Company-owned stock and stock options are assets that may generate significant wealth. They may also pose the largest risk to future financial security. This risk reward trade off is inherent to investing and is heightened as one’s concentrated stock position increases.
In truth, the value of a concentrated 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 are 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 Apple or Amazon?
While hindsight would certainly make answering these questions easy, we live in a world of investing uncertainty. Contrary to popular belief, 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 and the strategies available to monetize their concentrated 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 receives the full value of the $100,000 gift, and you 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. 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.