A Unique Solution for Concentrated Stock Positions

This article originally appeared in Morningstar Direct Cloud and Morningstar Office Cloud.

An investor comes to you with a high value of concentrated stock. As the advisor, you recommend diversification, but how can this be accomplished without generating a lot of tax?

Tried and True Most of us are familiar with the standard strategies, and although these strategies have advantages, they also come with disadvantages.

• Sales over time--Sell a limited amount of shares at a time in order to minimize and spread the tax over a number of years. This can lower the ultimate combined tax impact, but it can significantly delay full diversification.

• Sales offset by tax-loss harvesting--Generate tax losses when possible and use those losses to offset gains from selling the concentrated position. This strategy is an expansion of the "sales over time" methodology, allowing for an even greater amount of sales per year. Again, as above, diversification cannot happen quickly.

• Separately managed accounts--SMAs can be utilized to achieve diversification over time by selling a portion of the concentrated position and building a portfolio of individual stocks around the remaining holdings to gradually achieve a portfolio that is similar to a targeted index.

• Charitable strategies--For clients with charitable inclinations, the contribution of appreciated stock can create a deduction without incurring capital gains tax (hence providing an offset to gains from outright sales of the concentrated position). Charitable remainder trusts and charitable gift annuities can provide tax benefits while also generating an ongoing income stream to the donor.

But there is another tool in the toolbox that can help with accomplishing diversification with minimal tax exposure for qualified investors: exchange funds. These funds can be an attractive alternative or complement to the strategies listed above.

What Is an Exchange Fund, and How Does It Work? An exchange fund, sometimes called a swap fund, is similar to a mutual fund but, instead of contributing cash, the fund owners contribute stock. By holding stocks contributed by many contributors, as well as supplementing with other stocks, the exchange fund can essentially hold a basket of stocks equivalent to a target index. Each contributor will then own a portion of the entire basket, rather than solely the concentrated stock contributed. The big benefit here is that the transaction is not immediately taxed.

Exchange funds are typically limited partnerships or limited liability corporations created by large banks, investment companies, or other financial institutions. Eaton Vance is the largest provider of public stock exchange funds. Other providers include Goldman Sachs, Morgan Stanley, and more.

To qualify as an exchange fund, at least 20% of the portfolio must be in "illiquid" investments such as real estate. Generally, the rest of the fund will target an index such as S&P 500 or S&P 1500, but there are occasionally ones that target other corners of the markets for diversification.

Additionally, to qualify for favorable tax treatment, the investor must hold fund shares for at least seven years. Finally, exchange fund investments are typically not marginable.

Tax Treatment By contributing to an exchange fund, the investor can achieve instant diversification without immediate tax consequences. If the investor withdraws part or all of the contribution prior to seven years, he or she will receive back the originally contributed stock--at its original tax basis. If the investor makes a withdrawal after seven years, he or she will receive a proportionate share of the basket of stocks--with a basis equal to what was originally contributed. None of these transactions are subject to taxation until and unless the shares received are actually sold.

Downsides Beside the necessity for a seven-year holding period, the most problematic element to an exchange fund is that you might not be able to find one when you need it. That's because these funds are limited partnerships, and once they have reached their target capacity, they close to new investors.

But even when you find a fund that is available, the shares your client owns may not be accepted by the fund you’re trying to exchange into. Most funds accept only shares from mid- and large-cap companies. And lastly, there’s a good chance they will only accept a portion of the shares you are offering.

A Real-Life Example A client recently inherited a low-basis concentrated stock position of $75 million. To diversify by selling, he would incur federal and state taxes totaling approximately $25 million. This was obviously not an ideal scenario. Because our client was charitably inclined, we diversified approximately $10 million of the holdings with a charitable remainder trust and a donor advised fund. The tax deductions associated with these allowed us to sell approximately $7 million of the stock with no tax.

However, the client was still left with a balance of $58 million in the concentrated position. Because the client wanted to retain $15 million of the stock, we decided to diversify the remaining $43 million over time utilizing a combination of periodic sales and additional contributions to the donor advised fund. Additionally, we would take advantage of exchange-fund opportunities when possible.

We were able to find an Eaton Vance exchange fund that could absorb $5 million of the stock (a much smaller amount than we hoped). In order to participate, our client had to certify that he was a “qualified investor” with a minimum net worth of $5 million. The fund utilizes geographically diversified real estate as its 20% “illiquid” investments. Eaton Vance pays a 1% “finder’s fee” to Schwab, and the ongoing expenses are 95 basis points per year (70 basis points for management and 25 basis points to Schwab for account servicing).

Although the application process was rather complex (we had to work with Schwab’s Alt Desk), we were able to successfully diversify $5 million of our client’s concentrated stock position without any immediate tax consequences. And, there is potential for further exchange fund opportunities as early as November 2020 when we will try to contribute more of the client’s shares.

Final Thoughts An advisor must go beyond finding an open and available fund when considering this strategy for a client. Due diligence should include evaluating the experience and reputation of the offering company, analyzing the fee structure, determining capacity for the concentrated stock, and reading the fine print!

An exchange fund is not a magic bullet for all clients, but it is a great tool for your tool chest.

Sheryl Rowling, CPA, is head of rebalancing solutions for Morningstar and principal of Rowling & Associates, an investment advisory firm. She is a part-time columnist and consultant on advisor-focused products for Morningstar, and she continues to actively run her advisory business, from which Morningstar acquired the Total Rebalance Expert software platform in 2015. The views expressed in this article do not necessarily reflect the views of Morningstar.