New Moves for Concentrated Stock Positions
By Thomas J. Boczar, Esq.
Twenty-First Securities Corporation
Originally published by ABA Trust & Investments.  American Bankers Association: Washington, D.C., July/August 2001.

Proposed Regs Could Make Swaps Less Attractive (May 2004) The Taxpayer Relief Act of 2003 changed the profile of certain hedges.

The 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 after-tax result.

This 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.

Investor Objectives:

Ideally, an investor holding a concentrated position in an appreciated stock would like to achieve the following:

Hedge: Hedge against a decrease in value of the stock.

Defer and Eliminate Capital Gains Tax: Avoid triggering a current taxable event and still qualify for a step-up in basis at death.²

Gain 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.

Short Against The Box Is The Paradigm:

Prior 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.

Although 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.

In 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

Structuring Objective - Create An Income-Producing Collar:

Under 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.

Specifically, 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)

To 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.

The 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.

The cash flows of this type of collar resemble a short against the box but should not trigger a constructive sale.

Tools Have Same Economics But Different Tax Treatment:

Because 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.

Potential 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 appropriate tool.

I.R.C. 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.

Investors 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).

Analysis 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.

The 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.

As 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.

For 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 tax consequences.

Options: 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.

For 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 position.

Prepaid Variable Forward: 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.

For 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).

The 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

Swap: 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.

For 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.

Tax Analysis Re - Settling The Collar: Options-based collars and prepaid variable forwards are afforded essentially the same tax treatment.

A 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 below.

Long-term 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.

Unfortunately, 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.

In 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.

Most 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%.

Swaps 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.

For 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.

Tax 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.

Because 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.

However, 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.

For 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 contract.

In 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 period.

However, 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.

Also, 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.

Tax 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.

Recent Tax Developments: 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.

Also, 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.

While 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 IRS attack.

Swaps - 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.

Options-based 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.

While 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.

Exhibit A
Tax Treatment of Alternative Hedging/Monetization Techniques for Stock Acquired Before 1984

1. See proposed regulations 1.263(g)-3(c)(2) and 1.1092(c)-1(c)(iii).

2. 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.

3. 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.

4. The following is an example of the mechanics of the short against the box:

Assume 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.

5. 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).

6. 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.

7. 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.

8. 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 $110.

9. 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.

10. See FSA 200111011.

This article and other articles herein are provided for 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".