A great deal has been written about the risks of a concentrated equity position, a situation that may occur for owners of employee stock options. Generally, the consensus supports the theory that the downside risk of owning too much of one company’s stock is simply too much for any one person to retain. Therefore, diversification, or the theory of not putting all your eggs in one basket, may be a wiser option*.
The decision to diversify may be complicated by obstacles outside of your control as well as others within your control. For example, taxes, psychological barriers, and/or legal barriers may prevent one from diversifying a concentrated equity position.
Let’s explore some of the key factors that could inhibit someone from making the decision to diversify assets away from a concentrated equity position.
Generally speaking, you only pay taxes when you make money. So, in a sense, paying taxes is a good thing. Still, the aversion to paying tax is often so high that it prevents us from making a reasonable decision. In this case, the reasonable decision may be to liquidate stock, pay tax and diversify the assets. Other owners of concentrated equity, however, may be willing to accept the pending tax bill in exchange for the opportunity to invest their concentrated assets elsewhere.
In fairness, there is rarely a perfect answer to this question. There is however, analysis which can help dictate which decision may be best for an individual scenario.
To begin the tax analysis, it’s important to first consider various tax issues that may impact your exercise and sell of incentive stock options. Some of these key issues are:
- What is the cost basis of your non qualified or incentive stock? Said another way, what did you pay for the stock?
- It’s important to remember that for incentive stock options, you may have dual basis. Your regular tax basis is equal to the grant price of the shares that you have previously exercised. The AMT cost basis is equal to the share price upon exercise. This figure will likely be the higher of the two calculations.
- What is the holding period? – If you own a stock for less than one year, capital gains are subject to ordinary income rates. If you hold the stock for one year or longer, any capital gain is taxed at preferential long-term capital gains rates.
- What is the AMT for incentive stock options? – Any incentive stock conversation is likely incomplete without taking into consideration the AMT and the cash that will be required to perform an exercise and hold. This tax, potentially at 28% or more, creates a cash call on the exercised position. Some of this may be recovered through a future credit, but some of this may not. Generally speaking, the higher the spread between the grant price and the exercise price upon exercise, the higher the AMT paid and the greater the opportunity to “get back” taxes due to a tax credit. In this planning sense, it may make sense to sell shares of stock with a higher AMT cost basis, all else being equal.
- What about estate planning? – Upon a person’s death, their assets generally receive a step up in basis. This means that upon inheriting an asset, the cost basis for the asset is equal to the value at the date of death. If you hold a single, large, highly appreciated asset, it may make sense to hold the position as opposed to selling it and diversifying. For example, let’s assume that you have an asset worth $1,000,000 that you paid $50,000 for many years ago. If you sell the asset now, you will pay $142,500 in capital gains tax (assuming a flat 15% rate). If you die holding the asset and your beneficiaries sell it the next day (assuming the price stays the same), your beneficiaries’ basis will be $1,000,000, and they will not have to report any capital gains – a tax savings of $142,500.
While the decision to sell and diversify may make sense on paper, taking the action to do so may be difficult for some.
For example, some may have worked for a company since its infancy or for many years and feel a strong sense of loyalty. They may feel that selling the shares is a disloyal act toward their employer.
Others may have inherited a position from a spouse and/or another family member. In an effort not to offend their loved one’s memory, they may elect to retain the stock because “this is what he or she would want me to do.”
Other psychological barriers include having a “feeling” that the stock price will go up because it always has in the past. Another barrier may be picking an artificial stock price at which you will sell if the stock price reaches that price or waiting for the stock price to reach a value that it once was previously, locking in on a high point that may or may not be attainable.
In fact, these psychological barriers are so common that extensive research is being completed in the field of behavioral finance. This research relates to how our emotions impact our decision making, specifically as it pertains to finances and investments.
For senior executives or members of a board of directors, constraints may be in place that impact their ability to liquidate their shares as freely as other shareholders can. While beyond the scope of this discussion, it’s important to know that certain key employees are subject to rules regarding notification and reporting of transactions; no trading on material, non-public information; no short-swing profits; and limitations on trading of the founder’s stock.
Non Qualified and Incentive Stock Option Planning
In the end, the decision to retain or sell some or all of one’s incentive stock options should take into consideration personal financial well being and individual goals and objectives.
However, this should be coupled with attention to other technical and behavioral considerations, such as taxes and/or personal barriers to liquidation.
Once all of this has been considered, it should be much easier to create a path to retain, sell, or transfer shares in a manner that attempts to optimize the outcomes for the shareholder.
*Diversification and asset allocation 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.