Concentrated equity, also known as owning a large position in one company stock, can exist in many forms. One form of concentrated equity may be the result of working for an employer who has issued stock ownership via restricted stock and stock options.
These types of stock ownership and stock rights allow an employee to participate in the growth of the company via an appreciating stock price. If you are issued many shares or are issued shares of a company that has experienced meteoric growth, you may find yourself with a concentrated equity position rather quickly.
So what do you do if you find yourself with a large position of one company stock? Possibly seek help. Because managing concentrated equity positions may prove difficult. In fact, managing concentrated equity may require complex strategies and a deep understanding of plan rules, tax rules, selling restrictions, and overall portfolio impact.
With so many moving parts, it’s easy to understand why many owners of concentrated equity positions may feel overwhelmed. The combination of a large portion of wealth, a minimal understanding of the issues, and the fear of making a mistake can leave even the most sophisticated investor paralyzed.
Often you can start by taking stock of what you have.
Step 1 – What Do You Actually Own?
It’s not uncommon for a client to lack a full understanding of what they own. They know they own company stock in some form or fashion, but the details are lacking.
A first step is often to take inventory of what you actually own. Some common forms of company stock ownership and stock rights include the following:
- Outright ownership of company stock
- Company stock as part of an employee stock purchase plan (ESPP)
- Restricted Stock Units or Awards
- Incentive stock options
- Non-qualified stock options
- Shares in an Employee Stock Ownership Plan (ESOP)
It’s important to know exactly what is owned for many reasons. Primarily, it’s important because the rules and regulations governing each type of company stock ownership may be different. Different in terms of liquidity, accessibility, and tax.
Through this process it’s important to evaluate what has already occurred. For example, have you exercised stock options? If so, it’s important to know key dates and values for those actions.
Without knowing what you own and what has already occurred, it’s difficult to evaluate and create a strategic plan to manage your concentrated equity position.
Step 2 – What is the Cost Basis?
Cost basis is important because it impacts income taxes. Knowing the cost basis will help determine what type of tax will be paid and how much tax may be owed. From this, you can calculate how much you will receive net of income tax from the sale of your stock, or in other words, how much you have to spend.
Capital gain is what you have earned on the company stock over what you paid for it. When you sell your company stock, the gain (or loss) is subject to capital gains tax.
In its most simple format, cost basis is calculated as what you paid for the stock when you purchased it.
However it’s not always that easy. In fact, a more complicated cost basis scenario is that of incentive stock options. With incentive stock options, it’s possible your stock may have both a regular cost basis and an alternative minimum tax (AMT) cost basis, both of which should be tracked until liquidation of the stock. And both of which may have a material impact on income tax.
Other complicated cost basis scenarios may include net unrealized appreciation, which involves the tracking of cost basis for company stock purchased inside a 401(k) plan or cost basis for restricted stock with an 83(b) election.
Furthermore, for every lot of stock options or stock shares that are owned outright, it’s possible you will have a different cost basis.
Step 3 – What Key Dates Do You Need to Know?
It’s very common for company stock ownership to have key dates that should be tracked.
For calculating capital gains tax on the sale of shares that are owned outright, one year is an important date in that shares may be eligible for preferential long-term capital gains treatment.
Other important dates include vesting dates, expiration dates, and dates associated with a qualified disposition.
A vesting schedule is used to determine when you can take action on restricted stock and/or stock option plans. Prior to shares vesting there is a substantial risk of forfeiture. What you own is likely a future promise should you meet certain criteria. Once vested, that promise is fulfilled and you gain the ability to control your shares.
Vesting schedules may also drive taxability (depending on the type of company stock you have). For example, restricted stock is often taxable when it vests.
For stock options, a vesting schedule is important because it dictates when you can exercise your options. Prior to this date, you have no ability to exercise. Post vest, you can exercise as you wish.
The expiration date is on the other end of the spectrum as compared to vesting. The expiration date of stock options is the date on which the option goes away should you not exercise.
If your stock options are underwater and the expiration date passes, the stock options will disappear and be worthless.
If your stock options are in the money and you approach an expiration date, it likely makes sense to exercise the shares regardless of impending taxability. Otherwise, any in the money value will evaporate upon expiration.
A third set of dates that should be considered are those associated with a qualified disposition. For shares owned via an employee stock purchase plan and/or incentive stock options, meeting the standard required of a qualified disposition is likely advantageous from a tax standpoint.
However, seeking a tax advantage requires assuming risk – the risk of holding company stock for a certain period of time. During this time, the shareholder (you) is subject to market risk, or the risk of the stock price going down.
What you seek to save in tax may be lost due to a declining stock price.
Step 4 – How Much of Your Overall Investment Portfolio Is Invested in One Company?
Concentration risk is the risk of owning too much of one thing. In our discussion, this means too much of one company stock. This risk may result from a variety of situations including the focus of this article, company stock that is accumulated through employment.
Concentration risk isn’t all bad. In fact, concentration risk presents both opportunity and risk. When the company is doing well and valuations are going up, you will likely benefit from concentration risk.
However, during periods of poor company performance or enhanced volatility, concentration risk can lead to unpredictability and potential financial insecurity.
Furthermore, one could argue concentration risk is enhanced for someone who owns too much company stock AND is employed by said company. In a bad scenario, the stock price may drop precipitously as you get laid off and lose your income and benefits.
For these reasons, it’s important to understand how much concentration risk you have and how much concentration risk you are comfortable assuming. One rule of thumb in the industry suggests someone may want to own between 10-15% of any one company in a portfolio.
A more complete analysis of concentration risk and individual suitability would likely consider your overall net worth, your liquidity needs, your life stage, and your future plans.
Step 5 – Plan for Concentration Risk and Financial Planning
Managing your overall investment portfolio and financial plan requires a thorough analysis of your company stock and stock options. By combining the details of your plan with the goals of your financial plan, it’s possible to create an arrangement that strives to maximize value.
While there is no assurance that a diversified portfolio will produce better returns than an undiversified portfolio, and it does not assure against market loss, a diversified portfolio may reduce a portfolio’s volatility and potential loss. 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.