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- Herausgeber: John Wiley & Sons
- Kategorie: Fachliteratur
- Serie: Bloomberg Professional
- Sprache: Englisch
The Methodical Compendium of Concentrated Portfolio Options Managing Concentrated Stock Wealth, Second Edition is the adviser's guide to skillfully managing the risk and opportunity presented by concentrated stock holdings. Written by Tim Kochis, a recognized leader in financial planning, this book walks you through twenty strategies for managing concentrated stock wealth. Each strategy equips you with the tools and information you need to preserve and grow your clients' wealth. Supported with examples from the author's forty years of experience, this practical resource shows you the available options, the best order for clients to review those options, and the reasons why some options are better than others. Kochis addresses common obstacles--such as securities law, taxes, and psychological resistance--and shows you the strategies and execution to prevail. This new second edition includes: * Updated references, calculations, and illustrations regarding the latest tax laws * Revised coverage of derivatives strategies and more examples of potential blind spots * Tactics to convince some clients to diversify their portfolios and optimize their wealth * Techniques to exploit concentration in pursuance of greater wealth They say that you should never put all of your eggs in one basket, but compensation packages, inheritances, IPOs, buyouts, and other situations leave many investors holding a significant portion of their wealth in one stock--often leaving their portfolios in a dangerous position. Managing Concentrated Stock Wealth, Second Edition shows you how to manage the risks and turn a precarious position into an advantage.
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Veröffentlichungsjahr: 2015
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MANAGING CONCENTRATED STOCK WEALTH
An Advisor's Guide to Building Customized Solutions
Second Edition
Tim Kochis
with
Michael J. Lewis
Cover image: Summer blurry lights © Studio-Pro/iStockphoto; Stock chart © Maxphotograph/iStockphotoCover design: Wiley
Copyright © 2016 by Tim Kochis. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.
The first edition of Managing Concentrated Stock Wealth: An Adviser's Guide to Building Customized Solutions was published by Bloomberg Press in 2005.
Published simultaneously in Canada.
No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at www.wiley.com/go/permissions.
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Library of Congress Cataloging-in-Publication Data:
ISBN 978-1-119-13158-8 (Hardcover)ISBN 978-1-119-13384-1 (ePDF)ISBN 978-1-119-13386-5 (ePub)
For my father, Stephen Kochis, and my father-in-law, Henry Wong. Neither of them ever had significant financial resources, but both enjoyed a great wealth of practical wisdom, the guiding principle of this book.
Contents
Foreword
Acknowledgments
Introduction
Getting the Priorities Straight
Knowing the Client
Chapter Note
PART I: Sales
CHAPTER 1: Constraints on Managing Concentration Risk
Taxes
Pre-IPO Illiquidity
Post-IPO Lockups and Other Market Considerations
SEC Constraints, the Sarbanes-Oxley Act, and Dodd-Frank
Employment/Career Constraints
Psychological Barriers
Chapter Notes
CHAPTER 2: Sale and Diversification
Overcoming the Tax Constraint
Overcoming Psychological Barriers
ESOP Sales
Pre-IPO Considerations
CHAPTER 3: Coordinating Long Shares with Stock Options
Employee Stock Options
Taxes on Options
Exercise Strategies
Chapter Note
CHAPTER 4: Diversification Sales and Deferred-Compensation Plans
Deferred Compensation: Then and Now
The Benefits of Deferral
CHAPTER 5: An Out for Insiders
SEC Rule 10b5-1 Plans
Appendix XYZ Co. Nondiscretionary Rule 10b5-1 Sales Plan
CHAPTER 6: Restricted Stock: Tackling Temptation
Managing the Section 83(b) Election
All That Glitters
A Second-Best Strategy
The Right Fit
Chapter Note
Appendix
PART II: Gifts
CHAPTER 7: Gifts to Family
Transfer Taxes
Income Tax Leverage
Transfer Structures
Gaining Psychic Distance
CHAPTER 8: Nonqualified Stock Options: Gifts to Family
Investment Leverage
Tax Leverage
Timing and Valuation
CHAPTER 9: Gifts to Charity
Tax Savings
The Cost of Charitable Gifts
Special Income Tax Considerations
Structures for Charitable Gifts
A Word of Caution
Chapter Note
Appendix: Key Characteristics of Charitable Vehicles
CHAPTER 10: Charitable Trusts
The Charitable Remainder Trust
Coordinating a CRT with the Client’s Financial Plan
The Charitable Lead Trust
CHAPTER 11: Nonqualified Stock Options: Gifts to Charity
The Charitable Gift
Charities Close to Home
The Wealth Effect
PART III: Retention
CHAPTER 12: Margin: An Acquired Taste
Margined Diversification
Margin and Liquidity
The Unexpected
Chapter Notes
CHAPTER 13: Managing Concentration Through an Index Proxy
Tax Management
Limitations and Drawbacks
CHAPTER 14: Exchange Funds
By Invitation Only
Costs and Benefits
The Future of Exchange Funds
Stock Protection Funds
Chapter Notes
CHAPTER 15: Derivatives and Hedges: Buying Time
The Versatile Hedge
Tax Consequences of Derivatives
A Competitive Market
CHAPTER 16: Powers of Concentration
Embracing Risk
Corporate Stock-Holding Requirements
Stock Options: The Decision to Hold
Incentive Stock Options and the Alternative Minimum Tax
The Control Premium
Chapter Note
Afterword
About the Author
About the Contributing Author
Index
EULA
List of Illustrations
Chapter 2
Figure 2.1 The Efficient Frontier
Figure 2.2 The Often Imagined Frontier
Figure 2.3 Basis and the Tax Bite
Figure 2.4 Expected Returns
Figure 2.5 Expected Returns After Tax on Sale
Figure 2.6 Return Differentials: Example 1
Chapter 3
Figure 3.1 The Dynamics of a Stock Option
Figure 3.2 ISOs or NQSOs?
Figure 3.3 Tax Characteristics for an ISO
Figure 3.4 Taxation of Initial $5 Spread at Exercise of an ISO
Figure 3.5 Stock Option Strategy
Figure 3.6 Minimum Future Price to Justify
Chapter 4
Figure 4.1 After-Tax Equivalent Returns
Figure 4.2 Minimum Future Tax Rates
Chapter 6
Figure 6.1 Break-Even Analysis 1
Figure 6.2 Break-Even Analysis 2
Figure 6.3 Break-Even Analysis 3
Figure 6.4 Benefits of the Section 83(b) Election
Figure 6.5 Benefits of the Section 83(b) Election
Chapter 7
Figure 7.1 Calculating the Federal Transfer Tax Liability
Figure 7.2 Advantages of the IDGT
Chapter 8
Figure 8.1 Sample Black-Scholes Calculations: Varying Volatility
Figure 8.2 Sample Black-Scholes Calculations: Varying Strike Price
Chapter 9
Figure 9.1 Limitations on Charitable Deductions
Figure 9.2 Cost of Charitable Gift
Figure 9.3 The Reduced Cost of Charitable Gifts
Chapter 10
Figure 10.1 Tax Treatment of Charitable Lead Trust
Chapter 11
Figure 11.1 Valuation Leverage
Figure 11.2 Advantage of Option Transfer
Chapter 12
Figure 12.1 Maximum Initial Margin Debt
Figure 12.2 After-Tax Margin Leverage
Figure 12.3 Losses Affect Gains
Chapter 15
Figure 15.1 Operation of a Call: Call Payoff
Figure 15.2 Operation of a Put: Put Payoff
Figure 15.3 Operation of a Collar: Collar Payoff
Figure 15.4 Tax Consequences of Puts/Calls
Figure 15.5 Prepaid Forward Contracts: A Range of Outcomes
Chapter 16
Figure 16.1 Dividend Required to Justify Early Exercise
Figure 16.2 Evaluating Rollover versus Retaining Stock
Figure 16.3 Stock Option Strategy
Guide
Cover
Table of Contents
CHAPTER 1
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Foreword
Concentrated stock positions are among the most familiar issues financial advisors face—and one of the oldest. They long predate the booms and busts that threatened so many portfolios in the past 20 years—and may do so again. They’re likely to remain part of the job of managing wealth as long as entrepreneurs create new wealth and as long as stock, options, and other stock-based measures are part of executive compensation. Since the publication of the first edition of this book, many more options have been granted and, even more so, restricted stock and/or stock units have become heavy components of overall executive compensation. The very large grants of options made in the depths of the global financial crisis of 2008 and early 2009, to take advantage of much depressed stock prices, have since grown greatly in value and are now reaching the later years of their 10-year terms. Based on median grant data from S&P 1500 companies, presented by Equilar’s1 2012 report on executive compensation, options for more than 1.3 billion company shares were granted in 2009 . . . at 2009 prices! For 2013, Equilar reports that the value of other stock-based compensation (restricted stock and performance shares) was nearly 22 times greater than the value of the 2013 options grants for S&P 1500 CEOs. And these data only represent the 1,500 largest U.S. companies. No reliable data exists for what has occurred in the thousands of smaller companies, but a reasonable guess is that the potential wealth creation—and concentration—in publicly traded stock, overall, has been vast.
It’s fair to say that almost every investor is aware of concentration as an important investment issue and that every financial advisor recognizes the need to be able to respond to the concerns investors have about it. Virtually every book on investing describes the risks of concentrated wealth and identifies at least a few techniques for dealing with it—as a problem. Very few treat concentration as a potential opportunity.
In 2014, Equilar published the CEO Pay Strategies Report, which examines how the most influential companies in the United States motivate and reward their top executives. The report highlighted a few key trends:
Stock awards, especially restricted stock with performance-based vesting conditions, are becoming an increasingly large share of total CEO compensation.
Stock
options
, while still quite large in absolute terms, constitute a smaller portion of these pay packages.
CEOs are getting younger, thus with more time to either enjoy the benefits or suffer the burden of these potentially highly concentrated positions.
Meanwhile, total compensation packages tend to be even larger than ten years ago at the publication of the first edition of this book, with some of that increase coming from heightened cash compensation elements.
These factors suggest an even more nuanced compensation regime than was in effect during the first edition of this book. Executive compensation continues to be a favorite target of legislative and regulatory attention. The Dodd-Frank legislation of 2010 adds to the key earlier issues (Sarbanes-Oxley, the required expensing of options, and the constraints on flexibility in deferred compensation plans) that were top of mind when this book was first published. Executives and their advisors must still grapple with ways to address the lack of diversification inherent in their concentrated stock positions and the environment has become even more complex.
The first edition of Managing Concentrated Stock Wealth: An Advisor’s Guide to Building Customized Solutions was designed to put in one place a thorough review of the many techniques advisors have available to manage their clients’ concentrated stock wealth—both to reduce risk and to maximize opportunity. This new edition is an attempt to bring this message to advisors even more emphatically. The wealth-building opportunities today are even greater; the risks remain; but some of the tools to manage those risks are even sharper today. This second look sets out more than 40 years’ experience with thousands of clients, most of whom have had some form of stock holding that others, at least, would call concentrated. Some of these clients hadn’t recognized any special issues associated with their stock holdings; they were neither aware of any particular risks nor eager for any particular excess returns. Others, however, were quick to dismiss any concerns about such risk as naive, uninformed, or unworthy of the entrepreneurial spirit they wanted to cultivate in themselves or others. Most, however, were very happy to have a guide through the often-confusing maze of managing this aspect of their wealth. Here, then, is what we’ve learned about how to educate clients on the risks and opportunities related to concentrated stock positions and how best to manage these assets to achieve their objectives.
The book follows the organizational structure of the first edition. The most straightforward solutions are introduced first, followed sequentially by others, each increasingly more complex. That path has two purposes. First, it allows us to more thoroughly address the cumulative nature of the more complex strategies. Deploying a costless collar, for example, presumes a considerable degree of understanding of the more fundamental techniques. The second purpose is to lay out a pattern of choices to consider for the client. If the client’s problem can be solved with one of the simpler approaches, there may be no reason to go further. This triage is valuable even if you expect that the optimal strategy for a particular client situation is far along the scale of complexity. Clients often surprise us. Once exposed to a simple course of action, they often abandon what we thought was their taste for something more elaborate, and, once exposed to the costs and risks of those more elaborate strategies, they often want to go back to something more tame. Nothing about that trait of human nature has changed in the past 10 years.
The chapters that follow are grouped broadly into three areas—one dealing with various approaches to the disposition of the stock by selling (or not buying), the second dealing with gifts to family and to charity, and the third dealing with managing retention of the holding. As will become clear, no approach needs to be deployed in isolation. Very often, in fact, several of them can be combined to meet the idiosyncrasies of a particular client’s range of needs and desires.
Although financial advisors remain the primary audience for this book, clients should find it valuable as well. They’ll identify with the many examples we’ve drawn from actual clients to illustrate the concepts presented. They’ll be comforted to know that they aren’t the first or the only ones to face the particularly thorny financial situations that concentrated stock can create—especially if the eventual outcome on display is good. Perhaps even more important, clients can develop much greater confidence that objective, experienced help is available. Their advisors truly are in a position to help and have many effective tools at the ready.
Since the first edition of this book, many advisors have become more adept in helping public company executives deal with these issues, but there are still large gaps in the sometimes more complex situations of concentration in private companies. This book continues to address primarily opportunities relevant to public company stock. But, where relevant, we also explore risks and opportunities in the private company setting, especially regarding strategies for the investors in and the founders, executives, and early employees of private companies on a trajectory to go public or which are an acquisition target.
Note
1
www.equilar.com
.
Acknowledgments
I have many people to thank for their help in making this book possible. Let me begin with my wife, Penelope Wong, herself a writer, for her inspiration and for her patience with me over the many evenings and weekends devoted to this work . . . for the second time around.
Special thanks go to my former Aspiriant colleague and collaborator, Michael J. Lewis, for his great insight into the many intricate nuances of these management strategies and his unflagging enthusiasm for bringing this story to a new generation of wealth creators. Thanks also to our research assistant, Victoria Wong, for nearly overwhelming us with updated material.
But I owe my greatest debt of gratitude to the many clients with concentrated stock positions who have given us the opportunity, over many years, to learn how best to help them achieve their financial goals. This book is about them and for the benefit of others like them.
Introduction
Holding a concentrated stock position is unwise, at least theoretically, because of the downside risk. Mainstream investment theory holds that one is not compensated for taking risks that can be reduced.1 Since diversification of a concentrated position would mitigate its risk, failing to diversify means one is accepting risk for no expected reward—well, at least not expected by other investors in the marketplace.
Most people, of course, are eager to maximize their risk-adjusted investment returns. But some can’t easily do so because of concerns over tax liability on holdings with large capital gains. Particularly for executives of public companies, the alternatives for addressing the problem are often constrained by post-initial public offering “lockups,” specific employer-mandated shareholding requirements, and Securities and Exchange Commission restrictions on short-term trading or on the use of inside information. Concentration issues are becoming increasingly important for founders, and employees in private companies and for their advisors. For many, the amount of new wealth being created is very large, is being created at very young ages, and is very often the only wealth they have.
Many techniques are available—some very simple, others quite elaborate— for easing this concentration risk.
Getting the Priorities Straight
Shortly before writing the first edition of this book, I met with prospective clients, a couple in their late 50s. The husband had just retired from a long and successful career with a large public company. Their largest individual holding was more than $8 million in his employer’s stock. Its price had been falling, and the couple was quite agitated about what to do to preserve this large value. They had already consulted other advisors and were confused. “Some people say we should do puts or buy a collar. One advisor told us to do something called a ‘prepaid forward.’ Frankly, I don’t understand that. I hope you can help.”
“All of those things, and others, could be appropriate,” I explained, “but let’s start with the simplest steps. We could just sell it. Even if your basis were zero, the worst that would happen is you incur federal capital-gains tax of 20 percent.” (This was in an earlier tax environment, before rates had increased to now nearly 24 percent.) “With the remaining 80 percent, you get to do whatever you want,” I said. “Things get better if you have any basis at all.”
“We don’t have any net gains in this holding,” the husband shot back. “Overall, it’s at a loss.”
“Well, then, why don’t we just sell it—today?” At that suggestion, his wife jumped up, came around the conference table, and planted a big kiss on my cheek—and I had a new client.
The advice this couple had been offered as they shopped for an advisor demonstrates that too frequently advisors are so in love with fancy strategies that they neglect to inquire about the most basic facts of a client’s circumstances—such as the tax basis—and fail to gauge the client’s appetite for complex solutions. The simplest fixes are often the best in terms of controlling costs, reducing delay, and gaining clients’ confidence in the outcome.
It is crucial to recognize that a client’s appetite for complexity or for structural risks (will the counterparty to a custom put be solvent when the put is executed?) or for tax-compliance risks (will exchange funds continue to qualify for tax deferral?) is not necessarily the same as the advisor’s. Some clients are inclined to be very aggressive, in eager pursuit of elaborate techniques. In our experience, however, these people are the exceptions. Most clients are a lot less knowledgeable and, consequently, a good deal less comfortable with sophisticated strategy alternatives than their advisors are.
Moreover, their respective motivations can be very different. Every advisor has had the experience of attending a professional conference, hearing a presentation on a new strategy or a new enhancement to an old approach, and recognizing that he’s not up to speed on it. One of the presenter’s goals, of course, is to engender fear and guilt in his audience for their lack of complete mastery of every new, sophisticated technique. This is one of the ways a profession advances its art. Advisors are eager to achieve—and demonstrate—that mastery, motivated by the desire to maintain or advance their standing among their peers. But that’s not what motivates the client. And a demonstration of the advisor’s virtuosity in a particular strategy doesn’t help much if it isn’t, in fact, the best solution for the client. Often the best approach is one that’s simple, fast, low cost, and with little regulatory or tax exposure. Occam’s razor—first implemented in medieval philosophy and avidly adopted by the physical sciences—applies here as well: The simplest answer is probably correct.
Knowing the Client
As in all aspects of financial planning, the only legitimate starting place for dealing with a concentrated stock position is an understanding of the client’s objectives. Does the client want to accomplish a business goal (acquire or maintain control of an enterprise, for example) that necessitates some degree of concentration? Or does the client want to support an expense target that requires a reasonably predictable cash flow stream that would be jeopardized by the risks of concentration?
Advisors must be sensitive to clients’ idiosyncratic risk/return parameters. I’ve seen many advisors make the mistake of starting off by asking clients about their risk tolerance. Clients don’t really know how to respond—and might not tell the whole truth even if they did. They’re likely to tell you what they think you want to hear or what seems consistent with the persona or image they’d like to cultivate. In my experience, any a priori risk-tolerance statements from the client are unreliable or even misleading.
Consequently, I strongly encourage advisors to be skeptical of the often-used risk-tolerance questionnaires. The chief merit to such exercises is perhaps in having a piece of paper that demonstrates that you actually talked to your client about risk—both the client’s risk capacity and the client’s risk tolerance. There are better methods and more convincing evidence to use if you ever actually need it to defend your professional actions. So, in addition to using a risk-tolerance questionnaire, it’s best to perform the basic financial-planning exercise of determining the resources needed to meet the client’s objectives (commonly called a capital-needs analysis) to determine the client’s risk capacity; you can then use those conclusions to determine the client’s required or acceptable investment returns. Only then can you translate what you’ve learned into the required level of risk the client must be willing to tolerate. If the client can’t learn to tolerate that degree of risk, the only real alternative is to change objectives (lesser expense, later retirement, reduced gifts to family or charity, et cetera). In our experience, few clients are willing to lower their financial expectations; they’re willing, instead, to accept a higher level of risk—often far more—than they would have let on at a first meeting. Risk tolerance, in our experience, is a derived conclusion from careful analysis of client objectives; it’s not a reliable initial input. And it can be learned; we’ve seen thousands of clients do it. It is also dynamic. Both the capacity for and the tolerance for risk can change over time as the client ages, objectives change, or investment performance (or lack of it) occurs. What is tolerable at one point may become intolerable as time goes on. And, of course, the reverse, the intolerable becoming tolerable, can also occur.
Consequently, concentration needs to be managed only if the current capacity and tolerance for risk must be reduced. It can be maintained if the current levels of risk are, in fact, acceptable or if even greater levels of risk are necessary to accomplish the objectives your client truly wants to pursue. Be careful, therefore, not to assume that every concentrated stock situation is a problem to be solved. Many are, but some are not. For example, I’ve worked with a client—the chief executive officer of a public company—whose company stock made up more than 85 percent of his net worth. The balance of that wealth, however, was more than $30 million and was broadly diversified across an array of assets not closely correlated to that company stock. If concentration like that is a problem, it’s one most people would love to have.
The strategies presented in this book move from the simplest and fastest and, generally, lowest-cost solutions for reducing concentrated stock positions to the increasingly complex and often more costly techniques. No one solution will be right for every client, and many of the techniques can be combined to accomplish clients’ multiple objectives as well as to hedge against the potential for downside results that each of these strategies carries.
Another client, for example, had a very large holding of stock and options in the company he worked for and, after long deliberations, accepted our urgings to diversify the position. But that happened only after he became convinced he could pursue many approaches simultaneously. Once he gave himself permission to diversify, he was almost giddy with enthusiasm to try a little of everything. In short order, this client sold a large number of high-basis shares outright, exercised his lowest-priced stock options (and immediately sold the resulting stock), transferred substantial amounts of stock options to his children, and funded a multimillion-dollar private foundation with his lowest-basis shares. This was hardly the random search for an answer it may appear to be. The combination of tactics made a great deal of sense to this client, providing comfort that important progress would be made even if some of the techniques ultimately failed to measure up. In the end, the client still left himself with a very substantial position in the stock options—just in case the company’s stock price increased. For this client to make any diversification progress at all, a many-faceted hedge was indispensable.
Let’s consider, then, the approaches you can use—whether mundane or multilayered—to help your clients meet their objectives.
Chapter Note
1
Most people acknowledge 1990 Nobel laureate Harry Markowitz, beginning with his “Portfolio Selection” paper (
Journal of Finance
7, no. 1 [March 1952]), as the first in a long line of distinguished thinkers who, together, have given us modern portfolio theory. Diversification of investment holdings to reduce overall portfolio risk forms the core of this school of thought. William Sharpe, also the 1990 Economics Nobel laureate (with Markowitz and University of Chicago economist Merton Miller), introduced the capital asset pricing model (CAPM) in the early 1960s and with it the now-familiar concepts of systematic (market) risk and nonsystematic (company-specific)
diversifiable
risk.
PART ISales
Chapters 1 through 6 focus on the many and complex barriers to managing concentration risk and the most fundamental techniques for dealing with concentrated stock: selling the stock and not buying more. The simplicity and immediacy of this response often stuns clients—and their advisors. In all cases, it’s the right place to start—and in many, it’s where you can stop.
CHAPTER 1Constraints on Managing Concentration Risk
Clients face many constraints in addressing the risks of concentrated stock positions: Taxes, contractual limitations, legal requirements, employer mandates, and—perhaps trickiest of all—an array of psychological barriers that complicate the process. Third-party observers are often stymied as to why concentrated stock positions are such a challenge. To demystify things, let’s walk a short distance in the shoes of those who feel burdened by concentrated positions, get a feel for the shape of the obstacles they face, and uncover ways to surmount them. For advisors to those other clients who feel empowered by the concentrated position, bear with us. We’ll have more to say on that as the story unfolds. For now, you, especially, should pay close attention because the shift from empowerment to burden can be swift and unexpected since so much depends on factors (market values) beyond anyone’s real control.
Finding solutions to concentrated stock problems means navigating some dangerous shoals. In the following chapters, we’ll examine many of these obstacles in far more detail. Indeed, real-life examples of these constraints and how firms like Aspiriant have dealt with them form the core of the various management strategies explored throughout the book. But first, let’s get a basic understanding of why concentrated wealth can be so difficult to manage.
Taxes
No less an authority than Supreme Court justice Oliver Wendell Holmes observed in Superior Oil Co. v. State of Mississippi1 that every person has the right to minimize his exposure to tax and to take advantage of every opportunity to avoid tax liability. “The very meaning of a line in the law,” said Holmes, “is that you may get as close to it as you can if you do not pass it.” This completely legitimate, even laudable, tax avoidance must be distinguished from the criminal activity of tax evasion, such as not reporting income or reporting fraudulent information. Although evasion can sometimes be a strong temptation, no advisor, of course, can encourage or condone such behavior for clients. No one will find any suggestions in this book to encourage any violation of the tax or any other law. Plenty of lawful and effective strategies for managing concentration risk are available. There is no need to go beyond those boundaries.
Still, a deep vein of aversion to tax liability runs through our culture, particularly among those who, as least as they see it, created their own wealth. Many clients dread incurring tax liability so much that they will bear the significant (and sometimes even acknowledged) risk of concentration just to avoid it. This isn’t always the case, of course; some clients are quite willing to bear the tax cost, seeing it as an acceptable and indeed small price to pay for their financial success. Some even go to the opposite extreme and see taxes as a vehicle for giving back to society as a whole. As one of my tax professors at the University of Michigan Law School, L. Hart Wright, often told his students, “The federal government is my favorite charity.” We all believed that he meant it. In any event, it was important to hear him repeat it, giving his eager young law students the proper perspective on their future responsibilities: not to beat the system but to take pains to understand it and make sure it operates as intended.
But this tax-as-charitable-gift point of view is not the perspective that typically brings clients to your office—at least not those looking for solutions to their concentration problems. Instead, it’s often their aversion to the income tax exposure that the concentrated position presents. They are often surprised to learn that the gift and estate tax regime can also come into play (sometimes to their advantage but often involving additional costs). Be careful not to overwhelm your client with too much tax detail up front. We’ve had several clients, not savvy about tax law, become frightened by the intricacies and retreat to their former comfort zone, abandoning, at least for a time, any attempt to seriously address the tax issues around managing concentration risk.
So once you have the client’s attention—or are able to regain it—make sure you’re in command of the facts about the client’s concentrated position. Ask these four key questions:
What kind of asset is it?
Not every asset qualifies as a capital asset. Whether it is or isn’t has to do with facts and circumstances specific to the client. To an art dealer, a painting may be a piece of inventory (no capital gain, but ordinary income at sale); to the art collector who buys it from that dealer, it may be a capital asset. What’s more, some assets, like depreciable real estate, must have some or all of any prior depreciation recaptured at sale as ordinary income, with only the balance, if any, taxed as capital gain. And some categories of assets simply aren’t eligible for the favorable 0, 15, and 20 percent rates (underlying the ObamaCare 3.8 percent surtax where it applies). Capital gains on gemstones and precious metals, for example, are taxed at the underlying 28 percent maximum rate.
Does the holding qualify for long-term capital gains treatment?
In general, if it’s been held more than one year, the federal long-term capital gains rates apply:
Zero percent until the generally applicable ordinary income tax bracket exceeds 15 percent
Fifteen percent for gains until the generally applicable ordinary income tax bracket exceeds 35 percent
Twenty percent for gains that cause total taxable income exceeding the level where the generally applicable ordinary income tax bracket is 39.6 percent
If it has not been held that long, then it may be a short-term capital gain, subject to tax at ordinary income rates, but like a long-term gain, it can first be offset by capital losses before the tax rates actually apply. For example, if in one taxable year, your client has both a short-term capital gain of $100,000 and a long-term capital loss of $75,000, only the $25,000 net amount is taxed—but at ordinary income rates.
This illustrates the common strategy of taking any available tax losses—by selling loss positions—to offset gains that may be necessary to achieve the diversification of an appreciated concentrated stock position. Clients are prone to seeing each piece of their overall portfolio in isolation. Many are very happily surprised to realize that the tax burden of diversification is not so bad after all, once the available loss positions in their portfolio are taken into account.
State tax laws usually follow the same more-than-one-year rule if they provide a special capital gains rate. Some states tax capital gains just like any other form of income.
What is the basis? Income taxes are only a problem for concentrated positions if there is an actual capital gain in excess of the asset’s basis. A longtime client retired as chief executive officer of a public company and was immediately approached by a large brokerage firm to participate in an exchange fund it was assembling. To the brokerage firm’s surprise, the aggregate holding was at a loss. “Never mind,” was the broker’s reaction. Now, no longer constrained by his position as CEO, our client was finally free to simply sell, at no tax cost. See our discussion of Exchange Funds and similar structures in Chapter 14.
Capital gains and losses are measured from the asset’s basis. Generally this is the amount the client paid for it, but capital additions or depreciation can move the basis up or down. Probably, the largest volume of contemporary concentration problems are the result of first generation wealth creation in public companies, especially in newly public companies, and there may be even more in private companies on their way to becoming public. Much of this wealth has a basis close to zero. Nevertheless, many large concentrated positions result from gifts or inheritances of previously created wealth. Generally, gifts carry over the basis of the donor and, under current law, transfers of assets at death carry the date-of-death value as the asset’s basis in the hands of the recipient, commonly known as “step-up” in cost basis. If your client has a $10 per share basis in stock now worth $100 per share and gives that stock to a family member as a gift, that family member will then have the same $10 per share basis. If, instead, the client died and willed the stock to that family member, then the basis for that family member would be $100 per share. For reasons that we will explore in more detail, that basis improvement (“step-up”), by itself, does not mean that the transfer at death is the better strategy. Usually, it is not.
Many clients believe it’s wise to plan to hold a highly appreciated concentrated position until their death, so the basis can be stepped up to the value at that time and thus eliminate any income tax on the gain. We’ll have more to say about taxes and basis in Chapter 2, “Sale and Diversification”; Chapter 7, “Gifts to Family”; and Chapter 9, “Gifts to Charity.” For now, it’s enough to say that waiting for basis step-up at death is rarely optimal even under the current basis rules. It will be even more unlikely to be a worthwhile strategy if the basis rules change in the future as is commonly threatened as part of an overall structuring of the estate law. In any event, to achieve basis step-up, assets must be exposed to the federal estate tax. Those estate tax rates, when they apply, apply to the asset’s entire value (capital gains rates only apply to the gain portion) and are nearly as bad as the highest income tax rates, 40 percent for transfer taxes versus 43.4 percent for federal income tax. Managing around that set of tax exposures is often even more urgent an issue for very wealthy clients than dealing with the concentrated stock position.
What timing and location flexibility is available? The state tax on capital gains can be a very significant factor in determining when and where your client sells highly appreciated stock. The state tax is deductible in calculating regular federal taxes (but not taxes under the Alternative Minimum Tax [AMT]) and can yield federal tax savings at a higher rate than the rate on the capital gain itself. This is possible if the client’s ordinary income in the same tax year exceeds the state tax owed (or paid) on the capital gain and other taxable income. For example, assuming no special complications, in a state with a 5 percent tax on capital gain, the total capital gains tax would be 26.82 percent for a client in the highest tax bracket. Note that we are using 23.8 percent as the highest federal long-term capital gains rate, which includes the 3.8 percent ObamaCare tax on net investment income. We will use this rate in examples throughout the book, unless otherwise indicated:
Federal tax
23.8 percent
State tax
5.00
Deduction for state tax (.396 × .05)
(1.98)
26.82 percent
But special complications abound. The state tax is deductible in the year in which it is paid, not the year the liability for the tax arises. So you must be careful to determine whether it’s better to pay some or all of the state tax in the current year or wait until the following April 15. Complicating things even more is the fact that state taxes are not deductible for the AMT calculation and do not create a minimum tax credit to be used in some later year. Depending on the size and character of your client’s other income in the year of the capital gain transaction and in the year that follows, state taxes may apply at their full force with no offset from federal tax savings.
This potential state tax burden often prompts thoughts of moving in advance of the sale to a state with low or no income tax. Many California clients (with a current capital gains tax as high as 13.3 percent) consider a move to Nevada, for example—a state with no income tax—until they contemplate all the factors that must be accomplished to make such a change of domicile legitimate (having a believable principal residence in the new state, mailing address, club memberships, religious congregation, driver’s license, voting registration, etc.). Quite a few clients plan such a move for their eventual retirement, but for clients still actively involved in creating wealth, it rarely works as a strategy for ameliorating a specific capital gain exposure. And to be clear, changing one’s domicile would work only for an intangible asset, such as a concentrated stock position. The original, high-tax state would still collect its tax on the sale of local real estate for example.
And taxes aren’t the only menace.
