Managing Concentrated Stock Wealth

An Advisor's Guide to Building Customized Solutions

Tim Kochis, Michael J. Lewis

• Publisher: Bloomberg Press
• Year: 2015
• Print ISBN: 9781119131588
• eBook ISBN: 9781119133865
• Edition: 2
• Topic: Commerce
• Subtopic: Actions

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.

PART I
Sales

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 1
Constraints 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:

1. 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.
2. 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.
3. 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...

Table of contents

• Cover
• Series
• Title Page
• Copyright
• Dedication
• Foreword
• Acknowledgments
• Introduction
• PART I: Sales
• PART II: Gifts
• PART III: Retention
• Afterword
• About the Author
• About the Contributing Author
• Index
• EULA