Spread Your Portfolio Wings Confidently

Physician's Money Digest, February15 2003, Volume 10, Issue 3

Enron,WorldCom, and Tyco—these are just some of thefamiliar companies that haveseen significant declines in the priceof their stock. And if you happened toturn on your television last year,you're probably aware of how someinvestors lost large amounts of moneyafter these stocks declined (especiallyEnron employees). In an appropriatelydiversified portfolio, while declinesare disappointing, they are not devastating.However, stock declines canbe devastating when your portfolio isheavily concentrated in 1 stock or in asmall number of stocks.


Typically, stocks have a very lowcost basis and, therefore, trigger significanttaxes in the event of a sale. Inmost cases, if there were no tax issues,clients would be willing to sell all orpart of the stock and use the proceedsto diversify their portfolio into amuch broader range of stocks. Unfortunately,taxes are a reality. So justwhat is an investor to do if their portfoliois heavily concentrated? Afterrealizing the high risk, they should set2 goals: portfolio diversification andtemporary hedging.

Diversifying the portfolio is themost common goal of managing aconcentrated position. It is typicallyrecommended that no single stockposition represent more than 5% ofan investor's portfolio. An exceptionto this common unwritten ruleapplies to company stock—if youwork for the company, this holding isusually increased to 10%. In somecases, however, people may not beable to choose their holdings. Nowadays,key executives in many corporationsreceive stock options as partof their compensation package.

Next, an investor needs to providea temporary hedge against a pricedecline. For example, investor A hadthe opportunity to exercise a sizablestock option at a very favorable price.To avoid significant capital gainstaxes, investor A needed to borrowmoney to buy the stock and then holdit for 12 months. This allowed investorA to receive long-term capitalgains treatment (maximum 20% federaltax rate) instead of ordinaryincome taxes (39.6%).


If you are an investor with aconcentrated portfolio, the mostimportant question to ask yourselfis: If I had the stock's current valuein cash today, would I use it all tobuy this stock? If your response tothis question is no, then considerthe following 4 strategies:


• Sales over multiple taxyears. The strategy here is to sellyour concentrated stock position overa period of time so that your taxes arespread out over a number of years.This may be more of a psychologicalsolution than a true tax-saving strategy,since the 20% federal long-termcapital gains tax rate is likelyto be the same whether you sell allyour shares in 1 tax year or overmultiple tax years. However, salesover multiple tax periods may allowyou to manage your adjusted grossincome and avoid the itemizeddeduction and personal exemptionphaseout rules. Review otherholdings to determine if you haveunrealized losses that you can use tooffset the gains from the sale of yourconcentrated stock.

• Equity collars. An equitycollar is a hedging strategy that consistsof 2 options. The investor buysa put option (to hedge the risk of thestock going down in value) and sellsa call option to help finance the costof buying the put. Once the optionsare in place, the collar provides aminimum and maximum value forthe combined position for a specificperiod of time. This strategy is oftenemployed if the stockholder wantsto postpone the sale until a futuretax year but wants to protect thestock from significant decline. Theinvestor retains the stock, the votingrights, and the right to the dividendpaid on the stock.

• Exchange funds. With thisstrategy, you contribute your sharesto a fund in exchange for units in thatfund. Investors with concentratedstock positions in other companiesalso contribute, forming a diversifiedpool. No tax liability is incurred at thetime of the transfer. Exchange fundsare private equity placements and areonly available to qualified investors.

To receive the tax benefits of thistax-free exchange, you cannot redeemyour shares in the exchange fund for aminimum of 7 years. Make sure youlook closely at the securities the fundintends to hold to determine if thefund meets your objectives. Once theexchange fund is funded, it is typicallymanaged passively (ie, no buys orsales of the stocks in the fund).

• Charitable remainder trust.Your first consideration regarding acharitable remainder trust is yourcharitable intent. If your sole focus ison the tax benefits, then this will notbe an appropriate strategy becauseultimately there must be a gift to aqualified charity. However, if you dohave a charity you would like to support,a charitable remainder trust canbe an excellent strategy. Considerwhether the following apply to you:You desire to give to a qualified charity,you have appreciated propertythat you would like to sell while avoidingimmediate tax consequences, andyou desire an income stream.

Here's how it works. You establishthe trust and transfer your low-basis,concentrated stock (or anyappreciated asset) into the trust. Astrustee, you then sell the stock andreinvest it in a diversified portfolio.You structure your trust so that youreceive an income from the trustduring your lifetime, and at yourdeath, the remaining assets go to thecharity of your choice. The incomecan be paid over the joint lives ofyou and your spouse. Your income isbased on either a fixed interest rate(eg, 5% per year) or on a fixed payment(eg, $5000 per quarter).

Because your trust qualifies as acharitable trust, the sale of your low-basis,concentrated stock positiondoes not trigger an income tax. Youeven receive a partial income taxdeduction for your gift since yourchosen charity also receives bene-fits—an ideal win-win situation.


You win because you are able toconvert your concentrated stock positioninto a diversified portfoliowhile avoiding income tax on thesale. In addition, you have alsoremoved this asset from your estatefor estate tax purposes. The charitywins because it will ultimately receiveassets once you no longer need them.Heirs receive absolutelynothing in this transaction.

Stewart H. Welch III, founder of

the Welch Group, has been

rated one of the nation's top

financial advisors by Money,

Worth, and Medical Economics.

He welcomes questions or

comments from readers at 800-709-7100 or

www.welchgroup.com. Reprinted with permission

from the Birmingham Post Herald.