Creating tax efficiency for a highly appreciated stock position

• Stock protection funds wed modern portfolio theory to risk pooling/insurance.
• Such funds provide downside protection akin to that of at-the-money or slightly out-of-the-money European-style put options, but at a fraction of the cost.
• They also allow investors to retain full ownership of their shares.

Many corporate executives, investors and trusts own highly appreciated stock positions that they don't wish to, or can't, sell. Ideally, they'd like to preserve unrealized gains at a reasonable cost, retain all upside potential, avoid adverse tax consequences and, for company insiders, avoid triggering a reportable event.

Investors can utilize equity derivatives such as puts and collars to mitigate company-specific risk, but they are costly and, therefore, not practical to use uninterruptedly for a prolonged period. Investors can use exchange funds to diversify on a tax-deferred basis, but not to protect shares they wish to keep. The use of either causes a reportable event for company insiders.

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Stock protection funds (also called protection funds) are a marriage between modern portfolio theory and risk pooling/insurance that may help such investors. MPT demonstrates that, over time, there will be substantial dispersion in individual stock performance. Risk pooling makes it possible to cost-effectively spread similar financial risk evenly among participants in a self-funded plan designed to protect against catastrophic loss. By integrating these key principles, protection funds provide downside protection akin to that of at-the-money or slightly out-of-the-money European-style put options, but at a fraction of the cost.

Protection funds permit investors to retain full ownership of their shares, including all of their stocks' upside, while mutualizing only their stocks' downside risk. Investors, each owning a stock in a different industry and seeking to protect the same notional value of stock, contribute a modest amount of cash (not shares, which they can continue to own) into a fund that will terminate in five years. The cash is invested solely in U.S. Treasury bonds that mature in five years, and upon termination the cash is distributed to investors whose stocks have lost value (on a total return basis).

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Losses are reimbursed using a "reverse waterfall" methodology until the cash pool is depleted. If the cash pool exceeds the aggregate losses (70 percent probability), all losses are eliminated and the excess cash is returned to investors. If, on the other hand, the aggregate losses exceed the cash pool (30 percent chance), large losses are substantially reduced.

The shares being protected are not touched. Investors can continue to own their shares, or they can sell, gift, pledge, borrow against or otherwise dispose of them at any time during the five-year term of the fund.

Protection funds are tax-efficient, as the constructive sale, straddle and dividend holding period rules don't apply; therefore, any gain is long-term capital gain, any loss is currently deductible, and dividends remain "qualified" and taxed as long-term capital gain. For company insiders the use of a protection fund does not cause a reportable event, and company executives and employees can use a protection fund to protect both stock and stock-linked compensation, such as restricted stock units, nonqualified stock options, incentive stock options or an employee stock purchase plan.

Public companies could offer this protection to key employees as an additional component of its executive compensation plan.

With the stock market setting record highs and interest rates steadily ratcheting up, a protection fund may be helpful to certain investors, specifically those committed to the continued ownership of some portion of their stock position as a core long-term holding — to cost-effectively and tax-efficiently preserve their unrealized gains while keeping all upside potential.

— By Tom Boczar, CEO of Intelligent Edge Advisors