Addressing the Tax Concerns of Concentrated Stock Positions

One of the more challenging financial planning concerns that often comes up is the concentration risk of too much money in a specific stock that has a very low tax basis.   Investors are often torn between the risk of holding too much in any one company, and the potentially large tax bill that can come from realizing a large capital gain.


Sometimes this is a result of working for a company that has offered you stock grants or options as part of your compensation and has subsequently done very well.  Sometimes it is simply the result of getting very lucky and buying a stock that had some exceptional gains.   Either way, the this can present a tax dilemma.  Since it’s generally not advisable to have more than 5% of your liquid net worth in any one company, its important to explore your opportunities to mitigate this risk.


Tax Loss Harvesting

Tax loss harvesting is a long-term approach of selling one holding for another in order to capture a tax loss on a position that has declined, or a dividend lot that was reinvested at a higher price in order to replace it with an investment that is similar, but not identical.  As an example, selling an S&P 500 index fund at a loss in order to buy a Russell 1000 index fund.  Doing this over time can capture losses that can be used to offset gains and slowly peel back a concentrated position without disturbing the integrity of the risk profile and allocation of your other holdings.   Unfortunately, this will typically take a long time to generate enough losses to significantly reduce a large highly concentrated position with a big unrealized capital gain.



The use of options can be applied in order to hedge out the downside of a concentrated position while you slowly reduce it over the course of many years. Strategies known as options collars can be implemented in which an investor purchases out of the money put options, while simultaneously selling out of the money call options can limit the downside and the upside at once.   It is possible to do this at times with a relatively low cost.   However, options trading is something that requires a high degree of expertise and understanding of the risks involved in order to execute a proper hedge.  In some cases, if the position is large enough, there are investment firms that can create a specific structured product which can be tailored to a specific investor in order to help offload that responsibility when the investor doesn’t have the knowledge to hedge the portfolio themselves.


Exchange/Swap Funds

An exchange fund (not to be confused with an exchange traded fund), also sometimes known as a swap fund is a product offered to investors by large financial institutions that is essentially a partnership that invests in a diversified portfolio of stocks that track to a benchmark, not unlike a typical mutual fund.  However, they are designed to be funded with a stock holding that you transfer to the fund along with your lower cost basis, and in exchange you receive a proportionate amount of the same value of this diversified fund with the same cost basis.   While you still have the same problem of an unrealized capital gain, you no longer have the risk of a concentrated position.


This strategy comes with its disadvantages.   One is that you often have to maintain the fund for as long as 7 years, so you don’t have the same degree of liquidity.  However, if you were going to keep the stock holding, or otherwise invest it in something more diversified, it becomes an insignificant difference.  Another issue is that you have internal expenses to buy the equivalent of an index fund that are more typical of a managed mutual fund.   The cost to buy an S&P 500 index fund might ordinarily be 0.03%, while the cost of an exchange fund might run 0.80%-1.00% annually in internal expenses.


Additionally, these funds often pay you only the price return of the underlying index, and not the dividend income, so you sacrifice some of the upside for the immediate diversity. Such funds require that you deposit a large position, often $500,000-$1,000,000 in value.  It is also typically necessary that it’s a holding that is widely held and fairly liquid.  Exchange funds would most often not offer this to a new issue, or a thinly traded company.


Overall, these are a few common strategies available to reduce concentration risk in cases where taxes are a consideration and a significant liability.  It’s important to examine these situations from the perspective of your longer-term financial plans, and the risk reward of holding a concentrated position.  Oftentimes investors feel emotionally attached to a company because they made a lot of money with the stock, or they worked there.   Emotions and investing are an unhealthy combination.  It’s important to try and be objective as you possibly can.


Other times investors who worked for a company feel a sense of confidence because they feel they have a better understanding of how the company is doing from the inside.  Unfortunately, sometimes this is an unfounded overconfidence.   Lehman Brothers was a more than 180-year old investment bank, and one of the most powerful institutions in the world, and they imploded in a couple of weeks.  One can never be sure, and the safety and protection of a diverse portfolio compared to any one company cannot be overstated.


Tax considerations are an important part of the portfolio management process. However, it’s also important not to let the tax tail wag the investment dog too much.  Some of the strategies referenced can be a reasonable middle ground to addressing the tax concerns of a large gain in a heavily concentrated position.