Protecting "Synthetic" Equity Positions

Many investors have unrealized profits in positions they can’t actually sell, such as employee stock options, restricted stock or shares in private hedge or venture capital funds.  When the stocks underlying these positions gain value, such investors may wish to lock in profits but believe they cannot do so without holding the actual shares.  In most situations, however, it is possible for investors to create hedges that protect their holdings.

Passive Investments in Collective Vehicles

One common type of synthetic holding involves interests in private hedge or venture funds.  Passive investors in these funds usually cannot make investment decisions for the funds.  However, a passive investor may enter into completely separate personal investments to protect his or her share of a fund’s profitable position.  This strict separation of the two holdings has interesting tax implications.

One possible hedge would involve short sales.  A short sale is a sale of a stock the investor does not own.  If the stock goes down, the short seller will make money, and if the stock goes up, the short seller will lose.  Therefore, a short combined with the indirect ownership should create an economic situation that is similar to a sale.  From a tax perspective, this approach might appear problematic, because when a fund investor does a personal short sale of a fund holding, the combination of the personal hedge and the holding in the collective investment will include all the elements of a short against the box.  A short against the box often constitutes a constructive sale.  In this situation, however, if the investor has no control over the disposition of the long stock in the fund, and if the short position is kept strictly separate from the fund, then the combined holdings should not constitute a constructive sale for tax purposes.

Certain caveats apply to this approach.  The investor can’t directly or indirectly own more than 50% of the fund; otherwise, the combined positions will constitute a constructive sale.  Moreover, the strategy is only available to investors whose role in the fund is strictly passive; if an investor has control over fund decisions, then the strategy might constitute a constructive sale.  Finally, this strategy requires collateral.

Restricted Stock

Restricted stock presents different problems, but several techniques are available to manage the risk in such positions.  Under Rule 144, hedges on restricted stock do not stop the holding period clock, but investors should take care to ensure that their hedges are not constructive sales.  For more discussion of hedges for restricted securities, readers should review Protection For Restricted Holdings in the May 1999 issue of Tailored Solutions.

Employee Stock Options

Qualified options already exercised? Click here for information on hedging ISO stock. No-Action Letter Says Insiders Can Collar Options The Jobs and Growth Tax and Reconciliation Act of 2003 lowered the tax on ordinary income to 35%.

Employees with employee stock options can often hedge the positions with “regular” options, forwards or swaps.  However, options and forwards can create a whipsaw.  The reason is that income on employee stock options is ordinary income, while income on regular options or forwards is capital in nature.  If the stock increases after the hedge is put on, then the hedge will work in economic terms but not in terms of taxes.  The investor will gain value on the employee options and lose value on the hedge position, creating ordinary income on the employee options and capital loss on the hedge.  The ordinary income will be taxable at 40%, and the capital loss will be limited in its deductibility, like any other capital loss.  For this reason, swaps are the safest way to hedge employee options.  Income and loss on swaps are treated as ordinary, so they can always be allocated against income or loss on the employee options.

Investors with employee options should be aware that these options are different from stock in that they have no margin or collateral value.  Therefore, a hedge on these options usually requires appropriate margin or collateral from sources other than the options themselves.  For large positions involving a cooperative issuer/employer, the employee options may be “converted” into a marginable security.  The converted marginable security can then be used to satisfy the margin or collateral requirement.

Investors with employee stock options should also keep in mind that “affiliates” cannot short and can only buy a put or sell a call if they are long the same number of underlying shares.  A holder of unexercised employee stock options generally is not considered to be long for these purposes.  However, even for affiliates, there are risk management possibilities.  Affiliates who are interested in exploring this issue should contact Twenty-First Securities.

A Complex Analysis

The hedging of non-physical equity positions can be somewhat complicated.  Investors need to apprise themselves carefully of the effects of potential hedging transactions before they proceed.  In many situations, however, a viable hedge can be constructed to protect holdings without triggering any tax.