When Your Eggs Are All In One StockPam Black
Business owners, corporate executives, and investors who have amassed large
amounts of stock in a single company can use an equity swap to diversify their risk without selling their shares and paying capital-gains tax on the proceeds. Such swaps had previously been restricted to institutional investors looking to protect large holdings. Increasingly, however, institutions such as Bankers Trust New York and Citibank are doing swaps with high-income individuals.
Say you're the owner of a publicly traded company XYZ. Because you started the company years ago, your tax basis is low, but the stock is now worth $2 million and is a significant part of your net worth. XYZ is growing fast and has been reinvesting its earnings for expansion, so it doesn't pay you dividends.
ANNUAL FEES. You don't want to give up voting rights or control over your shares, but you would like to increase your current income and liquidity. Mostly, you want to diversify your holding without having to sell and realize a huge capital gain. An equity swap meets these requirements. You pay a fee to a commercial or investment bank and enter a contract agreeing to pay the bank the total return on XYZ shares in exchange for the return on a diversified basket of issues such as ones listed on the Standard & Poor's 500-stock index.
During the contract's term, typically three to seven years, you receive dividends from the S&P holding. When you terminate the contract, if XYZ is still worth $2 million, you and the bank are even. If XYZ went up 10%, you turn over the appreciation to the bank. Conversely, if XYZ dropped 10%, the bank is obligated to make up the difference to you.
The result is that you get current income from the S&P, and you've protected the value of your original stock for the contract period. For its trouble, the bank collects an annual fee of 1% to 3%, which comes out of the S&P return. It can also sell your stock short during the holding period. By betting against your stock, the bank makes money if XYZ falls. It will then use that profit to restore the value of your stock when the contract ends. If the price of XYZ rises, the bank's losses from the short sale are covered by the appreciation of your stock.
Because you sacrifice the upside potential of your holdings, you don't want to swap if you're confident that your stock is going to climb, says Steve Weinstein, a partner at Arthur Andersen in Chicago. "You would do it if you were worried about the risk of holding a single stock," he says, or if your current income is more important to you than stock appreciation.
HIGH VISIBILITY. Swaps are fairly complicated, and fees can vary depending on how well-capitalized your company is. The more volatile and less liquid your stock, the higher the fee, says Lisa Osofsky, director of personal financial planning at M.R. Weiser, an accounting firm in New York. And you need at least $10 million in total assets and $2 million in stock to enter the swap market.
Some caveats apply. The Securities & Exchange Commission ruled last fall that insiders--company officers, directors, or shareholders owning over 10%--must report swaps to the regulator. That report can look to outsiders as if insiders are unloading a bundle, which could be interpreted as a bearish sign, says Kevin Roach, a partner at Price Waterhouse. Thus, insiders might want to think about limiting how much stock they swap.
TAX RISK. The strategy is even better suited to noninsiders, who don't have to report the transaction. Typically that would be someone who sold a company in exchange for the acquirer's stock, a retired executive who's holding a wad of a single company's shares, or someone who has inherited a chunk of stock but who is not involved in the company's operation.
There is also a potential tax risk down the line. Some tax professionals believe that the Internal Revenue Service will make swaps taxable. Other experts say that isn't likely. "There has been a lot of jawboning about it," says Robert Gordon, president of Twenty-first Securities Corp., which specializes in hedged tax strategies. He argues that similar hedge strategies aren't considered sales for tax purposes, so there's no reason swaps should be. In the meantime, if you have a lot of eggs and they're all in one basket, an equity swap is one way to make sure they don't crack.