Estate Planning With Low Basis Stock And Concentrated Positions

By: Randall A. Denha, J.D., LL.M.

Holding a concentrated position in low basis stock can be a dilemma for many investors.  With federal long-term capital gains rates up to 20 percent, the 3.8 percent net investment income tax and state income taxes, the cost may be too high to justify selling the stock. Some will simply hold the stock until they die, providing their heirs with a step-up in basis resulting in little or no tax consequences.  This could be risky.  The worst-case scenario of having a large amount of wealth in one stock is that the company goes bankrupt and the stock value drops to zero. That would destroy or severely impair the financial future for many. A less obvious and more common risk is that the company under performs for a prolonged period. This can be due to the company’s sector falling out of favor, heavy regulation, or mismanagement of the company. In this case, the stock holding becomes a liability as opposed to the value generating asset it was in the past. There is usually more volatility in owning a single stock. The volatility increases the chance that the stock sells at a lower value.

The following are strategies for dealing with concentrated stock positions that should be considered. 

Gifting Stock to Family.  The stock can be gifted to family members or other individuals. Using the annual gift exclusion, up to $16,000 worth of stock can be gifted to any individual in a calendar year without using up any of the lifetime transfer exclusion. Married individuals, together, can gift up to $32,000 to each person.

The recipient of the gifted stock will maintain the historical cost basis as well as the holding period. Even if the recipient sells the stock immediately, the tax cost may be less than if the original owner sold the stock.  The current tax law provides for a 0 percent tax rate on the long-term capital gains for those individuals in the lowest tax bracket. The kiddie tax, which taxes a child’s income at the parents’ tax rates, needs to be considered when utilizing this strategy. Kiddie tax may apply to children as old as 23, if they are full-time students.

Exchange Funds.  Another strategy that reduces the concentrated stock position, but maintains the low-cost basis, is the use of Exchange Funds. Exchange funds, also known as swap funds—and not to be confused with exchange-traded funds have a limited partnership structure and U.S. tax law allows investors to swap highly appreciated stock for shares of ownership in these entities without triggering a capital-gains tax. An investor contributes the stock to an established “exchange fund” and receives a pro-rata ownership in the portfolio. This accomplishes the objective of reducing the concentration, but the investor’s basis in the new investment remains unchanged.  As a result, this is a tax-deferral mechanism, not a tax elimination scheme. If your original stock should drop in value, you hold the value of the diversified fund. Using an Exchange Fund also allows the original amount of the stock to be invested without first selling, paying taxes, then investing the remainder.

There are key constraints to using Exchange Funds. Individuals must be a Qualified Purchaser which is defined as having $5M in investable assets. And there are lock-up periods of seven years, potential loss of dividends, fund management fees, and other considerations. Also, if the original stock exchanged should outperform the fund, the investor is stuck with the fund value – you can’t have your cake and eat it too. Lastly, the investor keeps the original cost basis of the stock with the new fund position, though the need to sell is less due to diversification. Still, for investors who qualify, Exchange Funds are a viable option for diversifying a large stock position

Gifting Stock to Charity.  The stock can also be gifted to charity.  This will avoid the taxation of the capital gain on the gifted stock and provide for a charitable deduction.  By donating stock instead of cash, you reduce your stock position and are likely to receive a tax deduction. Donors are eligible for an income tax deduction for the full market value of the stock, up to 30% of adjusted gross income (20% if gifting to a private foundation). You benefit by reducing your position and capital gain exposure, and the charity benefits by selling the stock while paying no tax because it is a non-profit. The unused portion of the charitable deduction can be carried over for up to five years.

Another way to use the stock to make a gift to charity is through a charitable remainder trust (CRT).  When a CRT is established, the stock is gifted to the trust, and the donor (and/or another non-charitable beneficiary) retains an annuity interest in the property for a specified number of years or for the life or lives of the non-charitable beneficiaries. At the end of the term, the qualified charity specified in the trust document receives the property in the trust.  The terms of trust must provide that 1) the annuity payments be at least 5 percent, but no more than 50 percent of the initial fair market value of the assets and 2) the charity’s actuarial interest be at least 10 percent of the assets transferred. Gifts made to a charitable remainder trust qualify for income and gift tax charitable deductions.  The charitable income tax deduction is allowed in the year of the gift and is based on the present value of the remainder interest that will ultimately go to the charity. The distributions can either be fixed (annuity trust) or based on the fair market value of the assets (unitrust).

The trust is tax-exempt and, therefore, will not pay any tax.  The income and gains of the trust are taxed to the beneficiaries when they are distributed as part of the annuity payments. As a result, the tax consequences from the sale of the stock will be deferred and spread out a number of years.  This deferral and spread may help investors manage their tax brackets and avoid the net investment income tax. The opposite type of trust is a Charitable Lead Trust (CLT). With a CLT, the charity “leads off” by receiving annual income for a specified period, and the remainder goes back to the trust, family or heirs. There are other “flavors” in the charitable trust landscape and appreciated stock could be used to fund many of them.

Donor-advised funds (DAFs) are a flexible vehicle for gifting. An investor can fund the DAF with stock and potentially receive tax deductions for the value of the stock at the time of funding. The stock is sold, and the proceeds are deposited in investment pools which the investor controls. The investment choices are diversified pools of stocks, bonds and money markets, which gives the account potential to grow. When the investor is ready, they direct the DAF to liquidate funds from the investment pools to charities of their choice. With donor-advised funds, the investor is “banking” future charitable gifts while receiving a tax benefit now. Older investors should keep in mind that at death there is a step up in cost basis of their assets. For this reason, holding onto the security but hedging the position may be a viable solution. It is extremely rare to choose a single strategy for moving from a concentrated position to a diversified portfolio. Your overall approach will depend on the specific details of the investment and your complete financial situation. That said, large concentrated stock positions can be a challenge when trying to diversify and reduce risk. There are strategies that can reduce those risks, lessen the tax burden of reducing the position, and even fulfill other goals at the same time.