Once the employee's options are exercised, how does the executive protect his or her concentrated position without violating insider trading rules or sending a signal to the marketplace that he or she is worried about the company's future? One way to work around SEC restrictions and other rules is to set up a 10b5-1 trading plan with a brokerage firm. This written plan includes a formula that will control the trading of the executive's shares over a specific period of time.
Alternatively, the executive can set up a blind trust, giving the trustee full discretion to determine how much will be sold, at what price and when. A trustee working with a professional money manager can maximize the sale price of the stock in the trust. Blind trust managers will often use the same hedging strategies to provide some downside protection during the term of the trust.
Exchange Funds
For the investor who can't bear the risk of selling his or her stock, an exchange fund may be a consideration. In such a fund, the investor commingles his or her stock position with the holdings of other investors to achieve diversification without immediately paying taxes. The trade-off is that the investment lacks liquidity, offers limited or no current income, accrues high fees and gives the investor no control over what is owned within the fund. Because these are highly regulated private placements, they are limited to only the wealthiest investors who can qualify under the SEC rules. An investment in an exchange fund usually carries a $1 million minimum. They carry no guarantee that the diversified portfolio will do better than the single stock, and, as with any technique, tax laws can change.
Charitable Giving
Another vehicle suitable for managing the taxes incurred when diversifying a concentrated stock portfolio is the charitable remainder trust (CRT). A CRT provides income to its beneficiary over the term of the trust, which is usually the lifetime of the beneficiary. In most cases, the donor is also the trust's beneficiary. At his or her death, any remaining assets in the trust are transferred to the donor's choice of charities.
Typically, the donor will create the trust to avoid capital gains taxes on highly appreciated stock, while at the same time making a meaningful donation to charity. Because the trust is tax-exempt, the trustee can sell and reinvest the trust assets without incurring taxes for the trust or the donor. Eventually, any deferred capital gains will be recognized by the beneficiary with each income payment received from the trust.
Besides deferring capital gains and receiving income from a newly diversified portfolio, the donor may receive an immediate charitable income tax deduction for a portion of the gift.
The downside of any hedging strategy is its costs and risks. The CRT is no different. The cost of valuing closely held or thinly traded stock can be as high as $20,000, and some charitable trusts require revaluation annually. Coupled with complex legal and tax issues, the very nature of this irrevocable trust can deter the investor from moving forward.