From the April 2009 issue of Wealth Manager Web • Subscribe!

Losing Your Concentration

The virtues of diversification continue to be showcased by the volatile markets. Once simply considered an appropriate mix of stocks and bonds based on a client's age, today diversification for the high-net-worth client has become a much more complex matter, encompassing myriad investment classes including hedge funds, commodities, real estate and other alternatives. Understanding the diversification needs of these clients is one thing; getting them through the process is something altogether different.

High-net-worth clients reach their affluent position in various ways--through owning a business, investing in real estate, running a corporation or inheriting a fortune, for example. But one wealth-building factor they often share is that their affluence developed primarily from a single source--making diversification of assets or investments a special challenge. Corporate executives (or insiders), in particular, can present extraordinary challenges in the move to diversify holdings.

As a wealth manager, you likely have or will have corporate executives among your clientele. These people typically receive employer stock and stock options as a significant portion of their standard compensation and annual bonuses. If you strive to service this profitable market niche, knowing how to efficiently diversify their concentrated employer holdings is a must.

In the following paragraphs, I'm offering a "cheat sheet" of strategies and techniques to consider when a client is faced with concentrated risk from publicly traded equity positions. This is not an exhaustive list; rather, it is an overview of a select few possibilities. As you review the different methods, keep in mind that they are not "all-or-nothing" solutions; many work well in conjunction with one another.

Divest the risk

Divesting the client of concentrated risk can be accomplished in several ways.

Sell the position. Selling is simple and effective, but it is not without some obvious issues.

Most corporate executives hold low-basis employer stock, the sale of which creates an immediate tax liability. Although it is true that current capital gain rates are historically low, and that the tax liability is therefore mitigated compared with previous periods, it is my experience that clients are never excited to pay a large tax bill.

Selling the stock also prohibits the executive from participating in any future stock appreciation resulting from his or her dedication and hard work. This factor alone presents one of the biggest challenges, as employees tend to "marry the stock" of their employer.

Begin divesting the estate. Yes, I understand that it is difficult to convince a client to give away a portion of his or her wealth during a period when net worth is falling precipitously, but it may be a worthy strategy. Not only does it open an avenue for divesting risk, but it also provides the client with estate- and possibly income-tax relief.

Any taxpayer can give $13,000 to any individual during the 2009 tax year without incurring any gift tax ramifications. A client could begin a program of gifting to relatives that would immediately reduce the gross estate and transfer all future
appreciation to the gift recipients.

This move may be especially attractive now because asset values have been significantly depressed. One downside is that the gift recipient assumes the client's basis instead of inheriting the stock with a stepped-up tax basis. Unless the client is elderly or in poor health, the "carrot" in the form of stepped-up basis should not be the determining factor in deciding whether to make tax-free gifts.

Give it away to charity. The third method is similar, but the recipient of the gift is a non-profit organization. Clients with charitable intent tend to be the most rewarding clients to work with, as their intentions are uplifting and their charitable intent opens the planning process to many options.

One simple option is a direct gift of shares to a non-profit group. This produces an immediate charitable income tax deduction and provides a mechanism for the client to avoid paying any long-term capital gain built into the position. High-net-worth clients tend to implement charitable gift planning through use of donor-advised funds and private foundations. (See "Creating the Legacy" in WM's February and March issues.)

Trusts: Give it away later

As we mentioned previously, a client may consider you crazy to suggest giving away assets in today's market environment. That said, charitable planning may become a solution even for a client who doesn't have philanthropic intent--once he or she recognizes the many benefits of a charitable remainder trust (CRT) as a mechanism for divesting concentrated risk.

The CRT concept allows for an ultimate gift to charity, but the client retains an income stream for a term of years (or for life). At termination of the trust, all trust assets pass to the charity named as beneficiary, thereby giving the trust tax-exempt status. This means that the trust does not pay tax on the sale of the concentrated position, allowing for the reallocation of proceeds without immediate tax consequences. The trust's tax-exempt status also provides a charitable income tax deduction to the client equal to the present value of the remainder interest, which eventually passes to charity. Keep in mind, however, that the income stream payable to the client is taxable.

Cautiously long

For the client who won't consider any of these, you may want to explore more sophisticated strategies. One that is increasingly popular among holders of concentrated positions is a prepaid variable forward (PVF) sale.

A PVF allows a client to monetize and hedge a concentrated position for a specified term of years while deferring taxation associated with the sale. It provides the client with an up-front, one-time tax-deferred payment equal to as much as 90% of the value of the position (market conditions and other factors determine payment amount). Proceeds of the payment are then available to the client to create a diversified portfolio or address other liquidity needs.

The institution that provides the PVF creates a hedge around the position, providing downside protection as well as the potential for appreciation of the shares. At the end of the PVF term, the client may deliver shares or the cash equivalent value of the original payment to the PVF provider.

If the shares have appreciated during the PVF term, fewer shares will be required to satisfy the payment and the client will keep the remainder. Another alternative is the option to renew the hedge and continue the PVF (and the deferral).

A note of caution

When considering a PVF, however, be cautious, as the structure of the transaction is very important. To hedge the shares, the institution creating the PVF will short the stock as part of the hedge. Stock must be borrowed to create the short position. I mention this because in 2007, the IRS released a technical advice memorandum adversely affecting certain PVFs when the institution borrows the same shares pledged by the client instead of borrowing from the marketplace. This is referred to as client borrow versus market borrow. The IRS views a client borrow PVF as a constructive sale and therefore requires immediate payment of tax--as if the position were sold outright.

There are many complexities associated with a PVF, and explaining them all in detail would be beyond the scope of this article. But it is safe to say that a PVF can be a very effective strategy for the right client. As always, be sure to include qualified tax professionals in the discussions and implementation of all such plans for your clients.

Gavin Morrissey, JD ( is the director of advanced planning at Commonwealth Financial Network in San Diego.

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