Moves for Concentrated Stock Positions
Thomas J. Boczar, Esq.
Twenty-First Securities Corporation
Originally published by ABA Trust & Investments.
American Bankers Association: Washington, D.C., July/August
current volatility of the stock market has caused many investors
who own a single concentrated stock position with a low-cost basis
to. explore strategies that should enable them to hedge and
monetize their positions without triggering a taxable event. The
Internal Revenue Service recently proposed additional regulations
with respect to the "straddle rules," which, should they
become effective, promise to change the ground rules regarding
hedging stock that was acquired after 1983.1 Most
derivative dealers seem oblivious to the fact that the economics
of hedging and monetization can be achieved through a number of
derivatives options, swaps, or forwards - but that each derivative
"tool" results in different tax consequences depending
on an investor's particular situation. For instance, virtually the
entire dealer community is currently touting an instrument called
a prepaid variable forward as the "preferred" tool to
use in almost every situation where monetization is the objective,
even though that instrument will rarely deliver the optimal
article assesses the alternative strategies that currently exist
in the marketplace and should help professional financial advisers
better select the tool that achieves the desired economics while
minimizing an investor's after-tax cost.
an investor holding a concentrated position in an appreciated
stock would like to achieve the following:
Hedge against a decrease in value of the stock.
and Eliminate Capital Gains Tax: Avoid triggering a current
taxable event and still qualify for a step-up in basis at death.2
Liquidity: "Monetize" the position (e.g., currently
receive in cash a substantial portion of the market value of the
stock) to allow the investor to diversify into other investments.
Against The Box Is The Paradigm:
to the Taxpayer Relief Act of 1997 and the "constructive sale
rules" promulgated thereunder, short against the box was the
preferred tool because it was the cheapest and most efficient tool
that achieved these objectives.
the constructive sale rules have generally eliminated the use of
the short against the box,3 it is important to have a
basic understanding of its economics because it remains the
"paradigm" that all derivative-based hedging and
monetization strategies attempt to replicate as closely as
possible without violating the constructive sale rules.
a short against the box, the investor was simultaneously long and
short the same number of shares of the same stock and therefore
completely hedged.4 The fully hedged position earned
close to the risk-free rate of return on 100% of its value.
Because the position was fully hedged, the investor could borrow
up to 95% (or more) of its value. Although there was a cost
associated with the borrowing, the income generated by the hedged
position greatly offset the cost of borrowing, making monetization
very inexpensive. Because the long and short positions were
treated separately for tax purposes, the capital gains tax was
deferred. And because the long shares qualified for a step-up in
basis at death, an investor who kept the short against the box
open until death completely eliminated the capital gains tax.5
Objective - Create An Income-Producing Collar:
the constructive sale rules, a particular type of equity collar -
the income-producing collar6 - has emerged as the
preferred strategy because it remains possible to fairly closely
replicate the cash flows of the short against the box while
avoiding the constructive sale rules.
by structuring an equity collar with a fairly tight band around
the current price of the stock, an investor can minimize (within
limits) exposure to price movement of the underlying stock,
monetize the position, generate positive cash flow that can be
used to offset the cost of monetization, while deferring the
capital gains tax and possibly eliminating it (by still qualifying
for a step-up in basis at death)
avoid a constructive sale, an income-producing collar should be no
tighter than 15% around the current price of the stock and no
longer than five years. For instance, if a stock is currently
trading at $100 per share, an investor might buy protection below
$95 and sell-off all upside potential above $110.
Senate Finance Committee Report and the House Ways and Means
Committee Report with respect to the constructive sale rules both
contain an example of a 95% -110% equity collar. Although the
committee reports express no view on whether this collar is
"abusive" (and would therefore trigger a constructive
sale), this example was most likely included to give investors
some practical guidance as to what type of equity collar would not
trigger a constructive sale.
cash flows of this type of collar resemble a short against the box
but should not trigger a constructive sale.
Have Same Economics But Different Tax Treatment:
the economics (e.g., hedging and monetization) of an equity collar
can be achieved through the use of several tools (e.g., options,
swaps and forwards) and each of these tools can result in very
different tax consequences depending on an investor's particular
situation, investors and their professional advisers must engage
in an analysis to ensure that the derivative tool that is utilized
is the one most likely to minimize the investor's after-tax cost
of implementing the collar.
Impact Of The "Straddle Rules":
Whether or not the "straddle rules" of the Internal
Revenue Code apply is critical in the selection of the most
Section 1092 applies to "straddles." A straddle exists
when holding one position substantially reduces the risk of
holding another. Because an equity collar substantially reduces
the risk of owning the underlying stock, the stock and collar
together should be treated as a straddle for federal tax purposes.
face two negative ramifications from their stock and collar being
deemed a straddle. First, any loss realized from closing one leg
of a straddle must be deferred to the extent there is unrealized
gain on the open leg. Thus, as a collar expires, is terminated, or
is rolled forward, any losses must be deferred. Second, interest
expense incurred to "carry a straddle" must be
capitalized (as opposed to being currently deductible).
For Stock Acquired Before 1984:
The straddle rules do not apply to stock that was acquired prior
to January 1, 1984. Therefore, if stock was acquired before 1984,
a collar can be implemented without triggering the straddle rules.7
This results in significant tax-planning opportunities.
remainder of the first part of this two-part article will address
strategies for stock acquired before 1984. The second part will
address strategies for stock acquired after 1983.
previously mentioned, there are three hedging tools that can
produce the economics of a collar: options, which can be either
listed or over-the-counter; prepaid variable forwards; and swaps
with an embedded collar.
stock acquired before 1984, in most situations the optimal tool to
hedge and monetize an appreciated stock will be a swap containing
an embedded collar monetized through a margin loan. The two other
possible tools – options-based collars monetized through a
margin loan and prepaid variable forwards - produce less favorable
Options-based collars involve the simultaneous purchase of puts
and sale of calls on the underlying stock. The options eliminate
the potential for loss below the put strike price and for profits
above the call strike price.
instance, an investor holding ABC Corp. shares that currently
trade at $100 might buy a put with a strike price of $95 and sell
a call with a strike price of $110 and then borrow against the
hedged position (or other marketable securities) to monetize the
A prepaid variable forward is an agreement to sell a security at a
fixed time in the future, with the number of shares to be
delivered at maturity varying with the underlying share price. The
agreement effectively has the economics of a collar combined with
a borrowing against the underlying stock embedded within it.
instance, an investor holding ABC Corp. shares currently trading
at $100 might enter into a prepaid variable forward that requires
the dealer to pay the investor $88 at the start of the contract in
exchange for the right to receive a variable number of shares from
the investor in three years pursuant to a preset formula that
embodies the economics of a collar (e.g., a long put with a $95
strike and a short call with a $110 strike).
formula would require the investor to deliver all its ABC Corp.
shares if the price of ABC in three years were less than $95. If
the price of ABC were greater than $95 but less than $110, the
investor would deliver $95 worth of shares. If the price of ABC
were above $110, the investor will keep $15 worth of shares and
deliver the remainder to the dealer.8
A swap is an agreement between an investor and a highly rated
dealer with payments referenced to the price of a particular stock
and covering a particular dollar amount (e.g., the notional
amount). Under a swap agreement, the investor could agree to pay
the dealer any appreciation above a specified share price (e.g.,
the strike price of the embedded short call) plus any dividends
paid on the stock. The dealer in turn could agree to pay the
investor any depreciation below a specified share price (e.g., the
strike price of the embedded long put) plus an interest-based fee
on the notional amount.
instance, an investor holding ABC Corp. shares currently trading
at $100 could enter into a swap agreement to pay the dealer any
appreciation above $110 plus any dividends paid on the stock while
the dealer could agree to pay the investor any depreciation below
$95 plus an interest-based fee on $100. The investor could then
borrow against the hedged position (or against other marketable
securities) to monetize the position.
Analysis Re - Settling The Collar:
Options-based collars and prepaid variable forwards are afforded
essentially the same tax treatment.
decrease in the price of the stock below the put strike will
create long-term capital gain. Conversely, an increase in the
price of the stock above the call strike will produce a long-term
capital loss, which will be subject to the limitations discussed
capital losses are subject to very specific netting rules.
Long-term capital losses must first be used to offset long-term
capital gains that would otherwise be taxed at 20%. Only then can
they be used to offset short-term capital gains that would
otherwise be taxed at the ordinary rate.9 Any remaining net capital losses can then be used to offset a
maximum of $3,000 of ordinary income that would otherwise be taxed
at the ordinary rate.
because of the netting rules, when settling an options-based
collar or prepaid variable forward where the stock price has
appreciated well beyond the call strike, the investor will likely
achieve only a 20% benefit (as opposed to a benefit at the
ordinary rate) from the resulting loss.
our previous example, the investor implemented a $95 put
strike/$110 call strike collar. If the stock increases to $200 at
expiration of the collar, the $90 difference between the
then-current price ($200) and the call strike ($110) less the
premium received will be treated as a long-term capital loss.
likely the investor will sell $90 of the underlying stock to fund
its settlement obligation. Assuming the investor has achieved
long-term holding period on the shares that were sold and those
shares have a zero basis, the investor will recognize a $90
long-term capital gain. Under the netting rules, the $90 long-term
capital loss must first offset the $90 long-term capital gain.
Here the $90 long-term capital loss cannot be used to offset other
short-term gains or ordinary income that the investor might have
generated. Thus, the value of the loss is only 20%.
receive more favorable tax treatment. All payments made or
received under the terms of a swap agreement should generate
either ordinary income or loss. However, a termination of a swap
agreement should generate either capital gain or loss. Thus, with
proper planning an investor using a swap should be able to
recognize either capital gain or ordinary loss.
instance, if the underlying stock declines in value below the
embedded put strike, the investor could terminate the swap prior
to its stated expiration date, creating long-term capital gain. If
the stock increases in value above the embedded call strike, the
swap could be allowed to run until its stated expiration with the
resulting loss treated as ordinary, which should be deductible
against ordinary income that would otherwise have been taxed at
the ordinary rate.
Analysis Re - Deductibility Of Interest Expense:
Because the straddle rules do not apply to stock acquired before
1984, there is no question that investment interest expense
incurred for the use of the monetization proceeds is currently
deductible against investment income (e.g., dividends, interest,
and short-term gains) otherwise taxed at the ordinary rate.
both a swap with an embedded collar and an options-based collar
can be monetized through a margin loan (secured by the hedged
position and/or other marketable securities), the investor will
incur investment interest expense that is currently deductible
against investment income.
with a prepaid variable forward the investor cannot achieve this
same favorable tax result. Instead, the investor is required to
defer and capitalize the net cost of borrowing.
instance, in our previous example the investor holding ABC Corp.
shares currently trading at $100 entered into a prepaid variable
forward that embodies the economics of a collar (e.g., a long put
with a $95 strike and a short call with a $110 strike) that
required the dealer to pay the investor $88 at the start of the
this example, the difference between the $95 put strike (e.g., the
sales price) and the $88 advance is the net cost of borrowing.
Unfortunately, a deduction for this very real expense cannot occur
until the underlying shares are actually delivered to close out
the contract. Because the forward in our example has a term of
three years, the deduction will be deferred for at least this
if the investor cash settles and "rolls over" the
forward for another three-year term, the deferred expense merely
increases the investor's basis in the stock. If the investor then
dies, he or she will never receive the benefit of a deduction;
there will simply be less tax forgiven at death.
because this expense is capitalized, the value of the deduction is
slashed from the ordinary rate to 20%. For instance, assume in our
example that three years from now the price of ABC is less than
$95 and that the investor decides to physically settle the
forward. The investor would deliver all of his shares to the
dealer and would be taxed on the difference between the advance
received up-front ($88) and his or her basis in the stock that was
delivered. That is, the investor is not taxed on the difference
between the sales price ($95) and the amount received up-front
($88). Assuming the investor achieved long-term holding period
prior to entering into the forward, the benefit of the deduction
has been dramatically reduced.
Disadvantage Of Swaps:
Swaps have two potential tax disadvantages. The first limitation
is that the loss on the swap plus all of the investor's
"other" itemized deductions must exceed 2% of the
investor's adjusted gross income in order to be deductible. After
this hurdle is met, the deductible amount is reduced by 3% of the
taxpayer's adjusted gross income. The deduction is also disallowed
for alternative minimum tax purposes. Therefore, if the stock
price exceeds the embedded call strike near expiration of the
swap, the investor must determine whether it is better to generate
an ordinary deduction, subject to these limitations, or a capital
loss. The swap affords the investor his or her choice. Also, with
a swap any payment received during its term (whether an up-front
payment or one received periodically) will be deemed ordinary
income currently subject to tax.
As previously mentioned, in January 2001 the IRS published
proposed regulations that, should they become effective, promise
to change the ground rules for hedging stock acquired after 1983.
These proposed regulations should not in any way impact stock that
was acquired prior to 1984.
the IRS recently released a field service advice (FSA) relating to
the taxation of a financial instrument that economically resembled
a prepaid variable forward.10 The IRS concluded that
the investor was required to recognize gain upon entering into the
transaction. The IRS's rationale was that the benefits and burdens
of ownership of the underlying shares had shifted to the
purchasers of the instrument. This conclusion was reached
notwithstanding the fact that the investor retained the right to
vote the underlying shares, was entitled to receive dividends paid
with respect to the stock, and had the right to substitute
collateral for the underlying shares.
the FSA is troubling with respect to prepaid variable forwards, it
should not be fatal. An FSA is essentially an informal letter
issued by the IRS national office to an IRS examining agent. These
letters are not considered binding on other taxpayers. In many
cases, the analysis simply reflects the IRS's views on a
particular transaction without the benefit of having competing
positions "flushed out." Accordingly, the letters tend
to side with the IRS examining agent. Nevertheless, investors
should be aware that prepaid variable forwards are not immune from
- The Superior Tool For Stock Acquired Before 1984:
Based on the above analysis, swaps are the superior tool
for hedging and monetizing stock acquired before 1984. If the
underlying stock depreciates in value, the gain on the swap should
be long-term capital gain. If the stock increases in value, the
loss on the swap can be ordinary or capital - whichever the
investor desires. Also, because a swap is monetized through a
margin loan, the investor will incur investment interest expense
that is currently deductible against investment income.
Options-based collars and prepaid variable forwards produce less
favorable tax treatment.
collars receive essentially the same treatment as swaps if the
underlying stock decreases in value and because monetization
occurs through a margin loan, the investor will incur investment
interest expense that is currently deductible against investment
income. However, options receive less favorable treatment than
swaps if the stock increases in value. Prepaid variable forwards
receive essentially the same tax treatment as swaps if the
underlying stock decreases in value, but receive less favorable
treatment if the stock increases in value. Prepaid variable
forwards also require the investor to defer and capitalize the net
cost of borrowing. Prepaid variable forwards are also somewhat
tainted by the field service advice referenced previously.
all three tools achieve virtually the same economics, swaps should
usually produce a superior after-tax result. See Exhibit A to
compare and contrast the tax treatment of the three available
hedging/monetization strategies -- swaps, options, and forwards --
for stock acquired before 1984.
Tax Treatment of Alternative Hedging/Monetization Techniques for
Stock Acquired Before 1984
implements monetizing collar through:
||Options and Margin
(with Embedded Collar)
||Equity Swap (with
Embedded Collar) and Margin Loans
costs be currently deductible against investment income
|When cash settling
collar, if stock price is above call strike, what is
character of the loss?
or long-term capital loss at investor's discretion
|When cash settling
collar, if stock price is below put strike, what is
character of the gain?
gain or ordinary income at investor's discretion
See proposed regulations 1.263(g)-3(c)(2) and 1.1092(c)-1(c)(iii).
Under the recently enacted Economic Growth and Tax Relief
Reconciliation Act of 2001, the step-up in basis at death would be
eliminated beginning in 2010.
However, in certain situations it remains possible for an investor
to establish a short against the box position with all its
attendant benefits that should not be subject to the constructive
sale rules through merger arbitrage. A meaningful discussion of
this strategy is beyond the scope of this article.
The following is an example of the mechanics of the short against
that Investor owns 10,000 shares of XYZ Corp. and the current
market price is $100 per share. Investor deposits 10,000 shares of
XYZ into its account with the broker. The broker, on behalf of
Investor, borrows 10,000 shares of XYZ from a third party and
sells those shares into the market. Investor continues to own
10,000 shares of XYZ and receives all dividends paid on such
shares. Investor pays to the lender of the borrowed shares an
amount equal to all dividends paid on such shares (a substitute or
"in lieu" dividend payment). Dividend flows are thus a
"wash." Proceeds of the short sale ($1 million) serve as
collateral for the lender of the borrowed shares. Investor earns a
money-market rate of return (e.g., Fed Funds less 35 basis points)
on these funds. Investor withdraws (i.e., monetizes) 95% of the
value of the XYZ shares, or $950,000. Investor pays interest on
this borrowing (e.g., at a rate of Fed Funds plus 30 basis
points). Investor is free to use or invest the $950,000 in any
annex it wishes. The net financing cost will vary as the Fed Funds
rate and the price of the stock change.
For a detailed discussion of the economics of the short against
the box strategy see Boczar, Thomas, and Fichtenbaum, Mark,
"Stock Concentration Risk Management Strategies," Trusts
& Estates (June 1996).
There are three types of equity collars: income producing,
zero-cost, and debit. With an income-producing collar, the amount
received for selling the call exceeds the cost of the put and this
excess is used to subsidize the cost of monetization. With a
zero-cost collar, the premium for the put and call are equal. With
a debit collar, the cost of the put exceeds the amount received on
the sale of the call.
The straddle rules apply to any shares acquired after 1983.
Therefore, most if not all of the investor's shares must have been
acquired prior to 1984 in order to avoid the application of the
straddle rules. An unresolved issue arises when the original stack
was acquired before 1984 but the shares being hedged were received
for such stock in a tax-free exchange that occurred after 1983.
A prepaid variable forward could also be cash-settled. If this was
the case in our example and the price of ABC was less than $95
three years from now, the investor would pay the dealer the
then-current value of ABC in cash. If the price of ABC was between
$95 and $110, the investor would pay the dealer $95 in cash. If
the price of ABC was above $110, the investor would pay the dealer
$95 plus the difference between the then-current price of ABC and
Under the Economic Growth and Tax Relief Reconciliation Act of
2001, the ordinary rate will be 39.1% in 2001, 38.6% in 2002 and
2003, 37.6% in 2004 and 2005, and 35% from 2006 through 2010.
See FSA 200111011.
|This article and
other articles herein
information purposes only. They are not intended to be
an offer to engage in any securities transactions or to
provide specific financial, legal or tax advice. Articles may
have been rendered partly inaccurate by events that have
occurred since publication. Investors should consult
their advisers before acting on any topics discussed herein.|
Options involve risk
and are not suitable for all
investors. Before engaging in an
options transaction, investors must review the booklet "Characteristics
and Risks of Standardized Options".