Company-owned stock and stock options are assets that may generate significant wealth. They may also pose one of the largest risk to future financial security. This risk reward tradeoff is inherent to investing and yet it can be heightened as one’s concentrated stock position increases.
In truth, the value of a concentrated equity position may fluctuate wildly. It is this balance of risk and reward that makes the management of a concentrated position so difficult. For example, how does one plan for a specific goal, such as retirement, when so much of their assets can be at risk?
Once again, it is the same fluctuation that can lead to wealth generation beyond what one needs.
On the practical side, as one begins to accumulate shares in company stock, they may want to ask themselves the following questions: Should I continue to accumulate as many shares as possible, throwing caution to the wind and ignoring conventional wisdom that says not to have all my eggs in one basket? Or does it make sense to diversify early and often, quite possibly missing out on the next hot stock?
While hindsight would certainly make answering these questions easy, we live in a world of investing uncertainty. Contrary to what you might see and hear on TV from so-called experts, we don’t know what is going to happen next. Therefore, it is critical that the owner of a concentrated equity position understand the risk and reward tradeoff as well as the strategies available to them to monetize their position when they are ready.
Below, I’ll look at several ideas for those looking to help eliminate, mitigate, or transfer the risk of their concentrated equity.
Immediate Sale of Company Stock and Stock Options
The most obvious strategy for reducing the risk of a concentrated equity portfolio is to liquidate some or all of the stock immediately and then redirect the proceeds into a diversified investment portfolio (or an alternative investment position). Most notably, an immediate liquidation eliminates the downside risk of a concentrated equity portfolio.
In many situations, however, an immediate sale of concentrated equity may not be a workable or desirable situation. For example, if you are subject to SEC restrictions as an executive or an insider, an immediate sale may not be an option.
More likely, however, it’s possible an immediate sale of concentrated stock may not be desired for either personal or behavioral considerations. For example, you may not want to sell your company stock for fear of missing future price appreciation, for fear of exclusion and not being “part of the team,” or for wanting to invest in what you know.
Income tax plays an important role in the decision to liquidate. While we can argue whether taxes should or should not impact this decision, paying taxes is often a big deterrent to selling shares of a concentrated equity portfolio. Depending on the type and number of shares you own, the income tax implications upon selling may be large. In fact, many times potentially selling company stock will lead to a taxable event that is so large that it prevents the owner from pulling the trigger.
If you do decide to liquidate your stock, it’s important to understand what the implications of selling different forms of company stock ownership are. In fact, various forms of concentrated equity ownership are taxed under different rules. To put this another way, knowing which type of stock you own and the pending tax implications can lead to an opportunity to save (or defer) significant money on taxes. For example, the plan for high basis stock may be totally different than that of low basis stock.
But you need to remember that taxes are only part of the overall plan.
In fact, while paying taxes is often not desirable, it would be less desirable if the value of the company shares fell to a point at which your after-tax value was wiped out. For this reason, it’s important to consider how important your equity position is in your overall financial plan.
Is the money in your concentrated position money that you need to meet necessary expenses? Or is the value of your concentrated position in addition to other assets earmarked to meet your needs, making your concentrated portfolio “extra” money?
The answers to these financial planning questions are as important to the conversation as the risk of concentrated equity and the tax implications of selling.
Donating to Charity
Donating money to charity is a popular strategy for reducing income tax on an annual tax return. If you are planning on making a charitable donation, a concentrated equity position can be a fantastic option for giving. Two strategies can include giving low basis shares outright to charity or giving via a charitable remainder trust. Let’s explore the differences:
Giving Low Basis Stock
Using a hypothetical example, we can illustrate the benefit of giving low basis stock directly to charity. To do so, a few assumptions should be made:
- Current value – $100,000
- Basis – $10,000
Option 1 for giving to charity is to sell the shares first and give the proceeds to charity. If you do, capital gains of $90,000 will be incurred, and tax will be owed. If we assume a 15% tax rate, the tax repercussions of selling the stock would be $14,500.
Therefore, the cost of the gift to the charity is actually $100,000 of the gift PLUS another $14,500 paid in income taxes, for a total cost of $114,500 (or give $100,000 minus the taxes paid, which would lead to a gift of $85,500).
A second option is to give the actual shares to the charity directly. In this scenario, the charity can receive the full value of the $100,000 gift, and you likely get a deduction for the full $100,000. Furthermore, the charity is able to sell the shares themselves with zero income tax liability.
Using a Charitable Remainder Trust
A second diversification option that allows for a client to transfer shares to charity AND produce an income stream for themselves is a charitable remainder trust (CRT). One could suggest that a CRT allows for you to take a potentially highly volatile equity position and turn it into fixed income.
Simply stated, a CRT looks like this:
- A client contributes low basis stock to a trust.
- The trust pays income back to the client for a stated period of time as determined by the trust agreement (think fixed income).
- At the end of the stated period, the remaining value of the trust passes to charity.
With a CRT, the client receives a tax deduction in the year of their contribution for an actuarial determined value of the remaining interest of the trust, which then passes on to charity. (It doesn’t matter what passes on to the charity at the conclusion of the term; you still know at the time of the gift what your tax deduction will be.)
One benefit of the CRT is that once highly appreciated stock is in a trust, the trust is tax exempt and can liquidate and diversify the stock. In addition, the client can generate an income stream from an asset that might otherwise not produce an income or from an asset that is too costly to sell from a tax standpoint.
A final benefit of a CRT is that the asset is outside the estate of the taxpayer. For those who have used up their unified credit or for those seeking to remove assets from their estate, this can be a valuable planning tool.
Staged or Rolling Sale of Company Stock
For many people, a staged sale of concentrated equity is an attractive alternative to giving money to charity or immediately selling the stock and paying taxes. It allows them to retain some upside appreciation potential while reducing their overall position in the stock.
A staged sale typically involves selling a stated portion, percentage, or number of shares over a specified period of time (for example, 10% of my shares annually). A staged sale can implement a liquidation process that helps remove common behavioral and tax impediments that may otherwise influence a decision to sell (think automation, plan, or process).
Staged selling may also spread the tax impact out over several years. Taking this one step further, staged selling will likely create different lots of shares, each with a different tax basis and tax impact. This byproduct of stage selling may also allow for more advanced tax and liquidation planning due to having several lots of shares with a different cost basis and alternative minimum tax (AMT) basis.
It’s worth noting the potential negatives associated with staged selling as well however. Most notably, there is no immediate diversification. The risk of holding too much of one stock leaves the shareholder exposed to downside volatility or the risk of losing a lot of money. An additional concern may be the threat of rising tax rates, whether it is from reaching another personal tax rate as your income goes higher or the political risk of rising tax rates.
Staged selling can be thought of as a balance between an immediate sale and the accumulation of as much stock as possible. For some, staged selling may be a forced option due to the SEC restrictions. More likely, however, it’s a forced solution due to the expiration dates and vesting dates associated with restricted stock and/or company stock options.
Planning for Stock Options and Concentrated Equity
Concentrated equity means something different for each shareholder. For example, a young person with many working years ahead of them and no major liabilities may be more interested in concentrated equity than a 65-year-old looking to retire in the next year.
Furthermore, the asset’s size may impact the level of tolerance toward holding a concentrated position. For example, someone with $50 million in one stock may feel different than someone with two million dollars in one stock.
If we assume the stock price falls by 50%, the client with $50 million is still left with $25 million. However, the client who had two million dollars is now down to one million dollars. This may have a material impact on their ability to retire!
Ultimately, it’s important that anyone holding a substantial piece of equity understands the risk and reward tradeoff. With careful planning and attention to detail, it’s possible to develop a strategy that optimizes your chances for success.
Asset allocation or diversification do not guarantee a profit or protect against a loss.
Tax services are not offered through, or supervised by Lincoln Investment, or Capital Analysts.
None of the information in this document should be considered as tax advice. You should consult your tax advisor for information concerning your individual situation.
There is no assurance that the techniques and strategies shown are suitable for all investors or will yield positive outcomes. The purchase of certain securities may be required to affect some of the strategies. Investing involves risks including possible loss of principal.