Divesting a Concentrated Stock Position

We’ve seen clients diligently accumulate stock in their company over their careers. 

If they never sell the stock, it could become a very large portion of their net worth. Unfortunately, once steady and profitable companies can go bankrupt, which puts the client at risk of accomplishing their goals. At Wealthstream Advisors, we recommend against holding a large concentration of company stock.

You might want to hold onto your company’s stock since you have a deep loyalty to the firm and believe the price will continue to rise or there’s a large embedded gain and you want to avoid paying tax. We understand your point of view. 

In this insight, I will explain a few single stock risk management strategies to gradually liquidate a concentrated stock position in order to minimize taxes, diversify, and grow your wealth. These strategies not only apply to employer stock but also to individuals who invested in a single stock many years ago that gradually increased over time becoming a large portion of the individual’s net worth.

Strategy 1: Sell the Stock Over Time

One of the simplest, yet most effective single stock risk management strategies that you can use is a pre-defined selling schedule to take the emotion out of selling the stock. Your financial advisor can work with you to estimate the capital gains to take each year.

This plan can help you properly manage your risk tolerance and tax liabilities. Since the client is selling the same amount of shares over the same time period, the client is effectively dollar-cost averaging out of the stock position.

Let’s take a look at a sample selling schedule below:

A client owns 100,000 shares of ABC company valued at $1,000,000 with an unrealized gain of $800,000.

• If the client agrees that taking $200,000 of gains each year sounds reasonable, then a mock selling schedule could be to sell 12,500 shares every June 1 and December 1 for the next 4 years.

Another factor to consider is how to correctly invest and/or spend the liquid proceeds. A qualified wealth manager can help you create a custom-tailored plan to manage these proceeds today.

Strategy 2: Utilize an Exchange Fund

An exchange fund is an illiquid investment that lets you contribute a highly appreciated stock position and receive a basket of securities, thus lowering risk. 

Exchange funds defer capital gains taxes that you’d incur by selling a large stock position. These funds typically require a minimum single stock size of $500,000. Exchange funds invest mostly in publicly traded companies, but can invest 20% of the assets in private investments. Please consult with a qualified wealth manager to determine if this is an appropriate strategy.

There are a few rules to know as well:

• This new portfolio must be held for seven years to avoid penalties.  
• Management fees can be greater than 1%.
• You’d owe taxes on dividend income during seven-year holding period.
• After seven years, you’d receive a basket of securities with the same cost basis as your initial investment.
• You’d still have an embedded gain, but less risk as you’d own a diversified portfolio instead of owning a single stock.
• Here’s a hypothetical example: A client contributes a $1,000,000 position to an exchange fund. No tax is owed on the transfer and instead of owning one stock, the client now owns a fund that owns many stocks. After 7 years, the client receives stocks from the fund with the same cost basis as the initial investment.

Strategy 3: Covered Calls

Selling calls on your concentrated stock position can reduce risk and add income simultaneously. Options trading can be risky and complex. Covered calls are one of the single stock risk management methods.

When writing/selling call options, you’d sell the buyer a contract letting them buy a certain investment at a specific price called the strike price. The buyer would pay you a fee called the premium for this contract.

Simply put, you’ll receive additional income at the cost of limiting your upside potential in the stock. This strategy is especially helpful if you’re comfortable selling certain amounts of stock at specific price points, also called a price realization strategy. However, you are not protected if the stock declines in value. The stock will also not be sold unless it reaches the strike price.

Strategy 4: Transfer to a Charitable Remainder Trust (CRT) or Donor Advised Fund (DAF)

Donating this stock to charity can be a great way to reduce taxes, minimize risk, and help others all at once. Two single stock risk management tools that you could use are Charitable Remainder Trusts (CRTs) and Donor-Advised Funds (DAFs).

CRTs and Concentrated Stock Risk Management

A CRT helps diversify an appreciated stock position, avoids immediate capital gain taxes, and allows you to receive a charitable income tax deduction. This irrevocable trust would also provide you and your spouse with an income stream. When you pass away, these assets would then move on to charity.

To learn how CRTs can help you, read our Insights “Charitable Remainder Trust Case Studies.”

DAFs and Concentrated Stock Risk Management

DAFs are another single stock concentration risk management account that you can use to get tax deductions, give to charity, and reduce single stock risk. 

Please see our “Reasons to Use a Donor Advised Fund for Your Charitable Giving” insight for more details.  

Conclusion

One of the greatest reasons to gradually sell a large stock position is to avoid a substantial tax hit. Having to pay thousands – if not tens of thousands – in taxes on this gain can make it seem like a portion of your investment is gone.

It can be difficult to sell company stock due to loyalty and perceptions that the stock will rise in the future. However, many people thought the same things about Enron and Lehman Brothers. Yet, these once-great companies are now bankrupt.

From a risk versus reward perspective, we believe that diversifying a concentrated stock position is a good solution for many clients. When compared to owning one company, we are more confident that the entire stock market will rise over long periods of time. If you want to protect and grow your wealth, strongly consider implementing the 4 single stock risk management strategies discussed here.

Have extra questions or need a tailored plan about your stock holding?  Schedule a free consultation with one of our financial professionals today!