Diversification: Concentrated stock, selling real estate and inheritance.

Diversification events can be very dramatic, not only from a psychological perspective but also from a family financial legacy and security standpoint. The biggest diversification events, typically into the multi-millions of dollars but at least one million, require critical planning to ensure the desired outcome. Major diversification events include unwinding concentrated stock positions, selling real estate or a business and inheriting a large estate. All of our clients experience diversification events. Some are expected and others are not. Either way, you have to be prepared to make some major decisions. Great due diligence is required as these decisions will probably affect the rest of your life, and probably the rest of your family’s life too. Let’s discuss examples of what you must ponder if and when you have such a dramatic diversification event.


• You can create a substantial liquidity event with 100 percent downside protection, tax deferral and appreciation on your concentrated stock.

• Liquidity events exceeding $1 million require coordination of advanced planning strategies among your professional advisers.

• When selling your real estate or a business, keep the end in mind. If you think capital gains taxes are bad, just wait to see what estate taxes do.

We caution the reader that the following solutions are grossly oversimplified to illustrate the point. These strategies are very complicated and we advise involving your CPA and attorney before proceeding.

We’ll start with a solution to help diversify and hedge concentrated stock. This strategy can be applied to inherited stock, stock accumulated over the years or your employer company stock.

Let’s assume you have a $10 million concentrated stock position and you are interested in extracting cash while deferring taxes. Let’s also assume you wish to have 100 percent downside protection while participating in some of the stock’s growth. By executing a three year variable prepaid forward contract you would create a liquidity event for yourself to the tune of about $8.5 million, defer taxes for three years, retain the first $2 million of the stock’s gain (if the stock goes up) yet have 100 percent downside protection (if the stock drops).

The general guidelines for the ideal candidate for these strategies would be an accredited investor with $5 million or more total net worth and a concentrated position of at least $1 million. In addition, the stock should have a price of $5 per share or more; with a daily trading volume of at least 50,000 shares (some exceptions may be possible). Restricted-stock (Rule 144 & 145) holders may also qualify for these strategies. There are other strategies that can be customized and applied depending on the individual’s needs and concerns, but the one we laid out above is popular for obvious reasons.

Now let’s discuss a recent real estate sale. The transaction was worth about $8 million and the 70-plus-year-old father/owner wanted to execute a 1031 exchange to defer long term capital gains taxes and to diversify.

The father/owner of the property had purchased a large piece of land in Arizona. After a few years of holding it, a new freeway exit leading to it was built. This caused a dramatic increase in value, which in turn drove the father to decide he wanted to start receiving an income to enjoy life as well as to diversify his real estate.

His only son was not too involved in the transaction and neither the son nor the father were fully aware of the 1031 exchange (which is an effective strategy of deferring capital gains taxes) consequences when the father passed away and the son inherited the estate. If the father had known about other alternatives, he could have maximized the estate value after estate taxes and left more money to his son.

For example, a charitable remainder trust would have allowed the property to be sold with zero capital gains taxes being paid. A generous annual income (probably exceeding what the father gets now from the real estate he exchanged into) would have been paid to the father for as long as he is alive and through a wealth replacement trust the son would have received $8 million estate-tax-free. In addition, to offset the new income, the father also would have received a substantial tax deduction.

As it stands the son probably would not be subject to capital gains taxes upon his father’s death (since he’ll inherit the property at the appreciated cost base – unless tax laws change) but he will probably be subject to estate taxes, which are 45 percent in 2006. That would mean a loss of about $3.6 million to estate taxes. Another possible solution would have been a defective trust where the son would receive the property at a greatly reduced valuation and therefore save substantial estate taxes upon his father’s death.

There are usually no easy solutions to substantial diversification events which is why prudent planning is necessary. The solutions are out there. The trick is finding the right players on your team who will ensure the outcome is what you truly desire.

Christopher G. Snyder and Haitham “Hutch” E. Ashoo are principals of Pillar Financial Services in Walnut Creek. Contact them at 925-356-6780.


EBBJ Business Wise

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