Exchange Your Company Stock without Incurring Taxes - Here's how to diversify employer stock risk without incurring income taxes
Executives are often awarded their company stock as part of their compensation. If the company stock appreciates over time and an executive chooses to hold onto his or her stock, the tax cost to sell may get prohibitively high. In other words, the executive may not want to incur the tax on the gain and choose to hold onto the stock. Single stock ownership could pay huge dividends over time - quite literally - but can also be a risky proposition if the concentration becomes too high relative to one's net worth. The problem is if the stock does not perform well or worse like Enron or Lehman Brothers goes belly up.
Owning too much employer stock may not be a good thing
Investors holding large single-stock positions may benefit from diversification. According to Goldman Sachs research, since 1986, more than half of the stocks in the Russell 1000 have under-performed the index itself, while 24% have suffered permanent loss of capital. Concentrated stock risk - having more than 10% of one's portfolio in a single stock - may increase the risk and not necessarily help the return of the overall portfolio.
The real risk is threefold
The real risk of owning too much employer stock is not only the stock not performing over time, but the risk if things really go bad at the company. During a downturn or stock market bear market, an executive may find him or herself out of a job and his or her stock down 20%. Not only that, if the executive had any future compensation - options, restricted stock - those could be underwater as well. Diversification can help. But if the tax cost to sell a large tranche of employer stock is too high, what can be done?
An Exchange Fund Can Help Diversify away from Employer Stock without incurring the tax on the sale.
One Solution - the Exchange Fund
There are several ways an executive can diversify out of a concentrated stock position. Donor Advised Funds and 10b5-1 plans for example. Another more recent alternative is an "Exchange Fund." An Exchange Fund is an investment vehicle that provides a way to exchange concentrated stock positions for units of a more diversified portfolio. Exchange Funds are run by some of the largest and most respected investment firms who usually cater to CEOs and CFOs. Essentially, an investor with a concentrated stock position pledges his or her shares to a basket of securities managed by the investment firm. After a certain time period, say 7 years, investors may redeem their interest in the fund. Because there is no capital gains tax when stocks are contributed to a properly-structured exchange fund, investors can have more of their money working for them. Equally important are the diversification benefits. Instead of owning one stock, the Exchange Fund seeks to mitigate risk by owning a diversified pool of stocks from different sectors and industries. In addition, Exchange Funds must own 20% in qualifying assets - non-stock securities - namely real estate.
When investors leave an exchange fund they do not receive a cash distribution. Instead, they get a collection of individual stocks. Investors therefore need to pay close attention to the fund's composition. They should carefully review and understand the stocks in the fund's portfolio, since they will likely own them for several years.
What to look for in an Exchange Fund
Most Exchange Funds require a large commitment - usually $250,000 to $500,000 of stock. Also, you have to be a "qualified purchaser" - meaning an individual owning $5 million or more in investments, including investments held jointly with a spouse. Keep in mind Exchange Funds are generally not liquid and may have a surrender fee if you try to redeem your shares prior the end of the term, which is usually 7 years. The composition of the Exchange Fund, as mentioned earlier, is extremely important since this is a long-term investment. Finally, it's best to shop it around, as management fees will vary.
Every choice involves some level of risk. There are several risks to using an Exchange Fund. First there is no security against losing value. Though the fund is diversified, it will still fluctuate with the stock market. Also, there is a risk the tax law can change. Seven years is long enough for a new administration or Congress to change the tax code, this is a risk.
An Exchange Fund is a legal tax structure and is a unique way to help executives diversify away from their company stock without having to sell and incur unnecessary income taxes. An Exchange Fund is but one tool to help diversify away concentrated stock risk. A thorough financial plan can help you better understand your options.