Concentrated Stock Position: A Double-Edged Sword

In an investment landscape where prudence dictates diversification, having a concentrated stock position can appear as a double-edged sword. On one side, they offer the potential for substantial gains, while on the other, having a single equity position as a major source of overall net worth may also cause a great deal of stress and concern.

Many of the families we serve have accumulated wealth through a single stock holding. This article aims to demystify concentrated stock positions by providing six clear tax-efficient strategies to manage them effectively.

A concentrated stock position is defined as a single equity stake comprising approximately 10% or more of an investor's total portfolio allocation. Such positions often arise from various circumstances, such as inheritance, corporate compensation plans, participation in an IPO, or simply a successful investment that has grown disproportionately over time.

In any of the situations above, a common trend among these holders is that they’ve held on to these positions for long periods of time.

Why is this the case?

• Emotional Bias: It is inherent in human nature to develop an emotional connection to our finances, particularly to specific investments within our portfolio. The historical significance and personal narratives associated with certain holdings, as well as the effort put into building our portfolios over time, can make it challenging to let go and embrace diversification. The sentiment surrounding such decisions adds layers of complexity to this bias.
• Taxes: Some wish to avoid a large taxable gain and, therefore, a large tax bill. It may not be an option to offset those gains, or some simply don’t want to pay the taxes.
• Restrictions: In certain scenarios, it may be required for a senior executive or business owner to hold a specific amount of stock for a designated period. Additionally, market liquidity constraints can potentially impact the ability to sell.

What risks are associated with holding a large portion of a single company?

Even the largest and most successful companies are not immune to market volatility and economic downturns. This vulnerability was underscored in a study by Eaton Vance, which highlighted the potential risks and volatility associated with individual stocks.

During the study, they examined all actively traded stocks listed on NYSE and NASDAQ since 1981. In this scenario, 68% of US stocks experienced catastrophic loss (defined as a maximum price drawdown greater than 70%.) Individual stocks have historically posted higher volatility and lower median performance than the stock market. A concentrated stock position may expose an investor’s wealth to a wider range of outcomes and longer periods of loss than holding a well-diversified portfolio.

The primary risk of such volatility is that an investor will panic (especially when such a large portion of total net worth is in one position) and sell at the wrong moment in time. If the underlying fundamentals of the company are strong, then holding the position during a large downturn is the best course of action—this is easier said than done.

Often, emotions get the better of us, and selling is the only action to “make the pain stop.” A prudent step forward is to have a well-thought-out strategy that contemplates tax, diversification, and future returns to address the risks of a concentrated stock position.

Six Tax-Efficient Strategies to Manage Your Concentrated Stock Position

1. Gradual Exposure Reduction: If you are willing to sell some of your shares, there are tax-efficient ways to do so.
   
   
   • Create a strategy that’s part of a broader financial plan.
   • Selling over a determined time period, whether that’s monthly, quarterly, or annually.
   • Create an overall budget for capital gains, understand where you can offset some of those capital gains with other losses you may have in your overall portfolio, and what you are willing to pay in taxes, if any.
   • Be sure to create a tax-loss harvesting strategy that best suits your needs and what you feel most comfortable with.
     
2. Gifting Shares: Another method of diversification is to directly distribute shares to individuals of your choosing, especially if you no longer require the assets and can remove them from your estate. This straightforward approach not only allows for diversification but also streamlines the process.
   
   
   • Donor Advised Fund (DAF): A Donor Advised Fund is a charitable investment account you can use to gift to organizations you wish to support. You may gift any highly appreciated shares you own to the donor-advised fund and then receive an immediate tax deduction for that year. From that point on, you can use the DAF for your ongoing charitable needs (while also achieving tax-free growth.)
   • Charitable Remainder Trust (CRT): Another investment vehicle that can be used to transfer concentrated stock positions. You contribute your shares to a CRT, the CRT pays the donor a lifetime stream of income from the shares, and anything left at death goes to charities of your choosing.
   • Charitable Contributions: Another tax-efficient strategy involves donating a portion of your stock position to a charity. By gifting the shares directly, you may be able to deduct the full market value at the time of donation and avoid paying capital gains tax on the appreciation.
   • Estate Planning Strategies:  Grantor Retained Annuity Trusts (GRATs) or Intentionally Defective Grantor Trusts (IDGTs), can potentially reduce your concentrated stock position while also providing estate tax benefits. These strategies involve transferring shares into a trust with specific terms that allow for an income stream or other benefits to you while reducing your taxable estate.
3. Exchange Fund: These funds allow investors to pool their stocks together, providing diversification without triggering a taxable event. By participating in this fund, you can exchange your concentrated shares for a diversified portfolio of single stocks from the entire fund. This allows you to delay capital gains while benefiting from the reduced risk associated with diversification. However, it is important to note that there are certain requirements regarding the duration of your investment in the fund, as well as liquidity constraints.
   
4. Options-Based Strategies: There are a variety of options-based solutions available that can provide income and downside protection.
   
   
   1. • Protective Puts: To potentially reduce downside market risk while still participating in the upside.
      • Collars: Earn income while also mitigating downside risk.
      • Covered Calls: Income generation.
5. Prepaid Variable Forward: This is a forward contract that is made up of a collar plus an upfront loan. It allows the investor to participate in the appreciation of the stock up to a stated level, allows the client to hedge the stock against the depreciation of the shares starting at a stated level, and provides the client with liquidity without having to shell shares and cause a tax consequence.
   
6. Pledged Asset Loan: Borrow against the value of the stock and use those proceeds to invest elsewhere.
   

A single stock portfolio can be a blessing, a source of stress, and a bit overwhelming to manage. But they also provide opportunities for strategic wealth management. It's essential to understand these opportunities, the inherent risks, and the strategies available to manage them.

Despite the complexities, we at Carmel Capital Partners have ample experience managing concentrated portfolios and can provide guidance and solutions tailored to your unique situation.

Please let us know if we can answer any questions or help create a customized plan for you and your family.

Sources:

• Eaton Vance Management, March 13, 2023.
• Tax-related information sourced from the Internal Revenue Service. IRS.gov, 2023.

The content is developed from sources believed to be providing accurate information. The information in this material is not intended as tax or legal advice. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information and should not be considered a solicitation for the purchase or sale of any security. Investment advisory services are offered through Carmel Capital Partners, an SEC Registered Investment Advisor.