Tools and Techniques to Shield and Defer Taxes On Unrealized Stock Gains

By:
Thomas Boczar, ESQ., LLM, CPWA, CFA, and Elizabeth Ostrander, CFA
Published Date:
Oct 1, 2017


This article is the second in a two-part series about the tools and techniques to shield and defer taxes on unrealized stock gains. To read the first part published in the September TaxStringer, please click here.


Strategic Tools for Longer-Term Protection

What strategies might investors consider to strategically manage their single-stock risk over a longer-term period? Exchange funds, stock protection funds, and completeness portfolios are the primary tools investors can use to manage their stock concentration risk over a long-term period.

Exchange Funds

Exchange funds have been employed by investors holding highly appreciated stock since their conception in the 1960s. (See Marvin A. Chirelstein’s "Tax Pooling and Tax Postponement—The Capital Exchange Funds" (1965). Faculty Scholarship Series. Paper 4775, The Yale Journal, Vol. 75, Dec. 1965, No. 2.)

An exchange fund can prove useful for an investor who owns a highly appreciated stock position, wishes to exit completely from all or a portion of his position in a tax-efficient manner, and desires to diversify into a portfolio of publicly traded stocks. (See Exhibit I.)

Structurally, an exchange fund is a partnership or similar entity (i.e., a fund) whose partners each contribute their low tax cost basis shares into the fund. Before the contribution, each investor owns shares of stock of different public companies. After the contribution, each investor owns a pro-rata interest in the fund, which now holds a diversified portfolio of stocks in a variety of industries. An exchange fund enables investors to mutualize—and therefore substantially eliminate—single-stock risk. The investors obtain the benefit of diversification similar to that achieved through an investment in a mutual fund or ETF. Economically, it’s as if each investor sold his shares without triggering a taxable event and immediately reinvested the proceeds into the fund. (See Exhibit II.) Going forward, each investor is exposed primarily to the upside potential and downside risk associated with the portfolio of stocks that the fund sponsor has constructed, rather than solely to the stock that was contributed.

More precisely, at inception of an exchange fund, no more than 80% of the fund’s assets can consist of stocks and securities (and other enumerated assets treated as stocks and securities). This is due to the tax law, which authorizes the transfer of a single, concentrated asset with a low tax cost basis to a much larger portfolio of diversified assets while deferring any capital gains taxes until those diversified assets are eventually sold (IRC section 721). IRC section 721(b) denies IRC section 721(a) non-recognition treatment with respect to transfers “to a partnership that would be treated as an investment company (within the meaning of IRC section 351) if the partnership were incorporated”; however, like IRC section 351(e)(1) in the corporate context, IRC section 721(b) applies only if (i) the transfer results directly or indirectly in the diversification of the transferors’ interests and (ii) more than 80% of the transferee’s assets consist of stocks, securities, and other enumerated assets that are treated as stocks and securities for this purpose.

In 1997, Congress modified the definition of an investment company for purposes of determining whether a transfer of property to a partnership or corporation results in gain recognition (IRC sections 351(e) and 721(b)) by requiring that certain assets be taken into account for purposes of the definition, in addition to readily marketable stock and securities as under prior law. (See Monte A. Jackel & James B. Sowell’s “Transfers to Investment Corporations: Complexity in a Conundrum” in Tax Notes at 1664 (2002).) This was Congress’s attempt to rein in the use of exchange funds. (See Section 1002(a) of Taxpayer Relief Act of 1997, and 1997 Legislation Explanation at 183.)

In order to satisfy this requirement, most exchange fund sponsors make various forms of commercial real estate investments, which are typically funded through debt. For example, an exchange fund that accepts $1 billion of publicly traded stock as assets might also have illiquid direct real estate holdings of $250 million, which were funded through a $250 million loan against the fund’s $1.25 billion of assets. Investors with already heavy real estate exposure (such as senior executives of publicly traded REITS) should consider this factor in their decision-making process.

Thus, the contribution of shares to an exchange fund does not trigger a taxable event, and each investor’s tax cost basis in his fund interest is the same as his basis in the shares that were contributed (i.e., a carryover basis). For federal tax purposes, investors must remain invested in the fund for at least seven years. Subsequently, investors usually have the right to redeem their fund interest (and in turn receive a basket of securities equal in value to their fund interest) or remain invested in the fund. Exchange funds can be structured to terminate on a given date in the future, which term is typically the minimum holding period required for federal tax purposes (currently seven years). This type of structure is often referred to as a “bullet” fund. In a bullet fund, participating investors know exactly what the investments are that the fund holds upon initiation of the fund, and no additional stocks are accepted during the term of the fund. On the termination date, each investor receives his or her pro-rata interest in the fund’s assets. Bullet funds used to be quite common and popular, but none have been sponsored in recent years. Instead, exchange funds are currently structured with no fixed termination date (i.e., an unlimited life). These funds accept new investors or stocks periodically over time. Investors can remain in the fund as long as they desire; after seven years, they can periodically elect to redeem some or all of their interest in the fund. On redemption, with respect to funds with an unlimited life, the investor does not receive a pro-rata ”slice” of the fund’s assets, as is the case with a bullet fund. Rather, the investor receives a portfolio of stocks selected by the sponsor; if the investor does not like the stocks selected by the sponsor for redemption, the investor can opt to remain invested in the fund and elect to redeem in the future (i.e., typically quarterly).

If an investor elects to redeem his fund interest, the basket of securities received has the same tax cost basis as that of his fund interest (i.e., a carryover basis). For example, if an investor contributes shares worth $1 million that have a zero tax cost basis, elects to redeem his fund interest after seven years, and receives a portfolio of stocks worth $2 million, those stocks will have a zero cost basis. (See Exhibit III.) If those shares are sold, the investor would recognize a $2 million long-term capital gain.

If, however, an investor dies while invested in the fund, the estate or beneficiary of the decedent receives the fund interest with a stepped-up tax cost basis. If the estate or beneficiary of the deceased subsequently redeems its fund interest, it will receive a portfolio of securities that have the same tax cost basis that the fund interest possessed, which was stepped up to fair market value. Therefore, if an investor contributes highly appreciated shares to an exchange fund with an unlimited life, the investor can reasonably expect that the unrealized gains on the contributed shares and any further gains will be eliminated at death. For example, if an investor contributes shares worth $1 million that have a zero tax cost basis, remains invested in the fund for ten years and then dies when his fund interest is worth $2 million, and the estate or beneficiary of the deceased elects to redeem its fund interest and receives a portfolio of stocks worth $2 million, those stocks will have a tax cost basis of $2 million. (See Exhibit IV.)  Those shares could be immediately sold by the estate or beneficiary without triggering any capital gains tax.

Directly following the financial crisis, there was a sudden and sharp decline in the use of exchange funds; however, as the stock market rebounded, investors began to utilize exchange funds again. Data regarding the size of the market for exchange funds is very difficult to access, but one researcher has estimated that as of 2009, the market for  exchange funds exceeded $30 billion. (See David J. Herzig, Am I the Only Person Paying Taxes? The Largest Tax Loophole for the Rich - Exchange Funds, 2009 Mich. St. L. Rev. 540.)  Exchange funds have continued to benefit from rising asset inflows the past few years, and sponsors have begun bringing new funds to market. The growing appetite for exchange funds is likely due in large part to the continued strength of the stock market, the higher tax cost of selling outright, and the continued higher cost of equity derivatives that prohibits their consistent, long-term use.

Given that Congress has taken action to limit the growth of exchange fund usage several times in the past, and with the possibility of tax reform in the air, it is possible exchange funds could be viewed by the administration or Congress as a potential “revenue raiser.” Therefore, investors who are considering an exchange fund investment may wish to do so expeditiously, given the possibility that exchange funds could be viewed as a “loophole” to be closed in any tax reform legislation. (See David J. Herzig, Am I the Only Person Paying Taxes? The Largest Tax Loophole for the Rich - Exchange Funds, 2009 Mich. St. L. Rev. 540.)  

Stock Protection Funds

Stock protection funds (herein a “Protection Fund”), sometimes referred to as “stock protection trusts,” are a recent development. Protection Funds can be helpful to investors who wish to keep some or all of their stock position as a core, long-term holding by allowing them to preserve their unrealized gains and keep all upside potential in a cost-effective manner.

Protection Funds are a marriage of modern portfolio theory (MPT) on the one hand and risk pooling and insurance on the other. MPT demonstrates that over time, there will be substantial dispersion in individual stock performance. Risk pooling makes it possible to cost effectively spread similar financial risk evenly among participants in a self-funded plan designed to protect against catastrophic loss. By integrating these principles, Protection Funds provide downside protection akin to that of at-the-money or slightly out-of-the-money European-style put options—but at a fraction of the cost.

Protection Funds permit investors to retain ownership of their shares, including all upside, while mutualizing their stocks’ downside risk. Investors, each owning a stock in a different industry and seeking to protect the same notional value of stock, contribute a modest amount of cash (not shares, which they can continue to own) into a fund that terminates in five years. The cash is invested solely in U.S. Treasury bonds that mature in five years, and upon termination, the cash is distributed to investors whose stocks have lost value (on a total return basis).

Losses are reimbursed until the cash pool is depleted. If the cash pool exceeds the aggregate losses (approximately a 70% probability based on extensive back-testing), all losses are eliminated, and the excess cash is rebated to investors. (See Exhibit V.) If the aggregate losses exceed the cash pool (approximately a 30% chance based on extensive back-testing), large losses are substantially reduced. (See Exhibit VI.) Losses are reimbursed using a “reverse waterfall” methodology. (See Exhibit VII.)

The shares being protected are not encumbered in any way. Investors can continue to own their shares, or can sell, gift, pledge, borrow against, or otherwise dispose of them at any time during the fund’s five-year term.

Protection Funds add a new dimension to the portfolio construction process for investors with concentrated stock positions. As an example, senior public company executives and other investors with concentrated positions often  diversify out of some  of their stock position over time; however, for many reasons, they usually retain a significant position in their stock as a core, long-term holding which is unhedged and remains a major risk exposure relative to his or her net worth. Due to its cost effectiveness, a Protection Fund can be “married” to the retained stock position, thereby mitigating what is likely the investor’s biggest investment risk. Investors can continue to “chip away” at their positions over time, while using a Protection Fund to cost effectively protect that portion of their stock position they wish to retain as a core holding.  The use of a Protection Fund can be cashless if funded through a margin or private banking loan (i.e., 12% loan-to-value) against the stock position being protected; therefore, the investor’s existing asset allocation needn’t be disturbed.

For public company insiders, the use of a Protection Fund does not cause a reportable event—they are, of course, free to voluntarily disclose—and company executives and employees can use one to protect both stock and stock-linked compensation, such as restricted stock units, stock appreciation rights, non-qualified stock options, incentive stock options, and employee stock purchase plans.

A Protection Fund is a tax-efficient means to protect a highly appreciated stock position in that it doesn’t cause a constructive sale, the straddle rules don’t apply, dividends received remain qualified for long-term capital gain treatment, and the termination of the Protection Fund will result in either a long-term capital gain or a currently deductible capital loss.

The use of a Protection Fund should not cause a statutory constructive sale under IRC section 1259 because the participating investors retain all upside potential with respect to their underlying stock positions, including all future appreciation, dividends, and any other distributions. Economically, the protection afforded by a Protection Fund is similar to that provided by at-the-money or slightly out-of-the-money put options, which Congress did not intend to be subject to IRC section 1259. (See 1997 Legislation Explanation at 177.)

Likewise, the use of a Protection Fund should not cause a common law constructive sale because the investors retain all incidents of ownership with respect to their stock positions—that is, each participant investor retains all appreciation of his or her shares, keeps all dividends and any other distributions received on the stock, retains full voting rights  and—because a Protection Fund does not require that a pledge, lien, or encumbrance of any kind be placed on the shares—the investor retains the absolute discretion to keep, sell, pledge, borrow against, gift or otherwise dispose of his shares at any time during the term of the Protection Fund. More specifically, the right of an investor to receive a cash distribution upon a total return loss on his stock resembles the acquisition of a cash-settled put option, and an arrangement that is economically similar to an at-the-money put option does not transfer tax ownership upon acquisition. (See Lucas v. North Texas Lumber, 281 U.S. 11, 50 S. Ct. 184, 74 L. Ed. 668 (1930).)

The combination of an investor’s stock and his ownership interest in a Protection Fund should not be a straddle because the value of the stock and the ownership interest in the Protection Fund will not “vary inversely. Rather, the value of an investor’s ownership interest in a Protection Fund depends mainly on: (1) the change in value of that investor’s stock position, (2) the change in value of the other 19 investors’ stock positions, and to a much lesser extent, (3) the change in value of the cash pool. Put another way, an investment in a Protection Fund is economically similar to an investment in a diversified portfolio comprised of 20 unrelated stocks, with the risk reduction due to the changes in value of the individual stocks in the portfolio over time (i.e., the dispersion of returns). Special rules have been promulgated—for offsetting positions that reference any group of stock of 20 or more unrelated issuers—that determine whether such positions create a straddle with the actual stock position(s). (See 26 CFR 1.246-5(c)(1).) For portfolio or “basket” transactions, a position will be considered offsetting if there is a “substantial overlap” between the investor’s long stock position(s) and the offsetting position. An investor’s stock position(s) and offsetting position will be considered to substantially overlap if the quotient obtained by dividing the fair market value of the stock(s) held by the investor by the fair market value of all of the stocks referenced by the offsetting position is equal to or greater than 70%. (See 26 CFR 1.246-5(c)(1)(iii)(B).)

Since there are 20 equally weighted stocks referenced by a Protection Fund, assuming an investor doesn’t own any of the other 19 stocks, the overlap between the basket of securities referenced by the Protection Fund and the investor’s security is 5%. Since 5% is below the 70% threshold specified for substantial overlap, the basket of securities referenced by the Protection Fund and the investor’s stock should not be considered to substantially overlap and thus should not be considered offsetting positions for the purpose of determining whether a straddle exists. Therefore, the straddle rules should not apply.

Dividends must satisfy certain holding period rules to qualify for long-term capital gain treatment. (See IRC section 1(h)(11)(B)(iii)(I).) The requisite holding period is tolled for each day the investor “has diminished his risk of loss by holding 1 or more other positions with respect to substantially similar or related property.” Like the straddle rules, if the offsetting position references 20 or more stocks, the diminution in risk test is undertaken by determining whether the substantial overlap test described in the preceding section is met. Therefore, the substantial overlap test should not be met, and the holding period for purposes of determining whether dividends paid on an investor’s stock constitute qualified dividend income (or QDI) should not be tolled by reason of the investor holding an ownership interest in a Protection Fund. If dividends received on a stock otherwise satisfy the dividend holding period requirements and is QDI, an investor’s participation in a Protection Fund should not cause the loss of QDI status, and the dividends should be taxed at the long-term capital gain rate.

Upon liquidation of a Protection Fund, if the amount of a cash distribution received by an investor exceeds the tax cost basis of his ownership interest in the Protection Fund (i.e., the original cash investment into the Protection Fund), the difference will be treated as long-term capital gain; on the other hand, if the amount of the cash distribution received is less than the tax cost basis, the difference will be treated as a currently deductible long-term capital loss. A Protection Fund elects to be treated as a “C” corporation, and Protection Fund investors will therefore be treated as shareholders and their ownership interests as stock that they purchased in the corporation. On the termination date, a complete liquidation of the corporation will occur under IRC section 331. Therefore, the cash distribution will be treated as the proceeds of a purchase of the shareholder’s stock by the corporation and will qualify for long-term capital gain or loss treatment, provided that the stock of the liquidating corporation is a capital asset in the hands of the shareholder. (See 26 CFR 1.331-1(a) and IRC sections 1222(3) and 1222(4).) As analyzed above, holding an ownership interest in a Protection Fund and a designated security should not constitute a straddle. Therefore, the holding period should not be tolled for an ownership interest in a Protection Fund by reason of holding a designated security. Assuming an investor holds his ownership interest in the Protection Fund for the life of the Series (which is a requirement), he should meet the long-term holding period requirement.

For example, assume Investor pays $120K to acquire an ownership interest in a Protection Fund in order to shield his $1 million stock position in publicly traded ABC Corp. with a zero tax cost basis, which he’s held longer than one year. The straddle rules don’t apply, and the dividend holding period is not tolled. Therefore, if ABC Corp.’s stock price decreases, and Investor receives a distribution of $400K upon the termination of the Protection Fund, he will have realized a $280K long-term capital gain (i.e., $400K amount realized less $120K tax cost basis). If ABC Corp.’s stock price increases, and Investor does not receive any distribution upon the termination of the Protection Fund, he will have realized a $120K capital loss (i.e., $0 amount realized less $120K tax cost basis) that’s currently deductible. If ABC Corp. pays dividends over the five-year term of the Protection Fund that would otherwise be “qualified” dividend income (i.e., QDI) to Investor, his ownership interest in the Protection Fund will not “disqualify” the QDI and will remain taxed at the long-term capital gain rate.

In comparison, assume Investor pays $120k to acquire a put option in order to protect his $1 million stock position in publicly traded ABC Corp. with a zero tax cost basis, which he’s held longer than one year. The straddle rules apply and the dividend holding period is tolled. Therefore, if ABC Corp.’s stock price decreases and Investor sells the put for $400K, he will have realized a $280K short-term capital gain (i.e., $400K amount realized less $120K tax cost basis). In effect, Investor has converted $280K of long-term capital gain on his stock to short-term capital gain on the put. (This result is achieved because under IRC section 1092(b)(1) and Treasury Regulations section 1.1092(b)-2T(a)(1), Investor’s holding period in the put cannot “age,” with the result that any gain on the put will be short-term capital gain. Thus, even though this gain is, in an economic sense, simply the long-term gain built into the ABC Corp. stock at the time the hedge was established, the holding period termination rule renders that gain short-term. Investor could have avoided this result by physically settling the put by delivering the shares to the seller of the put upon exercise--because the gain with respect to the put is “merged” into the sale of the ABC Corp. stock, the resulting gain would be long-term rather than short-term.) If ABC Corp.’s stock price increases and the put expires worthless, he will have realized a $120K long-term capital loss (i.e., $0 amount realized less $120K tax-cost-basis) that’s not currently deductible; rather, the deduction is deferred and effectively increases Investor’s tax-cost-basis of his shares by $120k. (The loss in this example is long term because, under Temp. Regulations section 1.1092(b)-2T(b)(1), the shares being hedged satisfied the one-year, long-term holding period requirement, and therefore the loss on the put—i.e., the position in the straddle—is deemed to be a long-term capital loss regardless of the holding period. The loss is deferred as a result of the loss-disallowance rule of section 1092(a)(1) because the unrecognized gain in the stock exceeds the realized loss on the put.) If Investor holds his shares until death to take advantage of the step-up in basis, the result is that the deduction is never used (i.e., it’s simply less tax that is forgiven at death). If ABC Corp. pays dividends over the term of the Protection Fund that would otherwise be “qualified” dividend income (i.e., QDI) to Investor, his ownership of the put option will “disqualify” the QDI, and the dividends will be taxed at the ordinary rate. (See IRC section 1(h)(11)(B)(iii)(I).)

A Protection Fund—protecting 20 investors with stocks in different industries, with each protecting the same amount of stock and requiring an upfront cash contribution of 10% (2% per annum for 5 years) of the value of the stock protected—operated through the Financial Crisis from June 1, 2006, to June 1, 2011. Of the 20 stocks, eight incurred losses, some significant (37%, 32%, 24%, 18%, 13%, 8%, 5%, and 1%). All losses were reimbursed (i.e., the maximum stock loss was 0%), with the remaining cash returned to the investors. Therefore, each of the 20 investors received the equivalent of “at-the-money” put protection on their stock throughout the financial crisis, with the amortized pre-tax cost of that protection being 1.38% per annum (less after tax). It’s worth mentioning that it would have been cost prohibitive for each of these 20 investors to roll put options during the same period (i.e., throughout the Financial Crisis) in order to achieve at-the-money put option protection. Extensive backtesting suggests that the annual cost for such protection should be about 1.25% per annum.

There are some similarities between Exchange Funds and Protection Funds in that both are based on risk mutualization, but they satisfy very different objectives. Exhibit VIII and Exhibit IX compare Exchange Funds to Protection Funds.

Tax-Optimized Equity Strategies

Tax-optimized equity strategies combine investment and tax considerations in making investment decisions. They start with the concept of tax-efficiency and quantitatively incorporate dimensions of risk and return in the investment decision-making process.

In the context of managing stock concentration risk they are used two ways: 1) as an index-tracking strategy and 2) as a completeness portfolio strategy.

An index-tracking portfolio is funded by existing investor cash, or more typically, a partial sale or monetization of the investor’s position. The cash is invested in a portfolio quantitatively designed to track a broad-based market index (e.g., the S&P 500 Index) on a pre-tax basis, and outperform it on an after-tax basis. The goal is not to perfectly replicate the benchmark, but instead, to track it closely. Opportunistic loss harvesting allows the investor to sell a commensurate amount of his concentrated position without incurring capital gains taxes, thereby gradually reducing company specific stock risk over time.

A completeness portfolio goes further and incorporates the risk characteristics of the concentrated position to build a “completeness” portfolio such that the combination of the portfolio and concentrated position tracks the broadly diversified market benchmark to the best extent possible. A completeness portfolio is funded by existing investor cash or from a partial sale or monetization of the investor’s concentrated position. Loss harvesting allows a concurrent sale of a commensurate amount of the concentrated position without incurring a tax liability. Over time, the size of the concentrated position can be whittled down to zero, whereupon the completeness portfolio becomes an index-tracking one. (See Exhibit X).

These two strategies are implemented over a fairly long period of time, so the investor continues to retain the company specific risk of the remaining—albeit progressively diminishing—concentrated stock position. A Protection Fund can be used in conjunction with tax-optimized equity strategies to protect the concentrated position the investor continues to hold upon initiation of the strategy.                                           

Summary

With the stock market at record highs, equity derivative strategies (such as puts, put spreads, collars, and put spread collars) and the short-against-the box can be used by investors to tactically manage their single-stock risk, while exchange funds, stock protection funds, and tax-optimized equity portfolios are three strategies investors might consider to help them to better strategically manage their single-stock risk. (See Exhibit XI.)


boczarThomas J. Boczar, Esq., LLM., CFA, CPWA  is chief executive officer and general counsel of Intelligent Edge Advisors, a New York City-based investment banking and capital markets boutique. The firm focuses on M&A advisory and execution, real estate capital markets and hedging & structured solutions. Tom is a pioneer in the delivery of concentrated wealth advisory services to affluent and UHNW private clients through their wealth and tax advisors, and is recognized as an expert with respect to the tax-efficient monetization of closely-held businesses, real estate, concentrated stock positions and deferred tax assets.


OstranderElizabeth Ostrander, CFA, 
 is managing director and director of business development at Intelligent Edge Advisors, an investment banking and capital markets firm that works exclusively with financial advisors to plan, structure and execute liquidity events for their clients who own privately-owned businesses, commercial real estate and/or highly appreciated positions in a  single publicly-traded stock. Elizabeth works with independent broker-dealers, custodians, banks and wealth management firms to make Intelligent Edge’s service offering available to financial advisors and their clients. Elizabeth has authored or co-authored several scholarly articles on various issues surrounding concentrated wealth. 

 
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