THE BASICS OF DERIVATIVES FOR TRUST AND ESTATE LAWYERS: PUTS, CALLS, COLLARS AND FORWARDS
by James B. Ellis, Esq.*
The use of derivative instruments is increasingly common among wealthy investors. The last decade saw tremendous growth in wealth among company founders, entrepreneurs and corporate executives holding large blocks of low basis stock. Moreover, donors have funded trusts with concentrated stock positions, leading fiduciaries to consider the duty to diversify along with the realities of previous growth in securities valuation, market volatility, the market downturn of the last few years, and concerns regarding taxes and costs. As a result, we are seeing an increase in the creative use of derivatives in trust and estate planning. For example, collars can protect value in trusts or estates that hold blocks of stock that cannot be sold. Accordingly, in light of their clients’ changing needs and demands, trusts and estates attorneys must be familiar with the basics of common derivatives, as well as their income and transfer tax implications.1
I. WHAT IS A DERIVATIVE?
Generally, a derivative is a financial instrument whose value is determined by reference to another financial instrument, investment, security or product. The Uniform Principal and Income Act defines a derivative as: