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.