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Editor’s note: This is the second article in a two-part series on how to deal with a concentrated stock position. The first is 5 Ways to Manage Concentrated Stock (Plus, the Risks to Know).
More people than ever are reaching out to me with a concentrated stock problem. People like “Mary,” whose company went public last year and now makes up 60% of her balance sheet, and “John,” who bought AAPL stock in the ’90s and decided after the iPhone came out that he may just never sell.
In this article, however, I am going to talk about a client who invested in the Oracle of Omaha right around the time he got that name, in the ’80s. While Berkshire Hathaway is somewhat diversified as is, the client became apprehensive to bet on even an oracle as he approached his 90s.
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Below, I’ll walk through five examples of how this client can mitigate that risk. We will call her Sarah.
1. Direct indexing
Direct indexing has become mainstream mostly due to the elimination of commissions on stock trades at many custodians, paired with the advent of fractional share ownership. We can now do this for clients in-house, which typically brings down the cost. But what is it?
In 2023, the Russell 3000 Index total return was approximately 26%, and there were 1,681 positive stocks and 1,085 that were actually negative. The basic idea is that direct indexing allows you to build a portfolio around your concentrated positions.
Inevitably, some of the stocks will go down. You sell those to realize losses. At the same time, you recognize a gain in the concentrated position to offset those losses. Let’s look at a hypothetical example.
If Sarah rolls her BRK stock into a direct indexing strategy along with some cash, that cash will be used to buy a much bigger basket of stocks. Every time a stock goes down, it triggers a trading system to “harvest” or sell those losses.
Let’s say this happens on March 15, and $100,000 of losses are realized. You can then realize $100,000 of gains to offset those losses. The cash that is raised is then used to further diversify Sarah’s portfolio.
This strategy has gained popularity but there are a few drawbacks you should be aware of: You cannot buy back into any of the positions you sold within 30 days of sale. This would trigger a “wash sale” and those losses would be disallowed.
While you may have initially bought an index of stocks, it will not perfectly track that index. If Pepsi goes down, you sell it and buy Coke, you now no longer hold the index.
Lastly, you are likely to still have large, unrealized gains a few years down the road. However, they will be spread across a much more diversified portfolio.
Tax-loss harvesting does not eliminate market risk, does not guarantee tax savings, and may be limited by changes in tax law, gain/loss character mismatches, transaction costs or individual tax circumstances.
2. Tax-aware long-short
The idea here is similar to the pairing of gains and losses in the direct index. But add to that options, leverage, active management and, at first, quite a bit of confusion.
If the direct index is lifting weights, the tax-aware long-short strategy is lifting weights with steroids. The results can come much faster but with added risk.
In these strategies, as in many hedge funds, the manager takes long positions (bets on) the stocks they like. They take short positions (bets against) the stocks they don’t like.
In up markets, the short positions will be closed out or rolled forward and generate a loss. In down markets, the long positions will be sold at a loss.
These are strategies are designed to generate tax losses in certain market environments that may get you into a diversified portfolio faster than their cousin, the direct index.
As you may imagine, a strategy like this is also more expensive than a direct index. Such strategies face more IRS scrutiny if they are viewed as being used for the sole purpose of avoiding or deferring taxes.
Now add all the normal risks that come with options and leverage, including margin calls. When you take a short position on a stock, you face borrowing costs for those shares.
Leverage is used here to allow you to invest two dollars for every one dollar of your own capital (illustrative example). If a $2 position were to double in value, it would become $4, resulting in a $2 gain on your $1 equity investment.
If the investment declines significantly, losses can exceed your original investment and may trigger margin calls.
Tax-aware long-shorts are one of the most powerful strategies on the list, but they tend to require very large, concentrated positions and a seasoned team to manage the strategy.
These strategies involve substantial risk, may experience significant volatility, may underperform traditional long-only portfolios in strong markets, and are generally appropriate only for investors who can tolerate complexity, leverage and potential losses in excess of their initial investment.
3. Variable prepaid forwards (VPFs)
If Sarah went this route, she would be entering into a contract with an investment bank. There are three main components to the agreement:
Immediate partial liquidity. Typically, the bank will give you 75% to 90% of the current market value of the shares that you, in exchange, agree to sell at a specified future date.
Risk reduction. At the same time you receive your money, a collar is established on the position. See part one for a refresher on the investment equivalent of bowling alley bumpers. With these bumpers, you are mitigating downside exposure but you are also capping your upside.
Settlement. When the contract matures, the number of shares you must deliver to the bank depends on the market price relative to the collar. Generally, you can settle by delivering the required number of shares, the cash equivalent or by rolling the contract into a new VPF. Once the contract is settled, the taxes are realized.
If you’ve made it this far, you know that all the strategies have downsides. With this one, the complexity has to be up there.
Additionally, because these are private contracts, you face counterparty risk — the possibility that the investment bank defaults, leaving your pledged shares at risk in bankruptcy. See Lehman Brothers.
Variable prepaid forward contracts are complex legal agreements that restrict liquidity, may involve significant transaction costs, and require coordination with tax and legal advisers.
Early termination may be costly, and tax treatment depends on current law and individual circumstances.
4. Charitable trusts
Sarah is charitably inclined. That should be a prerequisite for walking down this path. If you can check that box, are looking for income and have more money than you need in retirement, this may be a fit.
Of the strategies in this article, we use charitable remainder trusts (CRTs) and direct indexing most frequently.
With a CRT, Sarah donates shares of BRK into a charitable trust. Because this is an irrevocable trust, this is a one way street. Just like making a contribution into your grandkids’ 529 plan, you cannot change your mind and get the money back out.
Sarah gets a charitable deduction for a portion of the contribution, subject to adjusted gross income (AGI) deduction limits. The capital gains are spread across many years as she receives income from the trust.
That income stream, either fixed or variable, will pay out for the rest of her life. Let’s say there is $1 million in the trust. If structured with a hypothetical 5% payout rate, she would receive $50,000 per year, subject to the trust’s terms and underlying investment performance. When she dies, the remainder goes to the designated charities in the trust.
Irrevocable trusts are also outside of your taxable estate, which make these tools useful for reducing state or federal estate taxes. Keep in mind that irrevocable trusts have unfavorable tax rates during life and require annual tax filing.
5. 351 exchange ETF
This may be the newest strategy on the list, but I’ve left it until last because it makes sense for someone with a larger number of highly appreciated stocks, not necessarily one.
This strategy allows you to swap a group of highly appreciated securities for stock in a newly formed corporation. That corporation is a new exchange-traded fund (ETF). Because it is an exchange, the gains are deferred and are not realized until the sale of the ETF.
By doing this, you are swapping a less diversified portfolio for a more diversified portfolio put together by the ETF manager.
Here are few highlights from the long list of rules: No one position can exceed the total value of all assets contributed. In other words., if you contribute $1 million, no more than 25% can be AAPL or any other single security.
The largest five securities combined cannot exceed 50% of the total amount contributed. Because of this, Sarah would have to bring other securities to the table or she would have to use this for a smaller chunk of her BRK stock.
Like some of the earlier strategies, this will not avoid the capital gains tax. Sarah will carry over her basis in BRK to this pool of investments. When she sells the ETF down the road, she will pay the taxes. This strategy does more to manage the investment risk than the tax risk.
Lastly, you face “economic mismatch risk” — once your stock is in the ETF, you lose control over its management. Combined with high setup costs and the potential for IRS scrutiny regarding “tax avoidance” versus “business purpose,” this strategy is typically reserved for high-net-worth families trying to solve bigger diversification problems across several investments.
Section 351 exchanges involve complex regulatory requirements, may limit liquidity, may involve significant costs and do not guarantee improved performance or tax outcomes. They are generally appropriate only for investors with multiple highly appreciated positions and substantial net worth.
Each of these strategies involves meaningful trade-offs between diversification, liquidity, cost, complexity and tax considerations. None eliminates market risk, and all require individualized analysis based on an investor’s financial position, tax situation and long-term objectives. This is provided for educational purposes only.
In conclusion, this should have been a two-hour CE course for CPAs, not a two-part column. That said, if you’ve stuck with me this far, I have a feeling it will be worth your while. If you want to dig deeper on your specific situation, you can schedule a time with us.