Hedge Your Stock
Hedge your stock using derivatives to (quite literally) buy yourself time.
Strategy Overview
The sale of stock is what triggers a taxable event. But when a company is publicly traded, financial instruments called derivatives frequently exist (and are traded on stock exchanges daily) that can allow you to manage (hedge) some/most of your investment risk without selling your stock.
For individuals with concentrated stock positions, derivatives can be utilized to help "buy time" by offloading some/most of the investment risk for a period of time into the future. In certain situations, using derivatives to defer a sale for months/years into the future may provide significant tax benefits.
If you're currently employed by the company you own stock in, your company's trading policy very likely prohibits hedging. Nearly all companies disallow their employees to trade in derivatives. It's worth checking (we know of 1 company who does allow derivatives trading), but its quite uncommon.
Hedging stock is more frequently an investment strategy versus a tax strategy. But as this page is dedicated to tax strategy, we detail the relevant ways hedging can be used to manage your taxes (versus focusing on the investment parts).
Tax Details
When you sell stock, it triggers capital gains tax in the year of sale. The rate at which these gains are taxed depends on how long you've held the asset and where you live:
Short-term capital gains apply to assets held less than a year and are taxed at ordinary income rates, which can be as high as 37%.
Long-term capital gains apply to assets held over a year and are taxed federally at preferential rates that cap at 20%.
The Qualified Small Business Stock tax exclusion can also apply in rare situations.
Some states also assess tax on capital gains.
Using derivatives (mainly publicly traded "call" or "put" options) to "buy time" can help you offload some/most of the investment risk for a period of time into the future. If deferring a sale for months (or possibly years) into the future would provide a significant tax benefit, derivatives may help you accomplish that. The most common situations where this may apply are: (1) achieve long-term vs. short-term capital gains; (2) achieving a qualifying ISO disposition; (3) achieving QSBS treatment; and (4) Relocating to a new (lower tax) state in the near future.
Implementing a derivatives strategy can have a cost, or be mostly/completely neutral to you--largely depending on the strategy and how much investment risk you are trying to protect against. This cost and the amount of investment risk it offsets should be considered relative to the anticipated tax savings to determine which strategy (if any) makes the most sense to pursue.
Hedging Your Stock Exposure: Three Common Strategies
When hedging stock for tax purposes, there are three strategies that are primarily used (detailed below). When implementing any of these, it is important understand and adhere to IRS rules so that you do not trigger a "constructive sale".
1. Buy a Protective Put
A protective put strategy involves paying money to buy put options on your stock (very likely at a price below the current market price). You need to pay money to buy the put options. And that makes sense because the puts provide you with protection against downside risk (and you still have unlimited upside potential).
2. Sell a Covered Call
A covered call strategy involves selling call options on your stock (very likely above the current market price). Selling calls (1) provides you with money (i.e. this is a cash inflow), but (2) you've sold away upside on the stock at/above a specified price. The income you receive from the sale provides a partial hedge for downside risk, but not a lot, and you've sold away your upside potential
3. Collar Strategy
A collar strategy involves combining both of the above; functionally providing both a "floor" and "ceiling" for your stock price. To implement a collar, one (1) buys a protective put to cap downside risk and (2) sells a covered call to cap the upside potential.
Depending on the price points chosen, a collar strategy can result in a net cash inflow (sale of the call > cost to buy put); be cash neutral (call = put); or requite a cash outlay (sale of call < cost to buy put)
Key Benefits
"Buying time" until a more tax-optimal selling date. Hedging your stock allows you to defer the sale of a position to a future period without some/most of the invest risk. Depending on your situation, deferring the sale until a future date may result in significant tax savings.
Key Considerations/Flags
IRS "constructive sale" rules limit how much downside protection is allowed. It's important to be aware of the IRS "constructive sale" rules when implementing a hedging strategy. These rules limit how much downside protection you can obtain without triggering a taxable event. You'll need to strike a balance between achieving adequate protection and avoiding a premature tax bill.
Premiums paid for options reduce capital gains and cash available upon sale. While options contracts can provide valuable protection, they can come at a cost. The cost paid to purchase put options eats into your gains and reduces your cash holdings.
Opportunity cost of deferring sale and not reinvesting proceeds for potentially higher returns. Deferring the sale of your stock options means you're also deferring the opportunity to reinvest those proceeds elsewhere. It's important to weigh this opportunity cost against the potential benefits of a hedging strategy.
Strategy: When to Consider This and When to Avoid It
If selling your stock in the future (vs. now) would provide considerable tax savings, but you're uncomfortable with, and/or believe it is unwise to take on, the investment risk of waiting to sell.
If you do not anticipate that your applicable tax rate on the sale of stock would be materially lower at some point in the next couple years.
If the cost and/or risk of hedging does not justify the tax savings.
If the investment risk of the hedging strategy would be unacceptable to you.
Example
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