Prepaid Variable Forward: A Great Way to Diversify Without Paying Taxes

Do you have a portfolio that is too concentrated in one stock? Are you thinking about diversifying your stock portfolio to lower your risk, but worry about the broker’s fees and capital gains taxes you’ll pay if you sell them? There is a better alternative to simply selling your stocks, paying capital gains taxes, and then diversifying with the proceeds. It’s called a Prepaid Variable Forward or PVF strategy.

Investors love flexibility!  Having control over your investment choices and the freedom to take appropriate action is essential to any solid investment strategy. All too often, this is forgotten.  Some investments even intentionally strip the investor from this flexibility by charging high fees or locking clients’ funds up for a period of time.  Investments like this are typically designed to benefit the broker more than the investor. 

Individual stocks are typically considered to be incredibly flexible.  However, now more than ever, many investors feel like they have very limited options when it comes to their otherwise liquid stock positions.  While the financial markets are continuing to make all time highs, most investors find themselves with large gains and potentially huge tax consequences.  More and more, we are meeting investors who feel “trapped” in these positions.

PVFs offer an alternative to investors looking for a tax-friendly diversification option.  According to Robert Wood in Forbes Magazine:

“…When you sign a prepaid forward contract and receive money, you enter a contract to sell a portion of your stock sale proceeds or lawsuit recovery later. A forward contract calls for a future sale. During the time between signing and closing the sale, the upfront cash is like a tax-free deposit. If a prepaid forward contract meets certain requirements, it provides cash to the seller with no immediate tax, just like a loan. “ 

Consider the Following Case Study

John and Joan Smith invested a modest amount of their portfolio into Apple and Microsoft stock years ago.  At the time, their original investment was a modest percentage of their overall investment portfolio.  Over time their investment portfolio has grown, but their position in Apple and Microsoft now makes up a substantial portion of their investments.  

They are now older and closer to retirement and feel the need to diversify.  They still love Apple and Microsoft stock, but are worried that they have too much of it.  These stocks have been great investments and they aren’t quite ready to sell them completely.  Selling these holdings would result in a substantial capital gains tax and they are reluctant to pay a lot of taxes to sell one of their favorite investments.  Still, they are a bit worried that they have too much exposure and don’t want to make investment mistakes this close to retirement.  How can they…

1. Protect themselves from a potential downside correction and reduce their risk of these concentrated positions?
2. Continue to participate in these stocks’ future growth?
3. Monetize the position’s value so they can invest into other diversified holdings?  And finally…..
4. Defer or avoid paying taxes?

Have questions about alternative investments? Let’s talk! Schedule a no-sales conversation with the team at Watts Gwilliam and Company to see how we can help.

How does a Prepaid Variable Forward Contract Work?

1. John and Joan would pledge or place their shares with an investment bank and enter into a contract that could result in them selling the shares at a future date. They would receive a percentage of the stock value in cash (typically 75-90% ). 
2. Because the transaction is not finalized until the contract matures, there are no taxes due at this point. 
3. Until the end of the contract, John and Joan retain their stock’s voting rights and dividends.
4. John and Joan are free to invest this cash in a more diversified portfolio or use the cash for any other need they might have. 
5. When the term of the contract is over, they can settle it by turning over the shares or rolling the PVF into another contract that can effectively defer the taxes on any sale of stock even further. They can continue to roll the PVF over several years if they want to continue to defer taxes over time.

Doing a PVF can offer tremendous advantages over simply selling and paying taxes!

Elements of a Prepaid Variable Forward Contract Should be Carefully Set

John and Joan would need to decide on the following to create a PVF Contract:

1. Set a Maturity Date and Number of Shares 
2. Create an Equity Collar –  this includes a Floor Price (PUT option) and a Cap Price (CALL option) on the final transaction, both options based on current share price. This limits John and Joan’s risk if stock price falls below the Floor Price, but could limit their potential gains as well.
3. The Equity Collar and shares secure the loan.
4. Set Financing Terms – this typically sets the amount of the Cash Advance, Finance Interest Rate, and Total Costs for the contract.

If you are an executive who owns a large number of shares of company stock, you can delay taxes on capital gains using this strategy.  If you are holding stock options you would like to cash in, you can time the PVF maturity to align with your option exercise date.  The PVF strategy could be a great choice in both these cases.

Bottom Line – Get Professional Advice

This is a complex transaction that is best managed by your financial advisor. The potential for tax savings and a diversified portfolio is exciting, but your contract should be structured to protect your assets as well as shelter your tax liability.  Consult a financial advisor in Gilbert, AZ who provides individualized wealth management advice.

Watts Gwilliam and Company is a fee-only, fiduciary financial advisory firm headquartered in Gilbert, Arizona that serves investors nationwide. Our firm was established to provide a conflict-free environment that’s dedicated to our clients’ success. We provide innovative investment and financial planning strategies to help you build wealth, generate income and secure your future. Our specialty is helping high net worth individuals whose financial lives are generally more complex.

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