Tools and Techniques to Shield, Defer Taxes on Unrealized Stock Gains

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

Investors with highly appreciated stock positions face a challenging environment. The stock market is at record heights, interest rates are steadily increasing, and risks seem to be lurking everywhere around the globe.

Investors also face considerable tax uncertainty. Since 2013, the tax cost of selling outright has spiked, with the capital gains tax rate increasing almost 60%: The American Taxpayer Relief Act of 2012, enacted Jan. 2, 2013, increased the top tax rate on long-term capital gains to 20% for high-income earners, and beginning in 2013, long-term capital gains became subject to an additional 3.8% surtax, enacted as part of the Health Care and Education Reconciliation Act of 2010. With President Trump in office and a Republican-controlled Congress, however, the possibility of significant tax reform is “in the air,” which might include a reduction in the capital gains tax rate, as well as the elimination of both the estate tax and the step-up in tax-cost-basis at death. Some investors holding highly appreciated stock would like to protect—and defer the capital gains tax on—their unrealized gains and “wait it out” until this tax ambiguity is sorted out.

Of course, some investors wish to maintain ownership of some or all of their concentrated stock positions for reasons other than tax planning, such as an emotional attachment to the stock, a belief in the further upside potential of the stock, a dividend yield that compares favorably to current fixed income yields, or restrictions on selling shares imposed by securities regulations or contract law—for example, an employment, IPO lockup, or merger agreement.

This article explores a variety of tools and techniques—some old, some new, some obvious, some not so obvious—that investors might avail themselves of if they want to protect, and defer the tax on, their unrealized gains.

Tactical Tools for Shorter-Term Protection

What strategies might investors consider to tactically manage their single-stock risk over a short-term period?

Puts, equity derivatives, short sales, and permutations thereof are the primary tools that investors can use to acquire shorter-dated protection.

Puts and Put Spreads

Perhaps the most basic form of protection is the purchase of a put. For example, as Exhibit I depicts, Investor A, who owns ABC Corp. stock, trading at $100 per share, pays $10 to acquire a one-year “at-the-money” put option (i.e., a strike price of $100). The results are quite attractive: Investor A locks in 100% of his gain and defers the capital gain tax while retaining all upside potential of the stock.

These desirable benefits, however, come at a price.  Puts have always been expensive, but since the financial crisis they’ve become even more expensive for several reasons. First, the volatility skew has become and remains unfavorable—puts have become much more expensive relative to calls post-financial crisis. Second, interest rates remain near historical lows. Third, the capital allocation ramifications of Dodd-Frank have been difficult and costly for derivative dealers to adapt to.

That said, many investors would like to reduce the cost of put protection, and this can be accomplished by several different means.

Shorter-dated puts (i.e., a maturity of three months to one year) are less expensive than longer-dated puts and therefore more practical to employ.

At-the-money puts (i.e., 100% protection below the current stock price) are the most expensive puts regardless of the maturity; therefore, it’s simply not practical to use them uninterruptedly for an extended period of time.

Out-of-the money puts (i.e., less than 100% protection below the current stock price—such as 90% protection below the current stock price) are less expensive than at-the-money puts, but they are still too costly to utilize to strategically protect a stock position for a longer time period.

Put spreads do not completely protect the investor below the current stock price or put strike, but rather protect a range of value below the current stock price. For instance, Investor B is concerned about the imminent demise of Warren Buffet and feels the stock price of Berkshire Hathaway shares might decrease up to 20% upon his death. Investor B buys at-the-money puts, but to help offset the cost of acquiring such protection sells puts struck at 80% of the current stock price. Investor B is protected below the strike price of the long puts down to the strike price of the short puts (i.e., 20% downside protection), but remains exposed below the strike price of the short puts.

Collars and Put Spread Collars

Collars are another way to reduce the cost of acquiring downside protection—and perhaps the tool most commonly used by investors to acquire downside protection. For instance, as Exhibit II depicts, Investor C, who owns ABC Corp., trading at $100 per share, pays $5 to acquire one-year, out-of-the-money put options with a strike price of $90 and simultaneously receives $5 for selling one-year, out-of-the-money call options on the same number of shares with a strike price of $105. Because the $5 premium received on the sale of the calls fully finances the purchase of the puts and therefore Investor C requires no out-of-pocket expenditure, this strategy is often referred to as a cashless collar.

The results are attractive—Investor C locks in his gain below $90, defers the capital gains tax, and retains some of the upside potential of the stock without incurring any out-of-pocket expenditure.

Most tax practitioners are of the view that the constructive sale rules promulgated as IRC section 1259 pursuant to the Taxpayer Relief Act of 1997 (the “constructive sale rules”) require that a collar have at least a 15% band around the current price of the stock, as per an example in the legislative history to the statute. In the example above, Investor C was able to achieve the requisite 15% band while implementing a cashless collar.

However, given current market conditions, this is not always possible. For instance, assume Investor C wishes to protect another stock, XYZ Corp., also trading at $100 per share, by acquiring one-year, out-of-the-money put options with a strike price of $90 and simultaneously selling one-year, out-of-the-money call options on the same number of shares with a strike price of $105. The XYZ puts cost $5, but the XYZ calls bring in only $4; therefore, in order to achieve the necessary 15% band, Investor C needs to pay $1 per share. This type of collar—which requires a cash investment from Investor C—is referred to as a debit collar. In this example, if Investor C wished to implement a cashless collar to protect his XYZ position by selling calls with a lower strike price (generating an additional $1 of premium), doing so would likely trigger an immediate constructive sale for tax purposes. Care needs to be taken to assure that investors maintain at least a 15% band, even if that requires an out-of-pocket expenditure.

Subsequent to the financial crisis, many investors with highly appreciated stock positions saw much of their unrealized stock gains evaporate. Investors also quickly realized that market conditions had changed, such that if they used cashless collars to protect their stock positions, they would greatly limit their upside potential should their stock recover. Hence, many investors with concentrated positions made the “bet” that their stock would recover, along with the stock market, and held their shares naked long during the recovery. Today, many of these investors are holding stocks that have appreciated dramatically since the depths of the financial crisis. Cashless collars still provide investors with very little upside potential, but they do give them the ability to lock in their huge unrealized gains with little or no cash outlay. Many investors find this to be attractive.

Current market conditions also require that investors wishing to use collars make other important decisions and trade-offs. For instance, when an investor protects a stock position with a collar, so long as the shares being protected were acquired after Mar. 1, 1984 (which applies in almost all instances), the combination of the stock and collar is deemed a “straddle” for tax purposes, and the tax straddle rules apply.

As such, if an investor uses exchange-traded options, including Equity-Flex options (exchange-traded options that can be customized allowing the writer and purchaser to negotiate the exercise style, strike priceexpiration date and other significant features of the contracts), to collar a stock position, some unfavorable tax consequences will arise. When implementing a collar using exchange-traded options, it’s typically executed as a “spread” order—meaning one leg of the collar can’t be executed if the other leg cannot be executed as per the order. If, however, the spread order is filled, there will be two contracts: one for the puts purchased and another for the calls sold. The exchanges do not yet permit “single-contract” collars, and this can lead to tax inefficiency. Referring to the collar depicted in Exhibit II, if the stock price of ABC Corp. at expiration of the collar is between the strike price of the put ($90) and call ($105)—where both the puts and calls expire worthless—Investor C nevertheless must recognize $5 of short-term capital gain (i.e., the premium received on the sale of the calls) and $5 of deferred, long-term capital loss on the puts. This “phantom” income—a result of the application of the straddle rules—can be eliminated by using over-the-counter (OTC) derivatives. Specifically, in the OTC market, a collar can be structured as a single-contract collar such that the premiums of the embedded puts and calls “net” for tax purposes. Therefore, in the example above, there would be no taxable event (no phantom income).

Prior to the financial crisis, exchange-traded options and OTC derivatives traded at approximately the same levels, with perhaps a slight nod going to OTC derivatives; however, subsequent to the financial crisis, exchange-traded options (including Equity-Flex options) have become somewhat less expensive than OTC derivatives. Hence, a new hedging dilemma has arisen—is it better for the investor to achieve a slightly better price for the collar by using exchange-traded options, but be subject to the possibility of recognizing phantom income on the collar? Or is it better to accept a slightly less robust price for the collar by using OTC derivatives, but eliminate the possibility of recognizing phantom income on the collar? It’s not necessarily an easy decision, and there is no right or wrong answer.

In the rare event the investor is protecting shares that were acquired for tax purposes before Mar. 1, 1984 and thus the straddles rules do not apply, it would appear prudent to utilize Equity-Flex options. (Note that the literal language of the legislation relating to the effective date of IRC section 1092(d) states that both “positions”—i.e., the stock position and the offsetting hedge position—must be acquired on or after the effective date in order for there to be a straddle.) The investor would likely benefit from slightly better pricing for the collar, and because the straddle rules should not apply, the investor should not be “whipsawed” by the straddle rules and the possibility of phantom income.

Put spread collars are yet another way to reduce the cost of protection. Put spread collars combine a put spread (described above) with the sale of out-of-the-money call options. For example, in the case of the Berkshire Hathaway put spread described above, Investor B might have also sold calls at 110% of the value of Berkshire Hathaway shares. The premium received would further offset or potentially eliminate the cost of the long put.

Short Against The Box

Short-Against-The-Box (SAB) was, at one time, a tool that investors heavily relied on for protecting single-stock positions. The constructive sale rules generally eliminated SAB as a long-term hedging and monetization solution, although it remains possible in certain situations to establish an SAB position that should not be subject to the constructive sale rules through merger arbitrage. Many investors and tax practitioners, however, erroneously believe SAB was completely legislated away by the constructive sale rules. In fact, there is a short-term hedging exception to the constructive sale rules, and SAB can still be used to achieve short-term protection.

SAB can be a useful risk mitigation tool. Perhaps most importantly, SAB is less expensive than equity derivatives. That’s because there is no optionality—that is, SAB is a delta one hedge, so changes in the volatility skew (for better or worse) have no impact on the cost of SAB.

Exhibit III depicts the payoff profile of SAB. The investor is completely hedged and therefore earns a money-market rate of return on the notional amount of stock being protected. Economically, the investor is completely “out of the stock” when SAB is in place—he has no upside potential and no downside risk, and he receives no dividends or distributions. It’s as if the stock was sold tax-free and the proceeds immediately reinvested in a money-market account for the term of SAB.

Although SAB can be a cost-effective tool to protect unrealized gains, there is a set of very mechanical tax rules that must be strictly complied with; otherwise, under IRC section 1259(c)(3), a constructive sale can inadvertently result. For instance, the investor must close out (settle) the short position no later than Jan. 30 of the tax year subsequent to the tax year when SAB was established, and then remain invested in those shares without any hedge for the next 60 days. If the investor dies when SAB is open or during the subsequent 60-day unhedged period, the investor must likely forgo the step-up in tax-cost-basis. Note that the investor’s tax year ends on the date of death, and it is therefore impossible for the investor to hold the shares unhedged for the requisite 60-day period.

Tax and Regulatory Considerations

Tax and regulatory considerations regarding the use of equity derivatives and SAB should be carefully addressed. Equity derivatives and SAB are generally not tax-efficient—these unfavorable tax results are achieved because in almost all instances, the stock position, when combined with the derivative hedging instrument, will be deemed a “straddle” under IRC section 1092; further, the dividend holding period requirements of IRC section 1(h)(11)(B)(iii)(I) won’t be satisfied. First, what would have been long-term capital gain on the stock being protected is converted to short-term capital gain on the hedge, unless the protected shares are delivered (sold). Second, losses are capital losses but are deferred and therefore effectively increase the tax-cost-basis of the shares being protected; thus, if the investor plans to hold the shares until death to take advantage of the step-up in tax-cost-basis, the result is simply less tax forgiven at death (the deduction is never utilized). Third, “qualified” dividends are “disqualified” and taxed as ordinary income; however, in the case of SAB there is an exact offsetting “in lieu of dividend payment” deduction.

The use of puts, collars, or other equity derivatives by company insiders (“affiliates”) triggers a reportable event for securities law purposes; however, insiders are not permitted to short shares of company stock or engage in SAB unless the short sale is closed out within 20 days under 15 U.S.C Sec. 78p(c).

Please look for Part 2 of this piece, which focuses on Strategic Tools for Longer-Term Protection in the October TaxStringer.

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. 

Views expressed in articles published in Tax Stringer are the authors' only and are not to be attributed to the publication, its editors, the NYSSCPA or FAE, or their directors, officers, or employees, unless expressly so stated. Articles contain information believed by the authors to be accurate, but the publisher, editors and authors are not engaged in redering legal, accounting or other professional services. If specific professional advice or assistance is required, the services of a competent professional should be sought.