There are a variety of reasons that investors find themselves with a large, highly concentrated position in one stock in a taxable account. The most common two are that the investor was an executive in a corporation or the investor received an inheritance of stock from a family member.
If you happen to inherit a large stock position, your basis is the price of the stock on the date of the owner’s death or six months later if you choose the alternative valuation date. The stock can move up or down from there, generating capital gains or losses. If the stock has not moved that much since the date of death, the best bet is to sell out of the position and move into a balanced portfolio to reduce risk. This won’t generate a large tax bill because your basis is going to be very similar to the sales price. If the stock has gone down slightly, and you can generate a small capital loss, $3000 of that loss can be used to offset ordinary income for the year. If the stock has moved down a lot, you may not want to sell the entire position at one time. Instead, evaluate all of the holdings in your taxable account. If you have large gains, you can sell these and use the losses in the concentrated position to offset these gains. You can always buy back the same stocks you sold 31 days later to avoid the wash rule. If you don’t have large gains to offset, sell off enough stock to generate at least the $3000 of capital losses if you have ordinary income to offset. The other strategy is to sell up to 100% of the stock and take the capital losses. You can then carry forward that capital loss into future years to offset any gains and the $3000 of ordinary income. This would be the best strategy if you felt the stock was going to continue to go down and lose more money.
Conversely, if the inherited stock has moved up since the date of death, you have other options. You always have the option of selling the stock and paying the capital gains. Depending on your tax bracket, this may be taxed at a lower rate than your ordinary income. You can also use capital losses from other investments to offset some of these gains, if they are available to you. If the thought of paying all of those taxes is not for you, or if you think that you may be in a lower capital gains tax bracket in the future, but being invested in a single stock makes you nervous, you could also consider what is called an exchange fund. This is also a good option if you are a retired executive of a corporation with a large amount of the stock of your former employer. Maybe you had a stock option plan, an employee stock purchase plan, or maybe your bonus was in company stock. When you are working for the company and have a nice income, being highly concentrated in that position probably didn’t make you as nervous because you were not depending on that money. However, in retirement, seeing that stock fluctuate is going to cause you to get nervous. Additionally, you may be restricted from selling part or all of your positions in that stock.
If you want to diversify without paying the capital gains, you can look at an exchange fund. An exchange fund is a private placement limited partnership or LLC that is designed for people in these situations. They are commonly owned by large financial institutions or investment banks (Goldman Sachs, JP Morgan, etc…). Exchange funds allow you to do a tax-free transfer of some or all of your shares to the fund. In return, you receive an ownership interest in the fund in proportion to the shares that you transferred in. This allows you to diversify your portfolio without paying capital gains taxes. The various funds differ in the assets they hold, and it depends on what the fund manager allows to be transferred into the fund. When you take money out of the fund, which is also a non-taxable event, you would get a basket of individual stocks instead of just the stock that you contributed. Only when those shares are sold will you trigger capital gains taxes, and your basis would be the same as it was on the stock you originally put in the fund.
I know this sounds like it may be too good to be true, but there are some downsides to exchange funds. They can have high entry requirements ($1 million plus). They generally do not protect investors against broad market declines, but they do limit single company risk. Liquidity can be a problem in these funds, as many of the funds have minimum time periods that investors must stay in them. Another problem with exchange funds is that you are in essence giving up control of the money, so you must be comfortable with the fund manager before you decide to use this strategy. Before using any exchange fund, make sure you are comfortable with the fee structure, as these investment vehicles can have high fees.
For more information about Exchange Funds and other diversification strategies, please call our office at 904.685.1505.