Many investors find that their portfolio sometimes develops an outsized concentration in the stock of a single company. They may have received shares as compensation through work, inherited the shares or simply made a fortunate early investment in a successful company. While there are circumstances in which such concentrated holdings can generate great wealth, there are also circumstances in which they can leave you with outsized losses that undo much of the work involved in building the portfolio up in the first place.
Take, for example, senior executives within industries that have been disrupted by technological change over the past several decades. Because executive compensation is largely centered on awards of shares and options on shares of their employer, they may have built sizable equity positions in their companies. However, the failure of certain companies to be able to adapt to the rise of new industries capitalizing on these technologies tends to hit the share prices of these incumbent companies hard, sometimes leaving crippling losses. For executives with large amount of their net worths concentrated in the stock, this disruptive change threatens very consequential losses that can put their financial goals in jeopardy.
While this example may represent the more extreme end of “what could go wrong” type scenarios, idiosyncratic risk that can affect single stocks independently of the broader market can add substantial risk to a stock portfolio that has significant concentration to individual securities. And the drawbacks of such concentrations are not limited to potential losses in the portfolio. For example, if the stock performs well, that may make it even more difficult to manage the portfolio or access the funds, given that any sales may trigger extremely large income tax liabilities, as they will typically owe income taxes on the difference between the price at which they acquired the shares and the price at which they sold.
Fortunately, there are strategies that can help you successfully diversify out of a concentrated position without triggering large tax liabilities even when there are significant unrealized gains. Here are four:
1. Equity exchange funds offer qualified investors1 a tax-deferred option, allowing them to place a stock that has gained significant value into a pooled vehicle with other investors in similar situations. Each investor can receive interests in the exchange fund, representing a proportional share of the newly created, diversified basket of securities with the goal of providing immediate diversification without incurring immediate capital gains taxes.
The downside to exchange funds is limited liquidity. If you hold the interests for seven years, you can withdraw your share of the pool, with unrealized gains allocated pro-rata over the entire portfolio. However, if you withdraw early, you’ll likely face hefty fees.
2. Tax-loss harvesting with separately managed accounts allow investors to employ a staged diversification strategy that may reduce the net capital gains of a concentrated stock or security position over time for federal income tax purposes. The investor can “harvest” unrealized investment losses in one account to offset net capital gains from the sale of concentrated stock or securities in another account, potentially reducing the federal income tax liability generated by those sales.
3. Giving shares to family members using annual federal exclusions and lifetime gift tax exemptions offers diversification and an opportunity to support loved ones. For 2024, the annual federal gift tax exclusion is $18,000 per individual or $36,000 per married couple who elect to split gifts. The lifetime estate and gift tax exemption is $13.61 million per individual or $27.22 million per couple.2,3
4. Donating shares to charity is an option for investors looking to combine their philanthropic intentions with opportunities to minimize taxes.
- Donor-advised funds (DAFs) are accounts held by public charities to which you can donate and receive an immediate federal income tax deduction, and which hold the donated assets until distribution to the ultimate charitable recipients. You can recommend how the DAF invests the donated assets, and those assets can stay invested and potentially grow, tax-free, until you direct which charities you want to receive a cash donation. You can name a successor to recommend investments and grants after your death.
- Charitable gift annuities are annuities offered by some public charities. You transfer assets to the charity in exchange for an annuity interest for yourself or someone else. The charity invests the assets and retains anything not used to satisfy the required annuity payments. You may receive an immediate federal income tax deduction for the value of the property donated, less the value of the annuity interest.4
- Charitable remainder trusts are irrevocable trusts in which you retain an income interest (or give the income interest to someone else) for life or for a term of up to 20 years. At the end of the trust term, the remaining property goes to charity. You may receive an immediate federal income tax deduction for the present value of the charitable remainder interest.5
- Pooled income funds invest your donation alongside those of other donors. You (or someone you designate) will receive an income stream for life, after which the remainder of your donation will be transferred to charity. You may receive an immediate federal income tax deduction for the present value of the charitable remainder interest.
Taking steps to manage a concentrated position can help you avoid additional risks in your portfolio. A Morgan Stanley Financial Advisor can help you determine which strategies may be most beneficial for you. Your Financial Advisor or Private Wealth Advisor has access to Morgan Stanley’s Total Tax 365 solutions to help you implement a tax-smart strategy that’s tailored to your unique financial goals. To learn more, request a copy of the Global Investment Office primer, Managing a Concentrated Stock Position.
