Enhanced Direct Indexing for Business Owners

If it’s time to sell your business, you have many things to think about and plan for. Of course, you want to find the right buyer and get the best price possible, which requires significant analysis and due diligence. You also want to ensure there’s a solid succession plan in place, so the transition is seamless and the business can continue to thrive. It’s also important to identify your future role (if any) with the company after you sell.

There’s also the matter of executing a tax-efficient sale so you can keep as much of the transaction proceeds as possible. For business owners concerned about paying taxes upon the sale of their company, enhanced direct indexing may be worth exploring, as it can be a potentially useful strategy to help manage taxes when divesting the business.

When a business is sold at a gain, the proceeds can be taxed federally as capital gains or, in some instances, as ordinary income. Capital gains can be offset with capital losses, and this is where enhanced direct indexing may be helpful.

Three indexing innovations

To better understand enhanced direct indexing, we’ll start with the overarching concept of index investing. An index fund is no more than a broad, predetermined group of stocks like the S&P 500 Index or the Russell 1000 Index. Index mutual funds and exchange-traded funds (ETFs) have been available for decades and offer a relatively inexpensive way to own a diversified basket of stocks that tracks the performance of a particular index.

Tax-managed direct indexing is a more recent innovation that allows investors to directly own a portfolio of securities that make up an index – rather than holding a mutual fund or an ETF – specifically to harvest tax losses and potentially improve after-tax returns. Instead of buying an S&P 500 index fund or ETF, for example, the investor holds some or all of the stocks that make up the S&P 500 in a separately managed account (SMA). The portfolio manager constantly monitors the portfolio, and when individual positions fall below their cost basis that position is sold in order to realize a capital loss. The portfolio manager will use the proceeds of the sale to adjust the holdings so that it will continue to track its target index, in this case the S&P 500. For example, if Coca Cola drops 15%, it could be sold, with the proceeds immediately reinvested in PepsiCo. Direct indexing allows you to always be invested in the market—in roughly the same proportions re: exposure to industries, sectors, etc.—and seek market-like returns while also potentially creating capital losses. While losses are not the goal, they are, in fact, commonly experienced throughout market cycles and may create opportunities to realize losses that can be used to offset taxable capital gains now and in the future.

Take 2020 for example. During this first year of the COVID-19 pandemic, the S&P 500 was up 18.4% for the year, but roughly 98% of the S&P 500 stocks experienced a drawdown (i.e., price decline) of 10% or more.1 Given the narrow leadership of winners in 2020 (i.e., businesses that met a critical need during the initial period of social distancing, remote work and heightened online commerce), about 92% of stocks experienced a drawdown of greater than 25%.¹ Investors who owned a mutual fund or ETF that invested in the S&P 500 received the broad-based return of the S&P 500. Contrast this with an investor in a direct indexing strategy based on the S&P 500. A tax-managed direct indexing strategy may generate capital losses among individual holdings in periods like 2020, while also generally tracking the overall performance of the S&P 500.

Enhanced tax-managed direct indexing is the most recent innovation. Enhanced direct indexing extends the standard direct indexing approach by adding a systematic long/short overlay alongside the traditional equity portfolio. The portfolio manager borrows and shorts securities (typically within the same index universe) that may be expected to underperform or have appreciated recently. If the stocks that have been shorted increase in value (as they would in a Bull Market), losses can be realized on the short side of the portfolio. If the stocks that have been shorted decline in value they generate unrealized gains and other stocks in the portfolio may have declined and can be sold to realize losses. The two sides of the portfolio, long and short, are managed in tandem this way, so that losses may be crystallized on whichever side of the portfolio is underwater, while the overall portfolio continues to track the target index. The long-short structure allows losses to be harvested on the short side when markets are up, and on the long side in down markets, creating more opportunities for tax-loss harvesting across a full market cycle.

These innovations in portfolio management allows investors to potentially harvest tax losses in either bull or bear markets. The size and scope of the losses are still driven by volatility, but investors may be able to take advantage of tax-loss harvesting even in bull markets.

Applying the strategy

For business owners who are selling their business, enhanced direct indexing may offer an opportunity to potentially reduce net capital gains and, hence, the tax liability created by the sale. Any losses generated in the year of sale can be used to offset capital gains from the sale of your business. However, additional opportunity may exist for those owners who have rolled equity into a new firm and may encounter another liquidity event in the future. The time that will elapse before the next transaction may allow capital losses to be “banked” to help absorb future capital gains, regardless of when they occur.

Reduced taxable gains mean business owners are able to keep a greater share of the proceeds of the sale of their business, which is often an important goal.

Speak to a Corient Wealth Advisor to discover how you can potentially reduce taxes with enhanced direct indexing and other strategies designed to help improve tax efficiency.

¹ Data source: Morningstar Direct. Data utilizes end of calendar year constituents’ data for S&P 500 index. The drawdowns measure the maximum decline from an intra-year peak to an intra-year trough using daily total returns. Past performance is no guarantee of future results.

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The S&P 500 Index measures the performance of the large cap segment of the market. The index is considered to be a proxy of the US equity market.

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5313834 – March 2026