Diversifying Concentrated Positions in the Most Tax-Efficient Manner

By Steven Berman, CFP, Wells Fargo Advisors, Pepper Pike, OH, and Christy A. Corrao, J.D, LL.M., Walter & Haverfield LLP, Cleveland, OH (not affiliated with Baker Tilly International)

Editor: Anthony S. Bakale, CPA, M. Tax.

Gains & Losses

This item explores the following techniques that may be used to the advantage of investors wishing to diversify concentrated securities positions in a tax-efficient manner:

  • Installment sales;
  • Charitable remainder trusts (CRTs);
  • Put/call options and collars;
  • Exchange funds; and
  • Variable prepaid forward contracts.
Installment Sales

Sec. 453(k)(2) prevents the use of the installment method to sell marketable securities. Further, Sec. 453(e) prohibits related-party installment sales from deferring gains where the buyer is a related party and, within two years of the purchase, the related party subsequently disposes of the acquired property. In these situations, the original seller accelerates gain related to future payments to the extent of the amount realized or fair market value of the installment property at the time of the second disposition, limited to the first seller’s payments that have not yet been received. A second disposition includes any disposition and is not limited to a sale or exchange. However, under Sec. 453(e)(6), redemptions of stock, involuntary conversions, and death are excluded as second dispositions.

The running of the two-year cutoff period is suspended when the property has a substantial diminishing risk of ownership with respect to the related party under Sec. 453(e)(2)(B). These situations include the holding of a put with respect to such property, the holding by another person of a right to acquire the property, or a short sale or any other transaction. When the risk of loss is substantially diminished, the second disposition will accelerate gain for the original seller if it occurs at any time before the original seller receives all payments with respect to the disposition.

For this purpose, “related party” is defined as any person described in Sec. 267(b) or any person to whom stock would be attributed under the rules of Sec. 318(a). This generally would include relationships such as siblings, spouses, ancestors, and lineal descendants; an individual and a corporation if more than 50% in value of the outstanding stock of the corporation is owned, directly or indirectly, by or for that individual; trusts and estates and their beneficiaries; grantor trusts and the grantor; and partners and the partnerships in which they are partners.

As discussed in the next section, one way to circumvent these prohibitions is the use of a charitable remainder trust. Another way is to contribute the securities to an S corporation and sell the S corporation stock on the installment method. If the seller is the only contributor of securities to the S corporation, there will be no diversification and no gain triggered on the contribution because there would be no investment company issue under Sec. 351(e). Because the sale is of the S corporation stock and not the marketable securities, the installment method is available. Sec. 453(e) does not apply because the property was not sold to the S corporation as a first disposition. Sec. 453(k) does not apply because the stock sold was closely held. The resulting gain is reported on the installment method for the seller, and the buyer may sell the securities out of the S corporation immediately without gain, by merely liquidating the S corporation and taking the cash.


A CRT is a tax-exempt trust that accepts a donation from the settlor and pays an annuity or unitrust amount back to the donor, the donor’s family, or both the settlor and his or her family simultaneously or in succession. After one or more life expectancies or a term of years not to exceed 20 years, the remainder goes to charity. The settlor gets an up-front charitable deduction for the actuarial value of the remainder, which must be at least 10% of the value of the property donated. The annuity or unitrust amount payable to the noncharitable beneficiary may not exceed 50% of the value of the property donated. If the annuitant is the donor or his or her spouse, there will be no gift tax issues. The investor may even be the trustee of the CRT if he or she wants to retain control. The trust may sell the security donated without tax, and the annuity payments carry out ordinary income first, then capital gain, then return of capital, and then tax-exempt income.

Example 1: Investor Q donates $1 million of marketable stock with a zero basis to a CRT designed for the minimum donation deduction of close to 10%. Assuming it is a 7% charitable remainder annuity trust for 20 years and the Sec. 7520 rate is 5%, the CRT can sell the stock immediately and invest $1 million, and the donor will receive $70,000 per year for 20 years, most of which will be taxable as ordinary income or capital gain or a little of each. Depending on assumptions about investment earnings, Q will be able to diversify the holdings without immediate tax.

If Q is confident in his investment powers, he may wish to use a charitable remainder unitrust instead, which will pay 7% of the beginning fair market value of the trust calculated each year. If a life expectancy is used, Q can buy a term insurance policy to protect against the risk of a premature death.

Put/Call Options and Collars

Options can be used to help an investor reduce the risk of holding a concentrated position. The two most common strategies are the covered call and the “collar.” While options are not suitable for all investors, these strategies are popular because they can be used in qualified and nonqualified accounts, require minimal paperwork or costs, and generally use listed options. Listed options are available for most publicly traded companies. They can be coordinated with trading windows and blackout periods.

Covered calls: In a covered call strategy, the stock owner sells a call option against all or a portion of the position, obligating him or her to sell the shares at a predetermined price (strike price) on or before the expiration date, often at a price higher than the current stock price. In exchange for selling the option, the stock owner receives an irrevocable premium (cash). The sale of a covered call, however, does limit the stock owner’s upside potential to the strike price. If the price of the underlying stock appreciates above the strike price, the stock will be called away, and the investor will not participate in any appreciation above the strike price.

There is no taxable event that occurs at the receipt of this premium, and the stock owner retains full ownership of the position, including dividends and voting rights. The purchaser of the option is the party that maintains the right of control on the contract and can exercise its right to purchase at or prior to the expiration of the contract depending on the terms.

If the stock price is at or below the strike price on expiration, the contract will usually expire. Upon expiration, the owner will retain the stock and will realize a short-term capital gain of the premium received. In this case, the owner still owns the stock and is subject to the full downside risk of the holding. If the stock is at or above the strike price and the option is exercised, a taxable event occurs on that date, with the option premium added to the sales price. Therefore, if the underlying stock is a long-term asset, even if the option was short term, it is treated as long term. This strategy is most appropriate when the stock owner wants additional cashflow (received from the option premium) but maintains a positive outlook on the stock and is willing to reduce the position at a higher price than the current price. When participating in a covered call strategy, the investor is still at risk of having to sell the underlying stock if the stock’s price rises above the sold options’ strike price. Remember, in exchange for receiving the premium of having sold the call, the investor is obligated to sell the underlying stock via assignment if the option is exercised.

Caution: Keep in mind that if the stock price falls, the investor is still the owner and subject to the full loss of the investment, reduced only by the credit from the sale of the call—covered call selling is not a protective strategy. Also, keep in mind when writing an option on a stock with a low cost basis that there are tax consequences to consider upon assignment.

Example 2: Investor R owns 100,000 shares of P Co., which is currently trading at $45. R is willing to reduce her position by 10% if the stock goes to $50. R sells 100 calls, each representing 100 shares, to T with a $50 strike price and an expiration date six months from the date of sale for $2.25 per share. R receives $22,500 today (10,000 × $2.25 per share premium). If the option expires without exercise, R has a $22,500 short-term capital gain. If T exercises the right to buy from R and pays R $500,000 ($50 × 10,000 shares), R reports sale proceeds of $522,500 based on the holding period of the underlying stock. R has effectively sold the stock for 16% more than the current price, helping to offset the tax implications ($50 strike price + $2.25 premium = $52.25 total proceeds; $52.25 proceeds ÷ $45 current price = 16% gain).

Of course, this hypothetical scenario does not take into account any fees or commissions, which would reduce the amount received by R and therefore the gain on the transaction. It is also important to note that R will receive only $50 per share for the stock regardless of the market price at the time the option is exercised: R’s upside potential is capped at the strike price.

As with all transactions, this strategy does not create any tax implications within a qualified account. It can be combined with various strike prices and expiration dates and utilized over time, helping to increase the cashflow for the investor and potentially reducing the position over time. The use of option strategies in a qualified account does not generate unrelated business income that would subject the account to tax on the income.

Collars: A collar combines the above covered call strategy with the purchase of a put to reduce the downside risk. A put provides the owner with the right to sell the stock at a predetermined price in the event of a price decline, limiting potential loss. The most popular structure is a zero-cost collar, whereby the investor uses the premium received from the call to purchase the put to provide downside protection. Depending on market conditions, however, a zero-cost collar may not always be feasible, and the investor may end up paying more for the put side of the collar than he or she receives from selling the call. This strategy is beneficial when an investor is positive on the company but wants to protect against a significant decline. By purchasing options, an investor has an opportunity to earn profits while limiting his or her risk of loss. Of course, an options purchaser may lose the entire amount committed to options in a relatively short period of time.

Example 3: The facts are the same as in Example 2, but R wants to also provide protection in case of a significant decline. R uses the $22,500 from the call to purchase a $40 put option, giving her the right to sell her stock at $40. R retains the downside risk from the current price of $45 to $40. As long as the stock trades between $40 and $50, R generally will retain her position, with no cost for the downside protection. As in Example 2, if the stock is above $50 the call option would be exercised and R would sell at $50, regardless of how high the stock price rises. If a significant decline were to occur, R could exercise her right to sell her shares at $40, providing protection. R would recognize gain or loss based on her sales price less the premiums she paid for the put. If both sides expire, R has a corresponding gain (call option) and loss (put option) that may offset each other in accordance with netting rules for capital gains and losses. Of course, this example assumes that the collar is zero-cost. If a zero-cost collar is not feasible, the amounts above would be affected by the net premium received or paid. The example also does not show the impact of fees or commissions, which would reduce the amount received by the investor.

Exchange Funds

One of the more popular ways to diversify a concentrated position is through the use of exchange funds. Exchange funds are partnerships with multiple investors that investors generally use to diversify positions in marketable securities without triggering immediate capital gain.

In order to understand how exchange funds work, a basic background in partnership taxation related to investment companies is necessary. Under Sec. 721, a taxpayer may contribute assets to a partnership, in exchange for an interest in the partnership, without triggering gain or loss. This rule applies whether the taxpayer contributes the assets upon formation or at some later time. Generally, the partnership will take the basis of the asset that the partner had before contribution. In addition, the partner will take a basis in his or her partnership interest equal to the basis of the asset that he or she contributed. The holding period of the asset will be tacked so that however long the contributor held it will be added to how long the partnership will have held the asset for tax purposes. The partner’s partnership interest will also have a tacked holding period that includes the holding period of the contributed asset. For example, if a partner contributes an asset with a long-term holding period to a partnership and the next day sells his or her partnership interest, the sale of the partnership interest would generate long-term capital gain because the asset contributed had a long-term holding period.

An exception to the nonrecognition rule exists where a person contributes property to a partnership that is an investment company under Sec. 721(b). A partnership is treated as an investment company if, as a result of contribution, the contributing partner has diversified his or her position and one of the following applies: (1) the partnership is a regulated investment company (RIC), (2) the partnership is a real estate investment trust (REIT), or (3) more than 80% of the value of the partnership’s assets (excluding cash and nonconvertible debt obligations) is held for investment and is readily marketable stocks or securities or interests in RICs or REITs. A transfer ordinarily results in the diversification of the contributors’ interests if two or more persons transfer nonidentical assets to the partnership in the exchange, and the contributors do not have diversified portfolios. A portfolio of stocks and securities is not diversified if it is made up of more than 25% of one issuer or more than 50% of five or fewer issuers.

If a transfer is deemed a transfer to an investment company, gain (but not loss) is recognized on the contribution of property under Sec. 721(b), and this is determined on a stock-by-stock basis. The basis of both the partner’s partnership interest and the partnership’s basis in the contributed property is increased by the amount of gain recognized under Sec. 721. Property covered by this rule is not limited to stock or securities but does not include real estate. Therefore, if more than 20% of the assets of the partnership consist of real estate, the partnership is not an investment company.

In addition, there are disguised sales rules that are also designed to prevent a partner from avoiding gain by contributing an appreciated asset to a partnership and, depending upon how the transaction is handled, taking a distribution from the partnership of assets other than the property contributed. There are two situations where this might occur: (1) the partner contributes property to a partnership and within two years takes a distribution of different property from the partnership, other than distributions of current income and certain expenses, or (2) the partner contributes appreciated property to a partnership and within seven years that property is distributed to a different partner.

An exchange fund is a vehicle that permits a contribution by an investor of a highly appreciated concentrated position to a partnership in exchange for a partnership interest without triggering the investment company rule of Sec. 721. As a result, investors go from a large concentrated position in one or few securities to a position of similar value that includes many other stocks and bonds. The exchange fund manages the portfolio to be diversified, and the investor may receive dividends and interest income but generally not much capital gain.

Example 4: Investor S, who wishes to diversify a concentrated portfolio, contributes his stock position to a fund that is a limited liability company (LLC) in exchange for an interest in that company. That fund is combined with other investors and other assets so that the LLC never owns more than 79% investment assets such as marketable securities, stocks, Treasury bills, etc. The other 21% consists of qualified assets, typically real estate, so the fund is not an investment company. Therefore, the contribution of the concentrated position to that fund does not trigger gain under Sec. 721(b). This fund is also an investor in another LLC that has other outside investors who have put a diversified portfolio into that LLC. And that LLC is the 100% owner of an “old and cold” portfolio (assets held that are also invested in by other open-end mutual funds). This allows S to put a concentrated position into a fund that is somewhat diversified (in that it has investable assets) but is 21% invested in real estate. That fund is then mixed together with another fund of investors, also with a diversified portfolio, and that fund is further diversified by investing in an older portfolio of diversified funds.

This arrangement has several advantages. First, the contribution of the concentrated position by S diversifies the portfolio without triggering tax. Second, the noninvestment company is further diversified by diluting the real estate assets by combination with another investment portfolio. Finally, because S must remain in the fund for at least seven years, exit from the fund will not trigger any of the disguised sale rules inherent in partnerships.

If S dies owning the exchange fund, the estate or the heirs will be able to liquidate tax free in order to avoid taxable income flowing through the funds. This, of course, presumes that the estate tax law and the attendant income tax step-up (down) at date of death do not change from what they have traditionally been for many decades. While the exchange fund may make a Sec. 754 election and step up the inside basis of the assets to equal the basis step-up as a result of death, ordinarily that will not happen because of the administrative and accounting problems with having so many partners and administering a Sec. 754 election. It is likely that the fund would liquidate some security positions to pay cash to the estate or heirs, and the resulting capital gain would be allocable to the deceased partner. However, the capital gain would be offset by the capital loss on liquidation of the interest, resulting in little or no gain. If, however, securities are distributed in kind instead of cash (in a nontaxable distribution), the securities would take a basis equal to the partnership interest in the hands of the estate/heirs, and no current gain or loss would be recognized.

Variable Prepaid Forward Contracts

Another way to diversify without triggering taxable gain is to try to engineer a financial instrument that acts like a diversified portfolio but does not require a sale of an investor’s holdings to take advantage of it. In a variable prepaid forward contract (VPFC), the investor agrees to sell a variable amount of shares (up to a maximum amount) to an investment bank at some date in the future (typically 3–5 years) in exchange for an upfront cash payment. The upfront cash payment generally represents 75%–85% of the current value of the stock. The investor will pledge the maximum amount of shares; the investor may satisfy the pledge by delivering the pledged shares, cash, or shares other than the pledged shares. Often, a VPFC also involves a share loan agreement. In a loan of stock, the investor delivers title to the investment bank borrower, giving the bank the ability to hedge its position in the pledged shares by having the right to sell, invest, use, commingle, or otherwise dispose of the shares while having dividend and voting rights on the stock.

In VPFC transactions, the main issue is whether a disposition of the stock occurs under Sec. 1001 or as a constructive sale under Sec. 1259. Sec. 1259 provides that a taxpayer holding appreciated stock recognizes gain on the stock if the stock is constructively sold. Under Sec. 1259(c)(1)(C), a taxpayer makes a constructive sale of appreciated stock if he or she (or a related person) enters into a forward contract, which is defined as a contract to deliver a substantially fixed amount of property for a substantially fixed price. For purposes of this rule, related persons are any persons described in Sec. 267(b) or Sec. 707(b) if they enter into the transaction with the purpose of avoiding Sec. 1259. Excepted from this rule, however, is a contract that provides for the delivery of an amount of stock that is subject to “significant variation.” Rev. Rul. 2003-7 holds that there is no disposition under Sec. 1001 and no constructive sale under Sec. 1259 if a shareholder:

  • Receives a fixed amount of cash;
  • Simultaneously enters into an agreement to deliver on a future date an unfixed amount of shares that may vary significantly based upon the value of the shares on the delivery date;
  • Pledges the maximum amount of shares for which delivery could be required, and such shares are held with a third-party trustee; and
  • Retains an unrestricted legal right to substitute cash or other shares.

However, in many VPFC transactions, the facts of Rev. Rul. 2003-7 are distinguishable, as most VPFCs involve stock loans with the bank’s ability to hedge the stock and the bank’s right to vote or receive dividends. In Rev. Rul. 2003-7, the investor retained the right to dividend and voting rights to the shares. Although the VPFC may avoid Sec. 1259, determining whether a disposition under Sec. 1001 occurs will turn on whether the “benefits and burdens” of ownership have passed. When the investor gives the bank the ability to hedge the stock, along with the dividend and voting rights, it is likely to be seen as a transfer of the benefits and burdens of ownership and thus a disposition under Sec. 1001. Sec. 1058, relating to certain loans of stock, may be applicable and provide nonrecognition of the gain, even if a disposition has occurred.

Sec. 1058 requires the satisfaction of four elements in order for the taxpayer to have nonrecognition treatment:

  • The loan must provide for the return of identical securities;
  • If dividends, interest, or equivalent payments are made between the initial transfer and the return of identical securities by the bank with respect to the transferred stock, the loan must provide for the payment of those amounts to the investor;
  • The loan must not reduce the investor’s risk of loss or opportunity for gain in the securities transferred; and
  • The loan must meet any other requirements prescribed in the regulations.

In Anschutz, 135 T.C. No. 5 (2010), the Tax Court held that the taxpayer had made a sale (but not a Sec. 1259 constructive sale) of his stock. This case involved a stock loan, unlike the transaction in Rev. Rul. 2003-7. The court determined that benefits and burdens of ownership had been transferred because the investor transferred legal title to the shares, all risk of loss, a major portion of the opportunity for gain, the right to vote the stock, and possession of the stock. Because the risk of loss was transferred, Sec. 1058 did not apply.

This case, of course, could sound the death knell for this technique. However, the court left open the possibility that a restructured transaction could work if the investor took significant market risk on the transaction. It remains to be seen if a restructured case could prevail. Further, taxpayers should be cautious because the IRS has indicated in an issue paper that VPFC transactions are an emerging issue and may be subject to accuracy-related or reportable transaction penalties under Secs. 6662 and 6662A (see LMSB-04-1207-077). The issue paper also indicated that Rev. Rul. 2003-7 would generally not serve as substantial authority in VPFC transactions involving share lending or other similar arrangements.


Anthony Bakale is with Cohen & Company, Ltd., Baker Tilly International, Cleveland, OH.

For additional information about these items, contact Mr. Bakale at (216) 579-1040 or tbakale@cohencpa.com.

Unless otherwise noted, contributors are members of or associated with Baker Tilly International.

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