Executives and professionals with compensation packages heavy in equity awards often own highly appreciated concentrated stock positions.
The challenge investors face with such portfolios include:
1) Triggering a significant capital gains tax liability if they sell, and a (likely) need to pay a current quarter estimated tax payment (or incur an estimated tax penalty)
2) the risk of owning a large allocation of a single stock creating a lack of diversification,
3) the opportunity cost of missing out on upside that may be available in other stock positions or other investments,
4) less cash in the bank to fund personal interests and financial obligations,
Clients often ask us what options are available to get around these challenges when risk concerns, liquidity interests and the decision to diversify is made.
Other clients, unfortunately, don't ask and simply sell a large percentage of their highly appreciated stock prior to our quarterly tax projection update and refinement session, bypass the opportunity to learn about strategies and elections they could have alternatively pursued to achieve their objective and avoid current year capital gains tax.
In the hope of ensuring you avoid selling a large percentage of highly appreciated stock prior to learning of alternate paths that exist that you may prefer to achieve your objective, we are sharing a few such strategies in this article.
If you have questions, learn of other options, would like to discuss your current situation, give us a call or schedule a consultation and strategy meeting here.
Selling to meet a liquidity need, such as a down payment on a new home
If you are considering selling a large percentage of an appreciated concentrated position to fund a liquidity need, such as funding a down payment on a new home, and aren't overly concerned with the risk of holding a concentrated position, you'll want to consider taking out a securities-back loan, and commit to paying down the loan on your next RSU/GSU vesting, or other near-term income stream. Interest rates are relatively low, and capital gains and capital gains tax are avoided.
Selling to reduce risk and diversify your investment portfolio
Investors with a sizeable concentrated stock position of stock in demand by a private investment exchange fund under construction may qualify to participate in a private investment exchange fund. As benefits include full deferral of capital gains, private investment exchange funds have been popular with executives with many years earning equity compensation such as RSUs & GSUs.
How Exchange Fund Work
An exchange fund aggregates the concentrated stock positions of many investors, creating a diversified collection of stocks that mimics an underlying, broad-based stock market index. Accepted investors swap their concentrated position for a partnership interest or share of the exchange fund, avoiding a taxable event and providing tax-deferred growth instead. Exchange funds have windows open for the periods they are accepting stock for exchange, and investors must hold shares of stock the fund has an appetite for (intends to include as a fund portfolio holding).
Benefits of Exchange Funds
The main reason to use an exchange fund is for diversification. Spreading your investment dollars across a wide range of assets can help you reduce volatility and investment risk, so that no one asset has an outsize impact on your overall investment portfolio. An exchange fund helps you replace a concentrated position with a diversified one.
Another benefit of exchange funds is deferring your tax liability. Some concentrated stock positions have become sizable due to the stock’s appreciation over time. This means that the stock would have accumulated large gains and selling shares to diversify would likely generate a significant tax burden. Depending on your tax situation, it may make financial sense to delay paying taxes to another time or leave your partnership shares behind to heirs since they will benefit from having a step-up in cost basis (heirs are able to adjust the cost basis of an asset to the fair market value at the time of inheritance).
Drawbacks of Exchange Funds
Accredited Investor Requirement
Typically, exchange funds are structured as private placement limited partnerships, or limited liability companies, which means that usually only accredited investors with over $5 million in net worth can participate. Exchange funds are not registered securities, so they don’t need to follow the SEC’s requirements for information disclosure.
Exchange funds usually require that you hold on to your partnership shares for at least seven years before redemption (completing the swap of your concentrated position into a basket of stocks) without penalty. Seven years is a long time to wait and could present an issue if your financial circumstances change and you need access to your investments during that time. Redeeming partnership shares early could mean a return of your concentrated stock rather than shares of the diversified fund you were seeking.
Exchange funds give you the ability to swap your stock for the fund’s partnership shares tax-free. To maintain eligibility for this preferential tax treatment, exchange funds are required to keep a 20% minimum of total gross assets in certain qualifying investments to help minimize portfolio volatility. Often, these qualifying investments might be commodities or real estate, which can potentially be more illiquid or riskier than traditional stock holdings.
It's imperative investors interested in private investment exchange funds understand all details outlined in the prospectus. We have provided an overview.
With year-end is rapidly approaching, August, 2022 is the time to ensure your 2022 tax strategy and tax projections are solid, and you are comfortable with Federal and State tax cash outflows and effective tax rates you are on-track to achieve.
Whether you are motivated to reduce 2022/2023 effective tax rates and increase tax savings, have an urgent tax matter, need to have your return prepared, would value a third-party review or looking for a new CPA / tax advisory partner, schedule a consultation and a strategy session to get our conversation started here.
Cobalt PacWest | CPAs & Advisors Palo Alto Square
3000 El Camino Real, Bldg 4 Palo Alto, CA 94306