Many investors own highly appreciated stock they don't wish to, or can't, sell. Ideally, they'd like to:
- Preserve unrealized gains at an affordable cost.
- Retain all upside.
- Avoid a taxable event and other adverse tax outcomes.
- Avoid a reportable event.
Investors can use equity derivatives to manage single-stock risk, but they are tax-inefficient and expensive, and thus not practical to use for an extended period. Investors can use exchange funds to diversify but not to protect shares they wish to keep. Moreover, the use of either derivatives or exchange funds constitutes a reportable event for company insiders.
A new risk management tool, called a stock protection fund, may be helpful to those investors. A protection fund marries modern portfolio theory and risk pooling. Modern portfolio theory reveals that over time there is 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.
Protection funds permit investors to continue to own and retain the upside of their stock positions, while spreading downside risk among a larger group. Investors, each owning a stock in a different industry and protecting the same value of stock, contribute a modest amount of cash (not shares, which they continue to own) into a fund that terminates in five years. The funds typically have about 20 investors to disperse the investment risk. The cash is invested in U.S. Treasuries maturing in five years. Upon termination, the cash is distributed to investors whose stocks have lost value on a total return basis. Losses are reimbursed using a "reverse waterfall" methodology until the cash pool is depleted. If the cash pool exceeds the aggregate losses (70% probability), all losses are eliminated, and the excess cash is returned to investors. If aggregate losses exceed the cash pool (30% chance), large losses are substantially reduced. Protection funds provide downside protection akin to that of at-the-money or slightly out-of-the-money put options, but at a fraction of the cost.
Low-cost protection funds facilitate long-term protection
Protection funds add a desirable dimension to the wealth planning and portfolio construction process for investors with concentrated positions. Investors often use sales, derivatives, and exchange funds to diversify out of their positions over time. However, for reasons such as emotional attachment to the stock, tax and estate planning considerations, and restrictions on selling shares, investors often retain some of their stock as a core, long-term holding, which is left unhedged and exposes them to major risks, especially relative to their net worth. Because of its affordability, a protection fund can be "married" to the stock that's retained, thereby mitigating what is often the investor's biggest investment risk.
The shares don't need to be pledged and can be transferred to a custodian whenever the investor desires. Therefore, the investor can sell, gift, donate, borrow against, or otherwise dispose of his or her shares at any time. If desired, investors can borrow against their stock to fund their investment into a protection fund without disturbing their existing asset allocation. Protection funds are easy to understand, fully transparent, and entail no counterparty credit risk. Furthermore, for company insiders the use of a protection fund is not a reportable event and can be used to protect both stock and stock-linked compensation.
Favorable tax treatment
A protection fund is a tax-efficient way to protect highly appreciated stock. 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 a protection fund will result in either long-term capital gain or currently deductible long-term capital loss. Conversely, the use of equity derivatives is not tax-efficient; generally, gains are taxed as short-term capital gains, losses are not currently deductible, and dividends received are disqualified (i.e., they are not qualified dividends) and are therefore taxed as ordinary income. (These unfavorable tax results arise because, in most instances, the stock position, when combined with the derivative hedging instrument, will be a "straddle" under Sec. 1092; further, the dividend holding period requirements of Sec. 1(h)(11)(B)(iii)(I) will not be satisfied.)
A protection fund does not cause a statutory constructive sale under Sec. 1259 because the investors retain all upside potential for their underlying stock positions, nor does it trigger a common law constructive sale because the investors retain all incidents of ownership of their stock positions. Each investor keeps all future appreciation and dividends, retains voting rights, and can sell or otherwise dispose of his or her shares any time. According to the legislative history of Sec. 1259, regulations should treat as constructive sales other financial transactions that, like those specified in Sec. 1259, have the effect of eliminating substantially all of the taxpayer's risk of loss and opportunity for income and gain for the appreciated financial position.
The combination of stock and an ownership interest in a protection fund is not a straddle because the value of the stock and the ownership interest does not "vary inversely" (Regs. Sec. 1.246-5(b)(2)). 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; (2) the change in value of the other 19 investors' stocks; and, to a lesser extent, (3) the change in value of the cash pool. An investment in a protection fund is economically similar to an investment in a diversified portfolio comprised of 20 unrelated stocks, with the reduction in risk a result of the changes in value of the individual stocks in the portfolio over time (dispersion of returns), and therefore the straddle rules do not apply.
Dividends must satisfy certain holding period rules to qualify for long-term capital gain treatment (Sec. 1(h)(11)(B)(iii)(I)). If dividends are "qualified," an investor's participation in a protection fund will not cause the loss of qualified status because a participant's ownership interest in a protection fund is not "substantially similar or related property" (Regs. Sec. 1.246-5(b)(1)) and does not result in a "diminished risk of loss" (Regs. Sec. 1.246-5(b)(2)). Therefore, dividends are taxed as long-term capital gain.
Upon liquidation, if the amount of the cash distribution received by an investor exceeds his tax-cost basis in the protection fund (the original cash contribution into the fund), the difference is long-term capital gain; if the amount of the cash distribution received is less than his or her cost basis, the difference is a currently deductible long-term capital loss. These results are achieved because a protection fund elects to be treated as a C corporation, and its investors are therefore 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 Sec. 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 investor's hands.
Assume an investor pays $100,000 to acquire an ownership interest in a protection fund to protect his $1 million position in publicly traded ABC Corp. stock with a zero basis, which he has held longer than one year. The straddle and dividend holding period rules do not apply.
- If ABC Corp.'s stock price decreases, and the investor receives a distribution of $400,000 upon the termination of the fund, he will realize $300,000 of long-term capital gain ($400,000 amount realized less $100,000 cost basis).
- If ABC Corp.'s stock price increases and the investor does not receive a distribution, he will realize a $100,000 capital loss ($0 amount realized less $100,000 cost basis) that is currently deductible.
- If ABC Corp. pays dividends over the term of the fund that are qualified, his ownership interest in the fund does not "disqualify" the dividends, and it is taxed at the long-term capital gain rate.
Assume the same investor pays $100,000 to acquire a put option to protect his $1 million stock position in ABC Corp. The straddle rules and dividend holding period rules do come into play.
- If ABC Corp.'s stock price decreases and the investor sells the put for $400,000, he will have realized a $300,000 short-term capital gain ($400,000 amount realized less $100,000 cost basis). In effect, the investor has converted $300,000 of long-term capital gain on his stock to short-term capital gain on the put.
- If ABC Corp.'s stock price increases and the put expires worthless, he will have realized a $100,000 long-term capital loss ($0 amount realized less $100,000 cost basis) that is not currently deductible; rather, the deduction is deferred and effectively increases the investor's cost basis by $100,000. If the investor holds his shares until death to take advantage of the step-up in basis, the result is that the deduction is never used (it's less tax forgiven at death).
- If ABC Corp. pays dividends over the term of the fund that are otherwise qualified to the investor, his ownership of the put disqualifies the dividends, and they are taxed at the ordinary rate (Sec. 1(h)(11)(B)(iii)(I)).
The loss in this example is long-term because, under Temp. Regs. Sec. 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 Sec. 1092(a)(1) because the unrecognized gain in the stock exceeds the realized loss on the put.
This result is achieved because, under Sec. 1092(b)(1) and Temp. Regs. Sec. 1.1092(b)-2T(a)(1), the investor's holding period in the put cannot "age," so 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. The 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 on the put is "merged" into the sale of the ABC Corp. stock, the resulting gain would be long-term rather than short-term.
A protection fund protecting 20 stocks and requiring an upfront cash contribution of 10% (i.e., 2% per annum for five 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, and the remaining cash (amounting to 31% of the cash contribution) was returned to the investors. Each investor received the equivalent of "at-the-money" put option protection on their stock, and the amortized pretax cost of that protection was only 1.38% per annum. (The actual performance results in this paragraph were audited by the accounting firm StarkSchenkien, LLP. StarkSchenkein, LLP is an independent member of BKR International.)
With the stock market setting record highs, interest rates steadily increasing, and risks seemingly everywhere, this new risk mitigation methodology could be timely and helpful to investors who hold highly appreciated stock, but can't, or don't wish to, sell their shares right now.
Thomas Boczar, Esq., LL.M., CFA, CPWA, is CEO at Intelligent Edge Advisors. He can be reached at email@example.com or 212-308-3345. Elizabeth Ostrander, CFA, is Managing Director at Intelligent Edge Advisors. She can be reached at firstname.lastname@example.org or 212-308-3343 ext. 228.