings appreciate in value over a period of years, investors are fortunate enough to be faced with the question of what to do with significant embedded long-term gains. Since it’s unlikely that an entire portfolio appreciates at the same rate, we will focus on what to do when gains are disproportionately concentrated in just a handful of names. For context, just ten stocks have accounted for nearly 25 percent of the S&P 500′s rise during the 10-year bull market from March 2009 to March 2019. If a few of those ten names made up only ten percent of your portfolio in 2009, they’d certainly make up a much greater percentage of your overall portfolio in 2019. And it’s likely those supercharged positions would have appreciated enough to be considered concentrated positions on their own.

A concentrated position is a single holding that represents a significant percentage– typically ten percent or more– of an overall portfolio.

Why concentration matters.

Concentrated holdings increase the overall volatility of a portfolio. Higher volatility affects compound returns in a very real way: Comparing two portfolios which average the same rate of return over time, a portfolio with lower volatility would have a higher compounded annual growth rate than a more volatile portfolio (see table below).

Seven questions to ask before reducing a concentrated position.

Every investment decision is personal. As a starting point, we encourage investors to answer the questions below if they are considering reducing a concentrated position with embedded gains.

1. How much the position should you divest, and what should be done with the remainder?
2. When is the best time to reduce the position?
3. What short and long-term needs and goals are relevant?
4. What is the short and long-term outlook for the position?
5. How is the stock held? (ISO, NQ, etc.)
6. Does the Qualified Small Business Stock (QSBS) exemption apply to the position?
7. What are the consequences of selling?

The answer to the final question invariably points to the tax consequences of selling a position with a large gain. But there are several ways to diversify a concentrated position in a tax efficient manner.

Tax-aware strategies for reducing a concentrated position.

There are several ways for investors to reduce concentration in a single position, while deferring capital gains tax.

Using a Trust When Selling Stock

Since trusts are their own entity they file separate tax returns, including the reporting of income and gains generated from investments. The situs is the location of the trust property and its location for legal purposes including its state tax jurisdiction.  Having the trust situs in a state with lower tax rates can help reduce the amount paid on long-term capital gains. Using a trust for selling stock works best for larger positions since the savings need to offset the legal and administrative fees for establishing the trust.

Exchange Funds

An exchange fund, allows accredited investors to ‘exchange’ an individual equity position for shares in a diversified pooled fund.  Before contributing, each investor owns their share of his or her own company stock.  After contributing, the investor has a pro-rata interest in the fund, which now holds a diversified portfolio of stocks in various industries.  The manager of the exchange fund must first approve the inclusion of your shares and the IRS requires a lock-up period of 7 years.  At the end of 7 years, the investor has the option to stay in the fund or receive a basket of securities with the same cost basis as the original company stock.

Gifting Stock to Charity (CRT)

A Charitable Remainder Trust (CRT) is a split interest trust broken into two components: a ‘life’ interest and a ‘remainder’ interest. A donor creates an account and makes a contribution of cash, stock, or other assets like real estate or artwork and can take an immediate tax deduction for the gift. The donor receives interest from the trust, usually for the life of its trustees; and the charity of the donor’s choosing receives the remainder interest. Charities benefit since they pay no capital gains tax on gifts of appreciated assets, while donors benefit through the initial income tax deduction, possible gift and estate tax savings as well as through lifetime income and diversification.

Donor Advised Fund (DAF)

A Donor Advised Fund is a charitable vehicle which allows donors to maintain control over funds beyond the date of contribution, allowing gifting to take place (and continue) well into the future.  Donors receive an immediate tax deduction of up to 30% of adjusted gross income (AGI) for gifts of appreciated securities, real estate and other assets.  Choosing to contribute highly appreciated assets to a DAF is a strategic move, which gives the donor the benefit of tax-deductibility of the asset at its present value while at the same time eliminates the burden of capital gains on the donated position.

Gifting Stock to Family (GRAT)

A Grantor-Retained Annuity Trust is an irrevocable trust created for a given period of time.  It pays an annual annuity interest to the grantor with total payments equal to the donation’s value plus interest (monthly rate determined by the IRS).  Any gains beyond the donation value accrue to the trust beneficiaries and paid when the term of the GRAT ends.  A GRAT is an estate planning technique that allows gifts in excess of federal lifetime limits but also has several drawbacks including the possibility of assets reverting to the estate should the grantor pass away during the term of the GRAT.  Grantors also need confidence in the appreciation potential of the gifted asset to at least cover the legal fees paid for establishment of the GRAT.

Protect against volatility without reducing your position: Options Strategies

Option collars can protect your concentrated position from short-term volatility. A collar consists of a long put option and the sale of a call to finance the cost of the put premium. The long put option provides a floor to protect against further losses, while the short call limits the upside potential during the life of the option.

For more on this strategy, see “An alternative hedging strategy for sophisticated investors” in our published article titled “Why holding Cash is not an effective hedging strategy.”

Special circumstances: How to address your concentrated position if you are a company insider

Insiders of publicly traded companies are subject to SEC rules, and therefore need to approach things differently. A systematic way to reduce your position over time, as an insider, is to set up a 10b5-1 Selling Plan.

Insiders of publicly traded corporations, see our published article on 10b5-1 selling plans.

Each approach discussed above creates unique tax implications, and offers unique benefits for investors. Remember if you hold highly appreciated stock, the position may also represent concentration risk within your portfolio.  That doesn’t necessarily mean you need to reduce concentration.  But, it is worth considering.