Of course, heavy exposure in any one stock is not prudent investment strategy, which is one reason forward sales caught on so quickly. Studies show that most top executives sell rather than buy their firm’s stock when they exercise their options. That’s smart, as long as their holdings don’t fall below any holding requirements. “Even Bill Gates sells [Microsoft] stock,” says Rhine. “Is diversification a sign of disloyalty? Not if you adequately explain it.”
No Solid Alternative
No matter how executives explain them, prepaid forward sales may not be a diversification option much longer. In Willens’s view, the IRS ruling essentially signals the death knell for such contracts.
So what should executives with large concentrations of one stock do to diversify and avoid, or at least defer, taxes? Personal-finance experts recommend the following alternatives, though each, as Lancaster notes, has its drawbacks:
Exchange funds. These funds allow you to defer tax by exchanging a position in a single stock with one in a basket of others. Buyers may find the basket insufficiently diverse, simply because there aren’t enough shares available except in the largest firms. The annual fees required can also be steep, typically running about 2 percent of assets every year (despite very little if any ongoing portfolio management).
Equity collars. The use of an equity collar compensates a stock owner for a decline in price beneath a specified level. The cost can be high if the collar must be kept in place for long, so they may be ineffective for anything but maintaining a position in a stock long enough (that is, less than 12 months) to convert the proceeds of a sale from ordinary income to a capital gain.
Another consideration is that the owner gives up any right to appreciation above a specified level. As a result, notes Lancaster, “many executives simply hope the price goes sideways for quite some time.” Thanks to a 1997 IRS ruling, this device may also not defer tax if you give up “substantially” all of any subsequent gain or have “substantially” nothing at risk. The IRS has promised for years to define what “substantially” means here, but has failed to issue formal guidance. In response, tax experts recommend that the strike price for the puts and calls involved in the collar be set at least 10 percent above and below the price of the stock at the time of the transaction. The IRS has told tax practitioners that such a strike price for “out of the money” puts and calls is acceptable, but there’s no assurance that the agency won’t change its mind, as it seems to have done with prepaid forward sales.
Charitable remainder annuity trusts. With such a trust, you donate stock to a charity and get a stream of income based on its value, potentially for as long as you live. While you get a deduction for the donation, based on the amount that the charity is estimated to end up with when you die, the money you receive from the trust before then is generally taxable as current income, and that must represent at least 5 percent of the assets’ initial value. Since the gift is irrevocable, such a trust isn’t appropriate if you can’t afford large donations.
There is one other alternative, of course: sell and pay the taxes.
Ronald Fink is a deputy editor of CFO.
Passing the Sell Test
The IRS’s attack on prepaid variable forward contracts underscores a quandary facing CFOs: how to act in shareholders’ best interest without harming their own portfolios.
The standard advice is to set up a formal plan to sell a specified number of shares at regular intervals. As with any insider sale, that requires a number of Securities and Exchange Commission disclosures. Jeff Lancaster, a principal and financial planner with California-based Bingham, Osborn & Scarborough LLC, notes that those disclosures provide ample opportunity to explain one’s reasons for selling and the circumstances under which the transactions will take place. There are a number of restrictions on such sales, however, so it’s necessary to consult a securities lawyer when establishing such a plan.
As for the tax consequences, Lancaster says that most of his clients have come around to the view that capital gains rates have nowhere to go but up. But while he notes that those with heavy exposure to a single company know they should diversify, he has difficulty convincing them to do so, partly because of the lack of alternatives. David S. Rhine, regional director of family wealth planning for Sagemark Consulting, recommends life insurance, because tax deferral adds smartly to its return and that benefit has long survived challenges from political opponents in Washington, D.C. — R.F.