Exiting a Stock Investment
The stock market's extreme volatility during the start of the decade caused many investors who hold a single concentrated stock position with a low cost basis to explore strategies to reduce their exposure to the stock.
Investors can eliminate or reduce the risk and reward of holding a single stock by:
□ Selling the stock outright
□ Establishing a short against the box position
□ Selling call options and buying put options
□ Entering into an equity swap
□ Entering into a forward contract
□ Entering into a single-stock futures contract
Ideally, an investor holding a concentrated position in an appreciated stock would like to
□ hedge against a decrease in the value of the stock;
□ defer and eliminate capital gains tax, that is, avoid triggering a current taxable event and still qualify for a step-up in basis at death; and
□ gain liquidity—monetize the position (that is, receive in cash a substantial portion of the market value of the stock) to diversify into other investments.
Outright Sale
Selling a stock outright is clearly the easiest way to eliminate the exposure. However, because an outright sale triggers an immediate capital gains tax, investors often look for a more tax-efficient alternative.
Short Against the Box
Before the enactment of the Taxpayer Relief Act of 1997 (TRA '97) and Section 1259 of the Internal Revenue Code (IRC), commonly referred to as the constructive-sale rules, the short-against-the-box strategy (SAB) was the cheapest and most efficient method investors could use for achieving their objectives. In a SAB, the investor shorts the same number of shares that are held, creating a perfect inverse matching position.
Although the constructive-sale rules have generally eliminated the use of the SAB, it's still important to understand how it works. First, through certain forms of merger arbitrage, it remains possible for an investor to establish a SAB that should not be subject to the constructive-sale rules. Second, the SAB remains the paradigm that all financial-derivative-based hedging and monetization strategies attempt to replicate as closely as possible without violating the constructive-sale rules.
In a SAB, the investor is simultaneously long and short in the same number of shares of the same stock. The fully hedged position will earn close to the risk-free rate of return on 100 percent of its value through a short interest rebate (for example, interest that's earned on the short-sale proceeds). Because the position is fully hedged, the investor can typically borrow up to 99 percent of its value. Although there's a cost associated with this borrowing, the short interest rebate greatly offsets the cost of borrowing, making monetization very inexpensive.
Before enactment of the constructive-sale rules, the long and short positions were treated separately for tax purposes, therefore deferring the capital gains tax, and because the long shares qualified for a step-up in basis at death, an investor who kept the short against the box open until death completely eliminated the capital gains tax. Also, the SAB is specifically exempt from the straddle rules (even though economically it's a perfect straddle), so the interest expense that's incurred is currently deductible, that is, it need not be capitalized.
From a tax perspective, before enactment of the constructive-sale rules, the form of the transaction, rather than its economic substance, controlled. The constructive-sale rules focus on the economic substance, rather than the form, of a hedging transaction.
The Constructive-Sale Rules
Because of the constructive-sale rules, investors must engage in a three-pronged analysis to ensure that they use the most tax-efficient hedging strategy:
□ Can the investor establish a short-against-the-box position that avoids the application of the constructive-sale rules? If so, that's clearly the preferred choice.
□ If this isn't possible, can the investor synthetically (through derivative structures) replicate the cash flows and payoff profile of the SAB fairly closely without triggering a constructive sale?
□ Are there alternative strategies (to a short-against-the-box or derivative-based solution) that might be appropriate in a particular case?
Escaping the Constructive-Sale Rules
It's common for one corporation to acquire another pursuant to a taxfree stock-for-stock reorganization (for example, a merger). Establishing a short position in the acquirer's stock in an announced stock-for-stock merger presents an intriguing investment opportunity for investors who own an appreciated stock position in the target. If the merger closes, the investor will have backed into a short-against-the-box position that should not be subject to the constructive-sale rules.
Under the constructive-sale rules, an investor is deemed to have made a constructive sale (which is a taxable event) of an "appreciated financial position" (for example, low-basis stock) if he or she enters into a short sale of the "same or substantially identical property." The term "substantially identical" is not defined in the IRC.
An investor who owns stock of the target enters into a short sale of the acquirer's stock at a time when the deal presents considerable risk (for example, before regulatory approvals are obtained and before the shareholders approve the transaction) should not be deemed, for tax purposes, to have entered into a short sale of substantially identical property. Further, the provisions of the TRA '97 that deny the step-up in basis to certain investors who have entered into a short against the box should not apply. On consummation of a stock-for-stock merger, long positions in the target's stock are automatically converted into long positions in the acquirer's stock. Thus, if the investor starts out with a long position in the target's stock and shorts the acquirer, the end result (if the deal closes) is a short against the box in the acquirer's stock, which could be kept open for a long-term period (for example, until death).
If an investor holds an appreciated stock position in a target corporation that is involved in a tax-free stock-for-stock merger, he or she could establish a short position in the acquirer's stock before the completion of regulatory approvals and shareholder votes (that is, at a time when the transaction is not yet a "done deal"). If the deal is consummated, the investor will have established a short-against-the-box position that should not be subject to the constructive-sale provisions of TRA '97. A similar opportunity exists if the investor is long in the acquirer and shorts the target. However, additional tax issues are raised in this "reverse" arbitrage context.
Replicating the SAB: Income-Producing Collars
If the merger arbitrage strategy is not available (and, obviously, in most cases it will not be), the investor must examine what type of derivative-based strategy will deliver the desired hedging and monetization economics, as well as the optimal tax treatment. An equity collar—the type that has become known as an "income-producing collar"—has emerged as the preferred strategy because it can fairly closely replicate the cash flows of the SAB while avoiding the constructive-sale rules. By structuring a collar that has a fairly tight band around the current price of the stock, an investor can minimize (within certain limits) exposure to price movement of the underlying stock and generate positive cash flow to offset the cost of monetization while deferring and possibly eliminating the capital gains tax (by qualifying for a step-up in basis at death). To avoid qualifying as a constructive sale, an income-producing collar should be no tighter than 15 percent around the current price of the stock.
The House and Senate committee reports on the constructive-sale rules both contain an example of what they deemed a standard collar. The example uses a 95 percent put and a 110 percent call. Although the committee reports express no view on whether this collar is abusive (and would therefore trigger a constructive sale), most tax practitioners believe this example was included to give investors some practical guidance as to what type of equity collar would not trigger a constructive sale. [See H.R. Rep. No. 105-148 (1997) and S. Rep. No. 105-133 (1997).]
The cash flows of this type of collar closely resemble a short-against-the-box strategy but should not trigger a constructive sale. An important corollary is that any derivative strategy that completely eliminates both the risk and the reward of holding the stock will be deemed a constructive sale.
The Straddle Rules
The economics of an equity collar (for example, hedging and monetization) can be achieved through the use of several derivative tools. Each of these tools, however, can result in very different tax consequences, depending on an investor's situation. Investors and their professional advisers (and especially fiduciaries who might have a duty to do so) should analyze the derivative tool to ensure that it's the one most likely to minimize the investor's after-tax cost of implementing the collar. Whether or not the straddle rules of IRC Section 1092 apply is critical in the selection of the most appropriate tool.
A straddle exists when holding one position substantially reduces the risk of holding another. Because a collar substantially reduces the risk of owning the underlying stock, the stock and collar together should be treated as a straddle for federal tax purposes. Investors face two negative ramifications when their stock and collar is deemed a straddle:
□ Any loss realized from closing one leg of a straddle must be deferred to the extent there is unrealized gain on the open leg. Thus, as a collar expires, is terminated, or is rolled forward, any losses must be deferred. However, any gains are currently taxed.
□ Interest expense incurred to "carry a straddle" must be capitalized (as opposed to being currently deductible). There has been (and continues to be) spirited debate about the methodology to be applied in determining the amount, if any, of the interest expense that must be capitalized under IRC Section 263(g).
Stock Acquired Before 1984
The straddle rules should not apply to stock that was acquired before January 1, 1984. Therefore, if stock was acquired before 1984, a collar can be implemented without triggering the straddle rules. This creates significant tax-planning opportunities.
The tools. The three hedging tools that can produce the economics of a collar are options (either listed or over-the-counter), prepaid variable forwards, and swaps with an embedded collar. Single-stock futures do not allow collar-like economics. Rather, by shorting futures the investor completely eliminates the risks and rewards of owning the underlying stock. Thus, the use of single-stock futures would constitute a constructive sale.
For stock acquired before 1984, in most situations the optimal tool to hedge an appreciated stock will be a swap, with collar-like economics built into it, monetized through a margin loan. The two other possible tools—an options-based collar monetized through a margin loan and a prepaid variable forward—produce less-favorable tax consequences.
Options. Options-based collars involve the simultaneous purchase of puts and sale of calls on the underlying stock. The options eliminate the potential for loss below the put strike price and for profits above the call strike price. For example, an investor holding ABC Corporation shares that currently trade at $100 might buy a put with a strike price of $95 and sell a call with a strike price of $110 and then borrow against the hedged position (or other publicly traded securities) to monetize the position.
Prepaid variable forward. A prepaid variable forward is an agreement to sell a security at a fixed time in the future, with the number of shares to be delivered at maturity varying with the underlying share price. The agreement effectively has the economics of a collar combined with borrowing against the underlying stock embedded within it. For example, an investor holding ABC Corporation shares trading at $100 might enter into a prepaid variable forward that requires the dealer to pay the investor $88 at the start of the contract in exchange for the right to receive a variable number of shares from the investor in three years pursuant to a preset formula that embodies the economics of a collar (for example, a long put with a $95 strike and a short call with a $110 strike).
The formula would require the investor to deliver all his or her ABC Corporation shares if the price of ABC in three years is less than $95. If the price of ABC is greater than $95 but less than $110, the investor would deliver $95 worth of shares. If the price of ABC is above $110, the investor would keep $15 worth of shares and deliver the remainder to the dealer.
Swaps. A swap is an agreement between an investor and a derivative dealer with payments referenced to the price of a particular stock and covering a particular dollar amount (called the notional amount). Under a swap agreement, the investor could agree to pay the dealer any appreciation above a specified share price (for example, the strike price of the embedded short call) plus any dividends paid on the stock. The dealer in turn could agree to pay the investor any depreciation below a specified share price (for example, the strike price of the embedded long put) plus an interest-based fee on the notional amount. For example, an investor holding ABC Corporation shares trading at $100 could enter into a swap agreement to pay the dealer any appreciation above $110 plus any dividends paid on the stock while the dealer could agree to pay the investor any depreciation below $95 plus a LIBOR-based payment on $100. The investor could then borrow against the hedged position (or against other marketable securities) to monetize the position.
Deductibility of interest expense. Because the straddle rules should not apply to stock acquired before 1984, there should be no question that the interest expense incurred in return for the use of the monetization proceeds is currently deductible against investment income (for example, nonqualified dividends, interest, and short-term gains) otherwise taxed at the ordinary rate.
Because both a swap with an embedded collar and an options-based collar can be monetized through a margin loan (secured by the hedged position and/or other marketable securities), the investor will incur investment interest expense that is currently deductible against investment income with a benefit of 35 percent. With a prepaid variable forward, however, the investor cannot achieve the same favorable tax result. Instead, the investor is required to defer and capitalize the net cost of borrowing with a maximum potential benefit of 15 percent.
In the example offered for variable prepaid forwards used for stock acquired before 1984, the investor holding ABC Corporation shares trading at $100 entered into a prepaid variable forward embodying the economics of a collar (that is, a long put with a $95 strike and a short call with a $110 strike) that required the dealer to pay the investor $88 at the start of the contract. The difference between the $95 put strike (that is, the sales price) and the $88 advance is mostly the net cost of borrowing. Unfortunately, a deduction for this very real expense cannot occur until the underlying shares are actually delivered to close out the contract. Because the forward in our example has a term of three years, the deduction will be deferred for at least this period.
In addition, because the expense of borrowing is capitalized into the forward price, the value of the deduction is slashed from the ordinary rate to 15 percent. Assume that three years from now the price of ABC is less than $95 and that the investor decides to physically settle the forward by delivering shares to the dealer. The investor would then be taxed on the difference between the advance received up front ($88) and his or her basis in the stock that was delivered. That is, the investor is not taxed on the difference between the sales price ($95) and the amount received up front ($88). If the investor had held the stock for a sufficiently long period before entering into the forward, the benefit of the deduction would have been dramatically reduced.
Tax disadvantage of swaps. Swaps have one slight potential tax disadvantage. Any payment received during the swap's term (whether an up-front payment or one received periodically) will be deemed ordinary income currently subject to tax. However, the only payment that the investor would be scheduled to receive (periodically) from the dealer during the term of the swap would be an interest-equivalent LIBOR-based fee based on the notional amount.
Proposed regulations. As discussed under "Deductibility of Interest Expense" above, the proposed regulations published by the IRS in January 2001, with respect to the straddle rules would change the ground rules for hedging stock acquired after 1983. These proposed regulations should not, however, in any way affect stock that was acquired before 1984.
Settling the collar. When it comes to settling an existing collar and rolling into a new one, if the stock price decreases, swaps with an embedded collar, options-based collars, and prepaid variable forwards are afforded essentially the same tax treatment. A decrease in the price of the stock below the put strike should create long-term capital gain, assuming the long-term holding period was met. Conversely, an increase in the price of the stock above the call strike should produce an ordinary deduction if a swap is used, a short-term capital loss if an options-based collar is used, but only a long-term capital loss if a prepaid variable forward is used.
In the example used for variable prepaid forwards, the investor holding ABC Corporation shares trading at $100 entered into a prepaid variable forward embodying the economics of a collar (that is, a long put with a $95 strike and a short call with a $110 strike) that required the dealer to pay the investor $88 at the start of the contract. Assume the stock increases to $200 at the expiration of the contract. Most likely, the investor will sell $90 of the underlying stock to fund the settlement obligation, assuming the investor wishes to roll into a new forward. If the investor has achieved a long-term holding period on the shares that were sold and those shares have a zero basis, the investor will recognize a $90 long-term capital gain. Under the netting rules for capital gains, the $90 long-term capital loss must first offset the $90 long-term capital gain. Here the $90 long-term capital loss cannot be used to offset other short-term gains or ordinary income that the investor might have generated. Thus, the value of the loss is only 15 percent.
Swaps receive more favorable tax treatment than prepaid variable forwards should the stock price increase above the embedded call strike. All payments made or received under the terms of a swap agreement should generate either ordinary income or loss. However, a termination of a swap agreement should generate either capital gain or ordinary loss. Thus, with proper planning an investor using a swap should be able to recognize either capital gain or ordinary loss.
For instance, if the underlying stock declines in value below the embedded put strike, the investor could terminate the swap before its stated expiration date, creating a long-term capital gain. However, if the stock increases in value above the embedded call strike, the swap could be allowed to run until its stated expiration. The resulting loss is treated as an ordinary loss that is deducted against ordinary income, which otherwise would have been taxed at the 35 percent ordinary rate.
Again, to be deductible, the loss on the swap plus all of the investor's other itemized deductions must exceed 2 percent of the investor's adjusted gross income (AGI). After this hurdle is met, the deductible amount is reduced by 3 percent of the taxpayer's AGI. The deduction is also disallowed for alternative minimum tax purposes. Therefore, if the stock price exceeds the embedded call strike near the swap's expiration, the investor must determine whether it's better to generate an ordinary deduction, subject to these limitations, or a long-term capital loss. The swap affords the investor this choice.
An investor who uses a swap should never be worse off than if he or she had used a prepaid variable forward. That is, if the 2 percent and 3 percent AGI limitations on miscellaneous itemized deductions prohibit the investor from receiving the full benefit of the ordinary deduction, he or she should simply terminate the swap before its stated expiration date and recognize a long-term capital loss, which is the same as if a prepaid variable forward had been used. Put another way, a swap should deliver only a potentially better result (never a worse result) than a prepaid variable forward.
Swaps: the superior tool. Swaps appear to be the superior tool for hedging and monetizing stock acquired before 1984. If the underlying stock depreciates in value, the gain on the swap should be long-term capital gain. If the stock increases in value, the loss on the swap can be ordinary or capital, whichever is more beneficial to the investor. In addition, because a swap is monetized through a margin loan, the investor will incur investment interest expense that is currently deductible against investment income. Options-based collars and prepaid variable forwards produce less-favorable tax treatment.
Options-based collars receive essentially the same treatment as swaps if the underlying stock decreases in value, and because monetization occurs through a margin loan, the investor will incur investment interest expense that is currently deductible against investment income. However, options receive less-favorable treatment than swaps if the stock increases in value (that is, no ordinary deduction is possible). Prepaid variable forwards receive essentially the same tax treatment as swaps if the underlying stock decreases in value, but receive less-favorable treatment if the stock
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