What to Do about Low-Basis Stock
As the Dow Jones industrial average hovers near record highs, some investors may find themselves "stuck" in a portfolio concentrated in a single low-cost-basis stock. The investor might be a retired executive of a public company who received the stock as compensation over many years. Or, the stock may have been received as a gift from a relative or acquired in a merger or acquisition. Alan D. Glatt, an investment advisor in the private client services group at Morgan Stanley and Co. in New York City and Darya B. Allen, CPA, a tax specialist for Morgan Stanley's private client services group, explain some of the options CPAs can offer clients for handling this problem. While owning a substantial amount of any stock should not be a problem, the "opportunity cost" of maintaining a portfolio concentrated in a single stock - what you forgo by letting the funds remain undiversified - must be considered. Even if the stock has appreciated, is it smart to allow the bulk of a client's net worth to be exposed to the market forces that can affect a single stock? A client who owns 400,000 shares of one stock, for example, can see his or her net worth change by $400,000 with only a $1 change in the stock's price. Such investors also may be missing the higher returns they could earn through diversification. The most straightforward strategy is simply to sell the appreciated stock. However, clients will then have to pay taxes on the capital gains. This may be the wisest strategy depending on the client's holding period and tax bracket. But although many would rather wait for a possible capital gains tax cut, they still don't want to leave their portfolios exposed to market fluctuations. Some advisers are suggesting that clients seek alternatives to free up cash now and realize the gains later. TRUSTS Low-basis stock often is held in trust - for example, a trust funded with gifts of stock over many years. Trust assets can present a particular problem because trustees are inclined to invest conservatively and are reluctant to sell assets that require the payment of taxes. Trust assets often remain in the same stock that created the trust for generations because trustees fail to consider the best aftertax investment alternatives available. Trusts are taxed at a top marginal tax rate of 39.6% on income in excess of $7,650. While a trust is responsible for tax payments, trustees are responsible for the growth and preservation of the trust assets. In many states and under some trust agreements, trust assets can be managed as "prudently" as an individual investor would manage his or her own portfolio. (This is known as the "prudent man" rule.) Yet trustees who invest their own assets in balanced portfolios - carefully managed at yearend to match gains and losses - will leave trust assets in the single stock of an industry in decline or let large loss positions remain open rather than sell the stock. SOLUTIONS It is difficult, and sometimes costly, to diversify stock holdings without realizing gains. Yet the potential returns can make it worthwhile. For example, a retired executive who had a large part of her compensation paid in stock may be anxious to diversify out of an industry that had a difficult year and faces hard times in the future. Should she wait for a capital gains tax cut? Probably not. This same client may want to continue to own stock in her former employer but still seeks protection against the downside risk. The securities industry has devised solutions to help investors deal with such problems. Some possible strategies are * A long-term "short-against-the-box" transaction. * A swap into an index fund - a custom-tailored basket of securities traded over-the-counter or a standard index such as the Standard and Poor's 500, the S&P 100 or an international index such as the Nikkei index. * A "zero-cost" collar. Note: A glossary of investment terms appears opposite. …