With the stock market at record heights, many investors own highly appreciated stock. With the federal capital gains tax rate almost 60 percent higher than just a few years ago and the possibility of tax reform in the air, many investors would like to lock in their substantial unrealized gains while deferring the capital gains tax to take advantage of a (hopefully) lower tax rate in the near future.
At the same time, many firms and their advisors are operating under a fiduciary standard. Even if a firm and its advisors are not (yet) operating under a fiduciary standard, if they hold themselves out as “expert” in a certain area, they will nevertheless be held to a fiduciary standard. Within the discipline of single-stock concentration risk management, a perusal of firm websites quickly reveals it’s hard to find a wealth management firm that does not claim expertise in this complex niche. That said, as fiduciaries, these firms and their advisors have the duty to do what’s best for their clients.
By far, the most common way for investors to protect their highly appreciated shares is to employ a “collar” implemented with exchange-traded (listed) options. For instance, Investor, a California resident, owns 100,000 shares of ABC Corp. stock currently trading at $100 per share. Investor has a very low tax-cost-basis (almost zero) and wishes to lock in the unrealized gains on his $10 million ABC stock position, and defer the capital gains tax into a hopefully lower tax environment as a result of tax reform legislation, and perhaps hold the shares until death to eliminate the capital gains tax as a result of the step-up in tax-cost basis. Investor sells call options with a strike price of $105 for $1 million, and uses the proceeds to purchase put options for $1 million with a strike price of $90. By using this “cashless” collar, Investor is protected should the stock price fall below $90 and forfeits any appreciation above $105.
At the expiration of this 18 month collar, ABC stock is trading at $102 per share. Therefore, both the put and call options expire worthless. Investor earned $1 million by selling the calls, and used those proceeds to buy put options that expired worthless. It logically appears that Investor should have $1 million of income and an offsetting $1 million of expense.
However, the tax straddle rules of the Internal Revenue Code dictate a different result. Because Investor utilized exchange-traded options, there were two contracts involved (one for the sale of calls and another for the purchase of puts). The combination of the stock and long puts constitutes a tax straddle, as does the combination of the stock and short call options, and the tax implications to Investor are onerous.
Investor certainly did not earn any “economic income” from the collar transaction—he earned $1 million by selling the calls, and used it to buy puts with a cost of $1 million, which expired worthless. Nevertheless, because the straddle rules apply, Investor is deemed to have earned $1 million of “phantom” income taxed as short-term capital gain.
As a California resident, Investor’s phantom income is subject to the federal 39.6 percent short-term capital gains tax rate and the 3.8 percent Medicare contribution tax, as well as the 13.3 percent California tax, for an “all-in” tax rate of 56.7 percent. Tax-adjusting the California rate for the federal deduction for state and local taxes paid, Investor’s all-in effective tax rate is 51 percent. Therefore, Investor owes a capital gains tax of $510,000 on the $1 million of call premium he received.
Unfortunately for Investor, although he’s incurred a capital loss of $1 million on the purchase of the puts, because the straddle rules apply, the capital loss is not deductible against his $1 million capital gain. Rather, the loss is deferred (effectively increasing the tax-cost-basis of his shares). Since Investor has such a low-cost-basis, he might hold the shares until death to benefit from the step-up in tax-cost-basis that occurs at death. In that event, the capital loss on the put option purchase would never be utilized. Rather, the result in such case would be simply less tax forgiven at death.
Prior to the financial crisis, exchange-traded options and over-the-counter (OTC) equity derivatives traded at approximately the same level, with perhaps a slight nod going to OTC derivatives. However, subsequent to the financial crisis, exchange-traded options have become somewhat less expensive than OTC derivatives, and have emerged as the tool du jour for advisors and investors wishing to implement collars. As fiduciaries, we need to ask ourselves, does this really make sense for most investors?
In our example, Investor’s “phantom” income—a result of the application of the straddle rules—easily could have been avoided if instead an OTC derivative had been used. More specifically, in the OTC market, a collar can be structured as a single contract (which is not yet possible with exchange-traded options), such that the premiums of the embedded puts and calls “net” for tax purposes. Therefore, in our example, although the stock and OTC derivative would have also constituted straddle, Investor would not have triggered a taxable event, and would not have incurred $1 million of phantom income subjecting him to an unnecessary $510,000 tax bill.