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2013, Study Session # 4, Reading # 13

LOW-BASIS STOCK
EF = Exchange Funds
1. DEFINING THE PROBLEM

Basis price that serves as the basis for the computation of capital gains
(might be different from the initial cost).

Low basis holdings in an individual portfolio may arise through:

Entrepreneurial success:

Significant shares in a founded company.

Cost equals to original investment in the venture.

Executive success:

Usually through equity compensation.

Value of these holdings may have risen substantially above the cost.

Investment success:

Portfolio comprising of several substantially appreciated securities.

Challenges while dealing with low-basis holdings:

Psychological attachments.

Investment issues (e.g. risk return tradeoff & taxes).

2. UNDERSTANDING STOCK RISK

Market Risk Specific Risk Residual Risk

Affect all securities.
Security specific. Counterparty Risk Regulatory Risk

Cant diversify away.
Can be diversified away.
Risk due to Risk that tax
dependence on a authorities may
counterparty to reject a tax
complete a treatment chosen.
transaction

Stages of Equity Holding Life

Entrepreneurial Stage Executive Stage Investor Stage

Very high specific risk.

Single security dealing.

Immature company.

The investor enters the
Multi security portfolio.
executive stage once the
Two stages:
business is public.
Diversified investor stage.

Specific risk is somewhat lower
Indexing stage.
but still high.

Less diversified equity holdings.

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2013, Study Session # 4, Reading # 13

3. APPLYING THE MODEL TO INDIVIDUAL CIRCUMSTANCES

The Entrepreneurial Stage The Executive Stage The Investor Stage

No diversification desire.
Diversification desire is linked to
Investor strongly requires

Look for ways to minimize the degree of control. diversification.
transfer costs.

The individuals position in the
Advisor should focus on
organization,
specific risk investors psychology.
tolerance.

4. REDUCING A CONCENTRATED EXPOSURE

Two fundamental strategies.

Financial strategies.

Charitable strategies.

Financial Strategies

Outright Sale Exchange Funds

Simple & often most expensive. Public EF Private EF

Capital gains tax.

Maximum flexibility.

Eliminates all residual risks.
Partnership for a minimum of seven years.
Usually involve a single security.

20% illiquid assets.
Investor or investors with concentrated

Each partner receives proportional low basis stock positions join partnership
distribution. with an unrelated party who buys the

Shortcomings: same holdings.

High management cost.
Benefits:

Lack of control.
Create opportunity to borrow.

Inflexibility.
No exposure to illiquid assets.

Flexibility.

Completion Portfolios Hedging Strategies

Utilized by investors with other, liquid assets in addition to the
Law often prohibits constructive sale (offsetting position).
large low-basis position.
Illiquid portfolios can be effectively monetized.

Investors goal is to reach a desired target portfolio (e.g. index).

Tax loss harvesting to shelter the capital gain realized each time
any low-basis stocks is sold.

May be time taking strategy.

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2013, Study Session # 4, Reading # 13

Two Alternatives

Pure Hedging Strategy Pure Monetization Strategy

Protect gains & let profits run.
Get the money out of a position

Reduce or eliminate downside (without taxable event).
risk
Reinvesting proceeds in a
desired way.

Equity Collars Variable Prepaid Forwards

Buying put selling call option.
Forward sale of a contingent no. of low cost basis

Principal requirement no constructive sale. shares in exchange for advance cash today.

Collar may have +ve, zero or negative cost.
No constructive sale requirement.

Collar sets the minimum value (serve as collateral), so
monetization is easy.

5. SUMMARY AND IMPLICATIONS

Useful for investors & advisors to

think in terms of diversification

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