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| Decision 2004 |
When the Levies Break
Dwight Cass
09/01/2004
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In a case like this,
selling a concentrated position and redeploying capital into more liquid and
diversified assets makes sense, apart from tax implications, says Wes French,
executive vice president at Wilmington Trust in Atlanta. If we can do so under a
lower-tax regime, all the better, French says, but that is always a secondary
consideration.
Hedging one of these positions is an alternative to selling
outright; it essentially postpones the sale. If we want to hold onto the
position for personal reasons—say, we wish to remain involved in a company we
founded—or we have agreed to a lock-up period and are unable to sell, then
hedging the positions to avoid the risk of a serious capital loss certainly
makes sense. However, if we hold the positions purely for their investment
potential, hedging them may prevent us from diversifying our portfolio, and
postponing a sale exposes us to the threat of higher tax rates.
Selling
outright is also cheaper and easier than hedging. The market’s recent volatility
has pushed up the prices of the derivatives used to hedge stock positions,
making many of these techniques costly, notes Holly Isdale, managing director
and head of the private banking advisory group at Lehman Brothers in New York.
Also, if we are company insiders, it is often easier to explain to other
shareholders and the public that we need to sell for tax reasons, or as part of
our estate planning, rather than to explain why we are hedging against a decline
in our own company’s fortunes.
We may also want to consider the effect of
higher taxes on the market’s performance, and by extension, the valuation we may
be able to secure for our shares, according to Robert Elliott, senior managing
director at Bessemer Trust in New York. Tax increases can hurt investor
confidence—although this is not always the case, as the rally after the Clinton
tax increases showed. “Our recommendation used to be that our clients should
hedge some part of their position, using prepaid forwards, exchange funds or
other mechanisms,” Elliott says. “Now we are advising clients to sell the
positions, or sell at least part of them, through some type of disciplined
program.” Bessemer still prices collars and prepaid forwards for clients, though
usually on a tactical basis as a bridge to a sale that is already planned, he
notes.
Real Estate Those of us with significant concentrations of wealth in real
estate, like those with concentrated stock positions, who want to diversify into
other asset classes, may want to act now to avoid the risk of higher capital
gains taxes. Also, depending on our age and goals, there may be strong economic
reasons to consider diversification. “I have several clients who are real estate
developers in their mid-50s, [who have been] rolling cost basis from one
property to another,” French notes. “If you are looking to change the risk
profile of your asset allocation by switching into stocks and bonds, then it is
a good idea to do so now.” REITs are offering developers attractive prices for
properties; there is also the worry that real estate prices may have plateaued
in some markets. In light of those concerns, a more diversified portfolio can
look more attractive. Carter agrees. “It’s a great opportunity for people to
take large nonincome-producing assets and convert them into some kind of
income-producing assets,” he notes.
Options and Compensation Like
Norman Brinker or Michael Eisner in 1992, many of us have a great deal of our
wealth held in the form of vested, in-the-money stock options. If we fear that
income taxes will rise, it makes sense for us to exercise these options sooner,
rather than later, Nersesian says. “Whether they sell the stock or hold it, the
IRS takes its pound of flesh at the time the option is exercised. If we believe
that tax rates are potentially heading higher next year or down the road, it may
make sense for investors who have options, and specifically those that are maybe
approaching their lapse date, to consider an exercise currently with a maximum
rate of 35 percent versus an exercise down the road at a higher rate,” he
argues.
There is an important caveat about options: These instruments are,
by their nature, leveraged investments—they usually rise or fall in value more
rapidly than the underlying stock. This can be a boon, as long as we understand
that the leverage increases both our potential return and our potential for
loss. When we exercise options, we give up that leverage advantage, Bank of
America’s Goldsbury notes.
We may also want to consider accelerating the
receipt of other income. We may want to ask our employer to pay our bonus in
December, rather than January, or we may want to offer our clients a discount to
settle our invoices in the fourth quarter, rather than in the first. However,
since we do not know which taxes will rise, or by how much, it is difficult to
decide how much in-come to forgo. “In this case, there is not a terribly strong
indication that ordinary rates will go above 35 percent,” notes Bill Baldwin,
president of Pillar Financial in Waltham, Mass. “I don’t have the sense that
anyone is rushing to accelerate income into this year.”
Charitable Contributions Income taxes may also affect the economics of our
charitable donations. “For the investor who is considering making a significant
charitable contribution to his alma mater, or to build a wing at the hospital,
we’d suggest that he consider delaying,” Nersesian notes. “A charitable
contribution today, in a world of 35 percent marginal tax rates, is less
valuable than a charitable contribution next year or the year after, if tax
rates were to rise to 40 or 50 percent.”
Illustration by Matt Mahurin.
Additional Information
 Paying
for Lunch
 Taxing
Decisions
 Golden
Oldies Back in Vogue
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