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Equity strategy can save on taxes

Recently, The Wall Street Journal reported that Gillette Co.'s research lab is working on a new deodorant that blocks odour receptors in the noses of people around you. Evidently, you can't stink if no one can smell you.

According to lab director Dr. Ahmet Baydar, Gillette carries out its testing using a synthetic version of underarm odour called the "malodor compound," which can leave an entire office reeking for days. "Just three or four molecules is all it takes," Dr. Baydar says. Testing also involves placing five judges in a "hot room" to sniff the armpits of test subjects. Armpits are rated on a scale of one to 10, with 10 meaning "your head snaps back," according to one employee.

Dealing with body odour can be a real dilemma. But it's nothing technology can't fix. And if you're an investor, certain tax problems can be fixed with technology too. Investment technology, that is. In fact, there's plenty you can accomplish with an equity monetization strategy.

The strategy

Picture this. You're the proud owner of a stock that has appreciated in value and you've got too much tied up in this one security. That's right, you've got too many eggs in one basket.

The problem? If you sell all or a portion of your holdings in the stock in order to diversify, you're going to trigger a tax liability large enough to wipe out the national debt, give or take. Not to worry. An equity monetization strategy can help.

Under this strategy, you can make use of a customized over-the-counter derivative contract -- a forward sale contract -- that will allow you to: (1) lock in any gains on paper that you have enjoyed, (2) defer tax on a sale of the stock by avoiding an actual disposition, (3) diversify your holdings through the use of a loan, (4) create an interest deduction, and (5) avoid any margin calls that might otherwise apply when borrowing.

The forward contract will allow you to lock in a selling price at a future predetermined date. Basically, a financial institution (say, a bank) agrees to buy your stock from you at a set price on a future date. Typically, you'll be restricted to publicly traded securities. Once you've locked in a price, the bank will lend you money based on the price you'll be collecting for your stock when the forward contract matures.

Consider Frank's story.

The example

Frank owns 25,000 shares of XYZ company, which trades at $40 today, for a total value of $1-million. His bank is willing to enter a forward contract with Frank that will give him the right to sell his XYZ shares to that bank for $45 a share five years from now. That is, Frank is guaranteed to receive $1,125,000 in five years for his XYZ shares.

In Frank's case, the bank has agreed to a cash settlement in five years, when the forward contract matures.

Suppose that XYZ stock trades at $40 in five years.

In that case, the bank will pay Frank $5 a share, since it guaranteed him a price of $45 ($5 profit per share) for the stock, and Frank will keep the stock.

If XYZ is trading at $48 in five years, Frank will have to pay the bank $3 a share because he was only guaranteed to receive a profit of $5 a share, and he'll keep his XYZ shares.

Any profit over the forward price of $45 belongs to the bank.

Finally, if XYZ trades at $45 a share in five years, no cash will change hands, and Frank will keep his stock.

Under the strategy, the bank will lend Frank $1-million. After all, Frank is guaranteed to receive $1,125,000 in five years -- so the bank, and Frank, know he'll be able to make good on the loan. Yes, the stock and forward contract will be pledged as collateral.

The result? Frank now has now eliminated any future risk of price fluctuations on his XYZ stock, has avoided a taxable disposition of the stock, will manage to diversify his portfolio with the newly borrowed $1-million, and can deduct the annual interest on the borrowed money invested. Finally, there's no potential for margin calls here. The drawback? Frank gives up any upside potential on his shares over the price in the forward contract.

The details

To ensure this strategy works from a tax perspective, it's best to have a cash -- not a physical -- settlement at maturity of the forward contract. Also, negotiate to retain all rights to dividends and votes attached to the shares during the term of the forward contract. Finally, visit a tax pro to discuss the idea in your situation.

Tim Cestnick, FCA, CFP, TEP is author of The Tax Freedom Zone and Winning the Tax Game 2003. He is managing director, National Tax Services, at AIC Ltd.

CESTNICK from page C1

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