Advanced Planning for Highly Concentrated Stock

Think about it: whether you've received Restricted Stock Units (RSUs) that have vested, exercised valuable stock options, or were an early founder with a rapidly growing startup, your investment in that single company's stock can balloon quickly. And while a concentrated position can create tremendous wealth if that stock skyrockets, it can just as easily wipe out a significant chunk of your financial security in a single bad day.

The obvious answer is diversification – spreading your investments around. But for many, it's not that simple.

• Ownership Requirements: Many executives face company-mandated ownership requirements, prohibiting them from selling large portions of their holdings.

• Insider Trading Risk: Corporate insiders are often privy to material nonpublic information, putting them at high risk for insider trading accusations if they sell shares at the wrong time.

• Limited Trading Windows: Company rules may restrict sales to very brief "open trading windows," making it hard to execute a timely diversification strategy.

• Loyalty & Confidence: Sometimes, sheer loyalty to the company and unwavering confidence in its future can make it emotionally difficult to diversify wealth out of "their" stock.

The good news? Strategies exist to mitigate the immense risk of a concentrated stock position.

Concentration Risk: It's Not Just for "Bad" Stocks

It's tempting to think, "My company is strong; its stock won't crash." But in 2022 for example, Netflix was down 70%, Wayfair 75%, Zoom 80%, and Zillow over 80% from their peaks. Even giants like Amazon, Google, and Home Depot experienced alarming volatility and declines.

There were no specific company issues causing these declines. Many stock declines happen due to macroeconomic factors, such as the pandemic, supply-chain shortages, high inflation, and the war in Ukraine. These can affect every stock out there.

Experts commonly cite 10% or more of your net worth in a single stock as a dangerously concentrated position. Many clients who receive equity compensation have far more than 10% of their wealth in their employer, often somewhere around 20% to 30%, which becomes a serious concern for financial advisors.

This isn't about predicting the next market crash or identifying "bad" companies. It's about recognizing that even the strongest companies are susceptible to broader market forces and unforeseen events that can trigger sudden, catastrophic losses, often without internal or foreseeable business reasons.

Core Strategies: Selling, Gifting, or Donating

The most straightforward way to tackle a dangerously concentrated stock position is to sell the shares and diversify. For executives, setting up a Rule 10b5-1 trading plan is crucial. This pre-arranged plan allows you to sell shares systematically over time, providing an "affirmative defense" against potential insider-trading charges, as the sales are scheduled in advance and not based on material nonpublic information.

However, as many financial advisors observe, clients are often reluctant to sell due to the potentially high tax bill. Combined federal and state capital gains tax rates can approach 40% on highly appreciated stock. This is a significant hurdle, but it's important to weigh the tax cost against the risk of losing substantially more if the stock plummets.

Beyond outright selling, two tax-efficient alternatives for reducing a concentrated position are:

1. Gifting Stock: A gift of stock, regardless of its size, is generally not considered taxable income to the recipient. This strategy can be particularly effective for individuals with large estates, as lifetime gifts can help reduce estate taxes at death. Techniques involving trusts, such as Gratuitous Retained Annuity Trusts (GRATs), can also be explored for more advanced gifting strategies.

2. Stock Donations: Donating appreciated company stock to a qualified charity is another powerful option. You typically avoid paying capital gains tax on the appreciated stock, and you may be able to claim a tax deduction for the full fair market value of the shares. Using a charitable remainder trust can also be a sophisticated way to combine charitable giving with income generation and tax deferral.

These core strategies offer direct ways to reduce your exposure, though they may involve tax considerations or a philanthropic intent.

Short-Term Strategies: Hedging Against Downside Risk

For those who are unable or unwilling to sell their shares outright, more complex "hedging" strategies can offer protection against losses without immediately triggering the full tax consequences of a sale.

Important Alert: Hedging transactions are sophisticated financial instruments. They involve complex legal and tax rules, require professional advice, and can sometimes attract IRS scrutiny. Moreover, many companies explicitly prohibit their employees from engaging in such transactions, so always check your company's policies before considering these options.

Four short-term hedging strategies:

1. Put Option: A put option gives you the right to sell a specified amount of your company's stock at a predetermined "strike price" on or before a certain expiration date. With a put option, you have the potential to control downside risk. This is considered a shorter-term strategy due to higher premiums, though lower strike prices can reduce the upfront cost. Essentially, you're buying insurance against a stock price drop.

2. Covered Call: A covered call involves selling a call option (giving someone else the right to buy your stock at a certain price) that is "covered" by your existing long position in the stock. This strategy provides income for the stockholder (from the premium received for selling the call), but it doesn't offer downside protection. You would typically use a covered call when you are neutral about the stock's short-term movement, expecting it to neither rise significantly nor fall.

3. Zero-Cost Collar: This strategy offers some downside protection by combining the purchase of a put option with the simultaneous sale of a call option. The goal is to structure it so that the cost of buying the put is offset by the income generated from selling the call, making it "zero-cost." You forgo some upside potential, but the put option protects you on the downside. While giving up some upside might seem like a disadvantage, for a concentrated position, hedging your bets can be worth giving up that upside potential to protect on the downside.

4. Variable Prepaid Forward: This is a more complex instrument. Like a zero-cost collar, it involves both a put and a call, but it also includes a loan. A variable prepaid forward is packaged with a loan for 75% to 90% of the value of the securities that will be sold in the future, typically in two to five years. The number of shares eventually delivered to the counterparty is variable, based on the stock's market price at the contract's expiration. A key benefit is that taxes on capital gains are deferred until the transaction is finalized years later. This technique can be particularly useful for executives with ownership requirements who cannot sell shares for a certain period. However, this approach can draw IRS scrutiny and is less popular for that reason.

These hedging strategies are powerful tools, but their complexity demands careful consideration and expert guidance.

Long-Term Strategies: Exchange Funds and Protection Funds

For managing concentrated stock positions over a longer horizon, a webinar presenter discussed two unique approaches: exchange funds and protection funds. Both are designed to "pool" concentration risk among multiple investors, thereby softening its potential impacts.

1. Exchange Fund: An exchange fund is typically a partnership where multiple participants contribute their low-tax-cost-basis shares in exchange for a pro rata interest in the fund. Because each investor contributes stock from different public companies, the fund immediately holds a diversified portfolio.

   • Tax Benefit: Critically, contributing shares to an exchange fund does not trigger a taxable event. The tax basis of your fund interest simply carries over from the basis of the shares you contributed. Economically it’s as if each investor sold his or her shares without triggering a taxable event and immediately reinvested the proceeds into the fund. This is highly beneficial for investors with highly appreciated stock who want to diversify in a tax-deferred manner.

   • The Catch: After a minimum of seven years (to ensure the tax-deferred treatment), you can exit the fund by receiving a diversified basket of stocks equal to your fund interest. However, the stocks you get when you exit the fund seven or more years later are not really your call. That’s down to the portfolio manager of the fund company. You may end up with a bunch of stocks you don’t really like and then have to sell them and pay taxes.

2. Protection Fund: A protection fund is an alternative risk-pooling strategy for investors who want to continue owning some or all of their core stock position long-term but mitigate significant downside risk. Each investor contributes a modest amount of cash (not their shares, which they can keep) into a cash pool that’s used to protect the participants from a large decrease in the value of their stock after a period of years. The presenter's firm specializes in these funds, for which they hold patents.

   • How it Works: Multiple investors, each with a different stock in a different industry, contribute cash (e.g., 2% of the protected stock's value per year for five years). This cash pool is invested, typically in low-risk government bonds. The crucial point is that the stock being protected is not pledged or subject to any lockup.

   • At Maturity: Investors whose stock appreciates retain their full upside. For those whose stock lost value, the cash pool is distributed on a "total return" basis. If the cash pool exceeds total stock losses, all losses are eliminated, and excess cash is returned. If losses exceed the pool, large losses are substantially reduced. It’s a way to mitigate the risk but let you keep the stock.

Both exchange funds and protection funds offer intriguing long-term solutions for managing concentration risk, but they are specialized products that require thorough investigation and expert advice.

Incentive Stock Options (ISOs) and Special Tax Issues

If your concentrated position stems from the exercise of Incentive Stock Options (ISOs), you need to be acutely aware of their unique tax rules. To get the favorable long-term capital gains tax treatment on the full gain over your exercise price, ISO shares must be held for more than two years from grant and one year from exercise (a "qualifying disposition").

An attorney specializing in this area noted that the ISO rules generally don't prohibit hedging transactions outright. Instead, they focus on whether a disqualifying disposition (i.e., a sale, gift, or certain hedging structures) occurs during the required holding period for ISO shares.

Important Warning: Certain strategies or ways of structuring a hedging strategy could be considered a constructive sale under tax law. This would trigger a disqualifying disposition of your ISO shares, causing you to lose the favorable tax benefits. The attorney also cautioned that any strategy must be carefully reviewed to avoid being labeled as a tax straddle, which carries its own set of unfavorable tax consequences.

The Bottom Line: Assess Your Risk, Plan Your Strategy

Having a concentrated position in company stock is a double-edged sword. While it can be a source of immense wealth, it also carries substantial, often unseen, risk. Ignoring this risk, especially as your net worth grows, is a gamble that few financial advisors would recommend.

The good news is that you have options. Whether it's the straightforward approach of selling and diversifying (when permissible), strategic gifting or charitable donations, or exploring more complex hedging strategies and pooled funds, there's a path to mitigate your concentration risk. However, these are not DIY solutions. Given the complexity, especially with tax implications and insider trading rules, consulting with financial and tax experts specializing in equity compensation is paramount to protecting your wealth and achieving your financial goals. Don't let your "eggs in one basket" turn into a broken nest egg.