I&WM Blueline.Indd

FEATURE

Structuring To Optimize Tax-Efficiency Recent Developments and Innovations in Single Stock Concentration Risk Management

By Thomas J. Boczar, Esq., LL.M., CPWA®, CFA ®, and Nischal Pai, CFA®

Editor’s Note: Th is is the second article The Basics of Hedging with for selling the calls, fully fi nancing the in a two-part series focusing on recent a Collar $5 premium paid to acquire the puts. developments and innovations in single Investors holding a concentrated stock Let’s assume the stock price increases stock concentration risk management. position can hedge against a decline in above the $120 strike price at maturity “Portfolio Margining” appeared in the the price of a stock, retain some upside and the calls are exercised. Th e investor January–February 2010 I&WM. potential, defer capital gains tax, and would deliver its long shares and receive avoid any out-of-pocket expenditure $120 ($120 from the exercise of the calls, by implementing a cashless (or zero- plus the $5 call premium received, less nvestors’ expectations regarding premium) collar. the $5 put premium paid). future returns have moderated con- Th e investor buys puts with a If ABC closes between $90 and $120 Isiderably over the past decade, with strike price that is either at or (more at expiration, both the puts and calls several repercussions. typically) slightly below the current will expire worthless and the investor First, more emphasis is being placed stock price. Th e investor must pay a will have paid the $5 put premium and on developing new asset allocation and premium to acquire the puts and in received the $5 call premium. portfolio construction methodologies. return is fully protected (subject to If the stock price falls below the $90 Second, investors are more focused the credit risk of the counterparty) strike price at maturity and the puts are on reducing trading costs and invest- from any loss should the stock price exercised, the investor would deliver its ment management fees. fall below the strike price of the puts. long shares and receive $90 ($90 from the Th ird, investors and their advisors Simultaneously, the investor sells calls exercise of the puts, plus $5 from the sale once again are concentrating on tax- with the same maturity as the puts of the calls, less the $5 cost of the puts). effi cient investing. After all, it’s not how with a strike price that is above the Figure 1 depicts the payoff profi le of much you earn that is important, but current price of the stock and in return a stock position combined with a cash- rather how much you keep. For instance, receives premium income. Th e strike less collar. tax-lot accounting and loss harvesting price of the calls is set at the level that are now commonplace, and structured brings in exactly the amount of pre- Tax Considerations products often are used to gain desired mium required to pay for the puts. In Related to Collars exposure with favorable tax results. other words, the sale of the calls fully Investors wishing to implement collars But little has changed within the fi nances the purchase of the puts. should consider carefully the implications. very specialized discipline of hedging Th erefore, although the investor for- Below is an overview of the key provi- a stock position. Investors wishing to feits some of the upside potential of the sions that need to be taken into account. hedge a single stock position often do underlying stock (the amount the stock so with little or no thought to the tax price is above the call strike at matu- Constructive Sale Rules consequences. Th e fi rst article in this rity), using a cashless collar requires no If structured properly, the use of a collar series introduced how the new portfolio out-of-pocket expenditure. to hedge a highly appreciated stock margining rules under Reg T can be For example, assume the follow- position should not trigger a construc- used to achieve greater tax-eff ectiveness ing: An investor owns shares of ABC tive sale under Code Section 1259 (the while reducing tax and Internal Revenue Corporation that are trading at $100. constructive sale rules). Service (IRS) audit risk. Th is article intro- Assume ABC one-year puts with a Th e legislative history of the duces numerous structuring opportuni- strike price of $90 are trading at $5 and constructive sale rules (e.g., both the ties that well-advised investors can use to ABC one-year calls with a strike price Senate Finance Committee and House achieve greater tax-effi ciency when the of $120 are trading at $5. Th e investor Ways and Means Committee reports) objective is to hedge (or hedge and mon- simultaneously sells the calls and buys contains an example of a collar with a etize) a concentrated stock position. the puts with the $5 premium received 15-percent band: a $100 stock combined

March/April 2010 27

with a long put with a $95 strike price FIGURE 1: ZERO PREMIUM (CASHLESS) COLLAR and a short call with a $110 strike price. Shareholder eliminates downside exposure below $90 and foregoes appreciation Th e consensus among tax practitioners above $120 with no upfront cash outlay is that this example was put into the Current Stock Price: $100 legislative history to give the investment Put Strike: $90 Put Premium $5 Stock and tax communities some guidance Call Strike $120 Call Premium $5 Stock with Collar about the magnitude of potential risk $40 and reward required to avoid triggering $30 Foregone a constructive sale. Appreciation $20 Because of this example, most tax practitioners are comfortable with col- $10

lars that have at least a 15-percent band P/(L) $0 between the put and call strike prices and Saved Depreciation with strike prices that either straddle or ($10) touch the market price at the time the ($20) hedge is implemented. For example, if the ($30) stock is trading at $100, 95/110, 90/105, 100/115, and 85/100 collars should each ($40) satisfy the constructive sale rules. $70 $80 $90 $100 $110 $120 $130 $140 Th e legislative history does not con- Stock Price tain any guidance about the maximum permissible length of a collar. However, lar will have no impact on the holding as short-term capital gains; if any most tax practitioners, as a rule of period of the shares being hedged. funds were borrowed with the collared thumb, are comfortable so long as the stock pledged as collateral, any interest collar term does not exceed fi ve years. Dividend Holding Period Rules expense would have to be capitalized. If the term exceeds fi ve years, most tax Long shares combined with a collar do practitioners would suggest the band be not satisfy the dividend holding period Structuring to Optimize considerably wider than 15 percent. requirements of the Jobs and Growth Tax Efficiency—Key Planning Practically speaking, except for Tax Relief Reconciliation Act of 2003 Concepts collars with a fairly short maturity, the (the 2003 Tax Act). Th erefore, any divi- Wall Street has created a variety of constructive sale rules are typically not dends received on the long shares will fi nancial tools and instruments that an issue for cashless collars because, by not be treated as “qualifi ed” dividend have fi nancial equivalency. Th at is, an their very nature, cashless collars usu- income taxed at the long-term capital investor wishing to collar a stock can ally have a band greater than the requi- gains rate but instead will be taxed at use a variety of tools, such as exchange- site 15 percent. Th at’s because the idea the ordinary rate (currently 35 percent). traded options, over-the-counter of a cashless collar is to have as wide a options, and swaps to accomplish that band as possible to put a fl oor under the Straddle Rules goal. However, the tax treatment of stock but give the stock plenty of room Th e combination of the concentrated each of these tools can vary consider- to appreciate in the future. stock position and collar may constitute ably. Well-advised investors can take a straddle for tax purposes. Th is will de- advantage of this incongruity. Holding Period pend on when the investor acquired his In addition, when structuring col- If the shares being hedged have not yet or her shares. Th e key date is March 1, lars to achieve maximum tax-effi ciency, accrued the requisite one-year holding 1984. If the shares were acquired before factors relating to both 1) the shares period necessary to achieve long-term that date, the straddle rules should not or other instruments (i.e., nonqualifi ed capital gain treatment, the use of a apply and therefore a straddle should not stock options and stock appreciation collar will terminate any holding period be created.1 If the shares were acquired rights) being hedged and 2) the hedg- that has accrued. on or after this date, the straddle rules ing tool used to implement the collar If the shares have already accrued will apply and a straddle will be created. should be taken into consideration. the requisite one-year holding period If a straddle is created, any losses Th e following four examples dem- before implementation of the collar with respect to the collar will be treated onstrate these valuable concepts, which (e.g., the shares were already long-term as deferred, long-term capital losses, too often are ignored by even very capital gain property), the use of a col- while any gains will be taxed and treated experienced investors and advisors.

28 Investments&Wealth MONITOR

Example #1: Using Listed Options. Th ere are two types of What Financial Tool Should Be Used to Hedge Stock options: 1) listed and 2) over-the-coun- Through a Collar? It All Depends ter (OTC). A listed option is traded on • If hedging shares that were acquired on or after March 1, 1984 an exchange, whereas an OTC option is » Use OTC collar documented as a single contract a privately negotiated contract between » Avoids whipsawing of straddle rules the investor and a derivative dealer. • If hedging shares that were acquired before March 1, 1984 When an investor uses listed options » Use exchange-traded (E-FLEX) options to implement a cashless collar, there are » No tax disadvantage to using exchange-traded options necessarily two contracts, one for the » Signifi cant non-tax advantages calls and one for the puts. Continuing • If hedging nonqualifi ed stock options or stock appreciation rights with our earlier example, an investor » Use swap embedded with the optionality of a collar might enter into a cashless collar where » Avoids mismatch in character between gain on the NQO/SAR and loss calls are sold with the investor receiving on the hedge a premium of $5 per share and puts are purchased with the investor paying a premium of $5 per share. Th e sale and sale of the call in the year the options is priced via negotiation with a single purchase of the calls and puts, respec- expired. In our example, the premiums dealer, although most sophisticated tively, can be executed on an options should net to zero, thereby avoiding an investors get bids from several OTC exchange simultaneously as a spread adverse tax result. dealers to ensure that some price dis- order (i.e., without concern that the So from a tax perspective, for shares covery has occurred. investor buys the puts without selling acquired before March 1, 1984 (where Fourth, though it is not an advantage the calls, or vice versa). Nonetheless, the straddle rules should not apply), per se, listed options include Equity there still will be two separate contracts, the use of listed options to implement Flexible Exchange (E-FLEX) options and this can result in adverse tax conse- a collar should not cause any tax dis- that allow the investor to customize the quences for certain investors. advantage to the investor because the key terms of the contract. Put simply, For instance, assume the shares premiums for the put and call should E-FLEX options grant investors most being hedged were acquired on or after net against each other. of the fl exibility of OTC options. For March 1, 1984 (i.e., the tax straddle When comparing listed (i.e., exchange- instance, the strike price of both the rules apply) and the cashless collar traded) options with OTC options, listed put and the call can be set at any level described in our earlier example expires options also have other advantages. (i.e., not just the customary $2.50 or $5 when the stock price is between the First, because the AAA-rated Options increments) so that a cashless collar is $90 put strike and the $120 call strike Clearing Corporation is the counterparty possible (i.e., there won’t need to be a prices (i.e., both the put and call end for listed options, the investor incurs less small debit or credit as when regular up worthless). In this case, the investor counterparty credit risk. With an OTC listed options are used to collar a stock). faces an immediate taxable gain on the option, the investor incurs the credit risk Th e term of the contract can be as long expired call. Th at is, the $5 premium of the single dealer counterparty that as 15 years. And perhaps most impor- received on the sale of the call will be executes the transaction. tantly, just as with OTC options, listed taxable as a short-term capital gain in Second, the investor can close out option contracts can be European-style. the year the options expired. However, listed options before maturity by acquir- Th at means the calls the investor sells the investor cannot deduct the $5 ing exactly off setting positions with any are exercisable only at the expiration of premium paid to acquire the put in market participant. With an OTC-based the calls, making an early exercise of the the year the options expire; rather, the collar, the investor can try to negotiate calls by the holder impossible. investor will have a deferred, long-term an early termination of the collar, but Th e lesson is that for shares acquired capital loss that increases his or her the dealer can—and usually does— before March 1, 1984 (for which the basis in the shares that were hedged. extract a price for early termination. straddle rules should not apply), using On the other hand, if the investor’s Th ird, by their very nature, listed listed (E-FLEX) options to implement a shares were acquired before March 1, options should achieve robust price collar should not disadvantage the cli- 1984, the straddle rules should not discovery. A request for quote (RFQ) ent from a tax perspective (the put and apply. Th erefore, the premium paid to is disseminated to dealers and fl oor call premiums should off set each other) acquire the put should be deductible traders and each trade is executed on and should bestow signifi cant non-tax against the premium received on the the options exchange. An OTC contract advantages upon the investor.

March/April 2010 29

Example #2: Use of OTC Single- Contract Collar. If the shares were Comparison of Prepaid Variable Forward versus Swap Structure acquired on or after March 1, 1984 (i.e., the straddle rules apply), an investor Prepaid Variable Forward who uses listed options to implement a • Losses generated by cash settling are long-term capital losses with a collar will be whipsawed by the straddle 15-percent benefi t rules as described above. Th at’s because • Carrying costs are not currently deductible as interest expense with listed options, two contracts are » Instead they are deferred and eff ectively converted to long-term capital involved—one for the puts and another loss with a 15-percent benefi t for the calls—and the straddle rules • Th e IRS’ position with respect to PVFs has been very inconsistent over the don’t allow the cost of the puts to off set past decade and audit risk is high the premium received on the sale of • Th ere are absolutely no limitations on the use of the proceeds the calls. Th e solution to this dilemma is to Swap and Margin Loan turn to the OTC derivative market to • Losses generated by cash settling are either ordinary losses with a potential implement the collar. Because the terms 35-percent benefi t or long-term capital losses with a 15-percent benefi t, at of such a collar are negotiated with the option of the investor a dealer, the collar can be structured » Investor has a free call option on a potential 20-percent tax benefi t as as a single contract. In contrast, the the stock price increases above the call strike exchanges don’t yet allow a collar to be • Carrying costs may be currently deductible as interest expense with a structured as a single contract. A single- 35-percent benefi t contract cashless collar won’t show » May be partially or completely deductible if the shares were acquired the cost of the call and put separately; on or after March 1, 1984 (through specifi c identifi cation of collateral it instead will show a net cost of zero. for the loan other than the collared shares) Most tax practitioners have become » Should be completely deductible if shares were acquired before March 1, very comfortable with this structure. 1984 Th e lesson is that for shares acquired • Th e swap structure eliminates the tax uncertainty surrounding PVFs on or after March 1, 1984 (where the • Th ere are absolutely no limitations on the use of the proceeds because the straddle rules apply), the use of an OTC loan is extended under the new portfolio margining rules of Reg T options-based collar documented as a single contract delivers a more effi cient tax result than the use of listed options. Th at is, it should spare the investor hedging NQOs is the potential whipsaw has capital gains from other sources, the from being whipsawed by the straddle that can occur if the NQOs and the capital losses would not be deductible. rules. Th e cost to the investor is forfei- hedging tool produce income and loss Assume an executive hedges NQOs ture of the non-tax advantages of listed of a diff erent character. using an options-based collar and options. Most investors and advisors Here’s some background: When that the underlying stock increases by feel this is a fair price to pay for the an investor exercises NQOs, ordinary $10 million above the strike price of tax-effi ciency of an OTC options-based income is created. In contrast, an the call options while the hedge is in collar documented as a single contract. options-based collar (or prepaid vari- place. Economically, the client has not Example #3: Use of Swap able forward contract) will give rise to benefi ted from this stock price increase with Embedded Collar to Hedge capital gain or loss. Th erefore, the use because the $10 million of income Nonqualifi ed Employee Stock of an options-based collar (or prepaid on the NQOs is exactly off set by a Options. Th e previous two examples variable forward contract) to hedge $10-million loss on the call options. assumed the investor is hedging shares NQOs creates the potential for ordinary However, when the collar matures of common stock. But what if the income on one side and capital loss and the investor exercises the NQOs, investor is hedging either nonquali- on the other. Th at is, if the underlying the executive will have $10 million of fi ed employee stock options or stock stock continues to appreciate above the ordinary income and $10 million of appreciation rights (NQOs)? Would the strike price of the call, the employee will capital losses, resulting in a mismatch investor be better off selecting a diff er- have ordinary income on the NQOs in character between the income on the ent tool to implement the collar? and a capital loss on the hedge, each in NQOs (ordinary) and the loss on the Th e key tax issue that arises when the same amount. Unless the employee hedge (capital). Unless the investor has

30 Investments&Wealth MONITOR

suffi cient capital gains against which practitioners do not believe that these has ordinary income during the year to off set these capital losses, he or she proposed regulations will ever become the swap expires. Th e lack of ordinary can deduct only $3,000 of the capital either temporary or fi nal regulations income or the limitations discussed in loss against ordinary income each year. with the force of law. Example #3 (i.e., deduction subject to the Th erefore, while this hedge provided Example #4: Use of Swap with 2-percent-of-AGI limitation, no deduc- the desired economics (downside Embedded Collar to Hedge and tion for AMT purposes, etc.) could protection), it also created $9,997,000 Monetize Stock Acquired before prohibit the investor from achieving the of ordinary income in the current year March 1, 1984. Example #1 showed full 35-percent benefi t. In any event, the with no off setting deduction. that it was probably better to use listed investor could simply terminate the swap A possible solution is to use a swap options instead of OTC options if the before its stated expiration and under that has the optionality of a collar straddle rules do not apply, because Code Section 1234A, and the result embedded within it. In this structure, using listed options should result in would be a deductible capital loss, which if the stock rises above the embedded no tax disadvantage but it does come is exactly the same result that would call strike and a loss is incurred on with other benefi ts such as reduction have resulted had options or a prepaid the swap, under current tax law, if the of counterparty credit risk. But might a variable forward (PVF) been used. investor allows the swap to run to its swap deliver an even better tax result if In other words, the use of a swap stated maturity and makes a payment the shares hedged aren’t subject to the to collar the shares gives the investor to the dealer to terminate its obliga- straddle rules? the equivalent of a free call option on a tion under the swap, such a payment Th e tax implications of using potential 20-percent tax benefi t. is treated as an ordinary deduction. swaps are intriguing. If the stock price It should be noted that the investor Th erefore, the subsequent appreciation increases above the call strike, the does not need to decide at the time the of the NQOs and the loss on the swap investor can choose how to treat the swap is put on whether to terminate should be treated as ordinary income loss on the swap. If the swap is allowed the swap early or let it expire; rather, and ordinary deduction, respectively. to expire at its stated maturity, the loss the investor can decide around the date Th e lesson here is that swaps solve on the swap will be treated as an ordi- when the swap is set to expire, when the whipsaw problem by matching the nary deduction. the investor and advisors should have a character of income from the NQOs If the straddle rules don’t apply, this good handle on what the best course of with the loss from the swap. ordinary deduction will be currently action should be. However, the use of swaps poses deductible against ordinary income— If the investor is not simply hedging several potential challenges. such as salary and income from the the position but decides to monetize First, the ordinary deduction relating exercise of nonqualifi ed employee stock (i.e., borrow against) the hedged posi- to such swap losses should be treated as options—with a potential 35-percent tion, the interest expense on the loan an “other” itemized deduction for fed- benefi t. should be deductible without limitation eral tax purposes and these deductions If the swap is terminated before its against investment income, including may only be taken to the extent that in stated maturity, the loss will be a currently short-term capital gains, with a 35-per- the aggregate they exceed 2 percent of deductible capital loss, and if the swap cent benefi t. In contrast, if a PVF was the investor’s adjusted gross income. was held open for more than 12 months used to hedge and monetize the stock Second, ordinary swap losses cannot this loss will be a long-term capital loss position, the interest or carrying charge be deducted for purposes of determin- with a potential 15-percent benefi t. for borrowing is eff ectively capitalized ing the alternative minimum tax (AMT). On the other hand, the appreciation and deferred. Th at is, it is refl ected as Th ird, back in 2004, Treasury of the stock that was hedged will be either a lesser amount realized (if the issued proposed regulations that could taxed at the long-term capital gain rate shares are delivered in satisfaction of result in adverse tax consequences (now 15 percent). the PVF) or as a capital loss (if the PVF for investors who use swaps. Th ese Th erefore, in the right circumstances, is cash-settled), in each case with a proposed regulations would have a the investor may be able to take advan- 15-percent benefi t. retroactive application date should tage of the potential 20-percent tax ben- Th e lesson here is that, if the straddle they ever become either temporary efi t. Th at is, as the stock price increases rules do not apply, the use of a swap or fi nal regulations (e.g., and have above the embedded call strike, gain on to collar a concentrated stock position the force of law). However, because the stock will be taxed at the 15-percent combined with a margin loan against of their extreme complexity, and the rate while loss on the swap could be the hedged position to monetize is supe- fact that no action has been taken on deductible at the 35-percent rate. Th is rior to a PVF for a number of reasons. them in almost six years, many tax result could be achieved if the investor Continued on page 47

March/April 2010 31

Boczar / Pai Continued from page 31

• Th e investor benefi ts from the eco- tools and techniques to optimize the program. Contact him at tboczar@ nomic equivalent of a free call option tax-effi ciency of hedging a concentrated intelligent-edge.com. on a potential 20-percent tax benefi t. position in a publicly-traded stock Nischal Pai, CFA®, is head of • Interest expense on the loan should through a collar. hedging and structured solutions at be deductible at the 35-percent rate To those unfamiliar with hedging Intelligent Edge Advisors. Contact instead of being deferred and capital- tools and how hedging transactions him at [email protected]. ized at the15-percent rate. are taxed, such disparate tax treat- And as discussed in the January/ ment among various hedging tools Endnote February 2010 Investments & Wealth that achieve essentially identical 1 Th e literal language of the legislation relat- Monitor article: results may seem odd. Others are ing to the eff ective date of Code Section • Prepaid variable forwards have been surprised to learn that it is our Internal 1092 (d) states that both “positions” (e.g., subject to intense IRS scrutiny dur- Revenue Code that gives investors this the stock position and the off setting hedge ing the past several years and the use opportunity. position) must be acquired on or after the of a swap combined with a margin Th e U.S. Congress and Treasury eff ective date (March 1, 1984) for there to loan eliminates the tax and audit risk may revamp our tax system so that be a straddle. Most tax practitioners in this surrounding PVFs. economically equivalent strategies are area point to the detailed discussion of this • Because the margin loan can be taxed the same, but that time seems a issue contained in: 1) Bradley L. Ferguson et extended under the new portfolio long way off . Until then, well-advised al., “Th e Latest Stock Hedging Regulations,” margining rules of Reg T: taxable investors should take advantage 67 Tax Notes1795 (1995) and 2) New York » Th ere are no limitations on the use of this tremendous fl exibility to choose State Bar Association Tax Section, “Report of proceeds. Th at is, just like with the hedging tool that optimizes their on Proposed Regulation Section 1.1092(d)- a PVF, the investor can invest loan tax effi ciency. 2,” 95 Tax Notes Today 199 (1995). Each proceeds in publicly-traded stocks. concludes that a reasonable reading of the » Th e amount of cash released to the Thomas J. Boczar, Esq., LL.M., eff ective-date language of Section 1092(d) is investor should exceed the amount CPWA®, CFA®, is chief executive that the straddle rules don’t apply to stock that the investor could access officer of Intelligent Edge Advisors positions acquired before the eff ective date. through a PVF. in New York, NY. He teaches the stock concentration risk manage- Conclusion ment component of IMCA’s Certified To take the CE quiz online, Investors can use a wide variety of Private Wealth AdvisorSM (CPWA®) visit www.IMCA.org.

March/April 2010 47