Reposted with Permission from Robert S. Keebler, CPA, MST, AEP
Planning for Concentrated Stock Positions: Variable Forward Sales, Charitable Remainder Trusts and Exchange Funds
The detrimental effects of concentrated stock portfolios are well documented. Not only do they subject the investor to a high level of risk, but their volatility tends to drag down returns.
Fortunately, a number of strategies have been developed to address the problem. This is the last in a three-part series of columns explaining those strategies. In the first column I explained how asset volatility drags down returns, quantified the benefits of diversification and provided a model for analyzing when simply selling off a concentrated position and reinvesting in a diversified portfolio produces a better economic result than holding the stock. In the second column, I pointed out that there are hedging strategies like protective put options and cashless collars that seek to give taxpayers the best of all possible worlds. In this month’s column, we will explore variable forward sales, charitable remainder trusts and exchange funds as alternative hedging strategies.
Variable Forward Sale
In a variable forward sale (VFS), an investor agrees to tender stock to a counter party at a specified future date in exchange for receiving a specified amount of cash up front (usually as a percentage of the underlying stock’s current value). A typical VFS term is generally two to five years and the stated percentage 75 percent to 90 percent. The taxpayer could immediately use the sale proceeds to invest in a diversified portfolio even though no tax will be payable until the sale closes, either by physical delivery of some or all of the stock or by cash settlement.
A VFS is not simply a tax-deferred stock sale because it also provides downside protection and caps upside potential. Thus, it could be thought of as a cashless collar plus a loan against the stock to be sold. In other words, the investor is purchasing a put option to protect the downside, selling a call option limiting potential gain and receiving a current cash advance on the stock subject to the collar. The embedded collar would be subject to the constructive sale rules of Code Sec. 1259 just like any other collar, so the spread between the put strike price and the call strike price should be at least 15 percent.
A properly executed VFS accomplishes four important objectives:
- Provides immediate liquidity for reinvestment
- Provides downside protection below the put option strike price
- Enables the investor to retain growth potential up to the amount of the call option strike price
- Defers gain recognition until the VFS is closed
Variable Forward Sale vs. Outright Sale
Research suggests that an outright sale generally outperforms a VFS. This is not to say, however, that there are not situations in which a VFS can perform better than simply selling the stock. Perhaps the most common situation is one in which the taxpayer is concerned about the risk of a concentrated stock position but is nevertheless bullish about the stock’s prospects in the short term. A VFS would… READ MORE
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