If you currently work or have worked for a tech company then it is very likely you have managed to accumulate vested stock. You may even have a large, highly appreciated, and concentrated vested stock holding. If so, this portion of your portfolio probably has done well for you over the last several years. Although it is a winner you may be wondering how you are going to reduce the risk of loss and the impact of tax.

This is a scenario that many of our clients face every day. Usually what stands in the way of risk reduction strategies is the tax consequence of selling stock of your current or old employer. Luckily, you have a variety of options to help you either reduce the risk, manage the tax hit, or both.

Below we have curated a comprehensive list of ways you can manage the risk and taxes of your current or old employer stock. This is a high-level overview of your options and should be a great starting point for your research.

If you need help weighing the pros and cons of these strategies as they apply to your unique situation find some time on our calendar HERE.

Option 1 Sell Outright: Manages Risk

Pros

• Easiest option to execute.
• Reduces the greatest amount of risk.

Cons

• Recognizes the greatest amount of tax.
• Could potentially bump you up into a higher capital gains tax bracket.
• Eliminates the potential upside of continuing to hold the stock.

Summary:

The easiest investment risk management strategy for any investment is to sell it down and reinvest it. This is also the strategy that everyone understands but is most reluctant to make for a couple of reasons.

First, the tax consequence of selling stock that has greatly appreciated is a hard pill to swallow. It usually stands in the way of the sale being executed. Furthermore, if you are still bullish on the company stock you may be reluctant to sell all or any of your shares.

However, this is the best method for reducing risk since you eliminate exposure to several factors. First, you eliminate exposure to the broader market this company is part of. Such as the domestic market or international market. Second, you eliminate the exposure to the industry itself such as technology. Finally, you eliminate the exposure to any company-specific risk including fraud, poor product launches, CEO scandals, and more. 

Selling your vested stock is especially prudent if you are a current employee. While an employee you have risk of both your paycheck disappearing and the value of that stock dropping significantly.

If you do choose to go this route. Keep an eye out for how much capital gains you recognize. As of 2021, if your income plus your capital gains exceed $250,000 for Married Filing Jointly or $200,000 for Single you will owe an additional 3.8% Medicare Tax on any capital gains above that amount. If your income plus your capital gains exceed $496,601 for Married Filing Jointly or $441,451 for Single you will owe 20% instead of 15% on any capital gains above that amount.

Option 2 Tax Loss Harvesting and Selling: Manages Risk and Tax

Pros

• Allow you to defer paying taxes and grow the portfolio faster.
• Allows you to use money from vested stock for other goals and diversification.

Cons

• Does not make capital gains disappear.
• Complex and requires a lot of attention.
• Requires additional assets beyond your stock holding.
• May take several years if not a decade to fully unwind the position.

Summary

I recently wrote on the process of tax-loss harvesting that you can read here. In summary, tax-loss harvesting is the process that allows you to use your capital losses at any point in time to offset capital gains. This process relies on tax rules established by the IRS and has specific nuances that need to be accounted for like wash sales.

To utilize tax-loss harvesting for investment risk management and tax reduction, you need to have additional taxable assets beyond your current stock holding and a willingness to sell. The process requires you to keep an eye out for opportunities where an investment has a loss. In order to maximize this outcome, you should pay attention to your portfolio throughout the year.

Here is the hypothetical process:

1. Find a loss.
2. Sell the investment at a loss.
3. Buy a similar or comparable investment to maintain your investment strategy.
4. Sell your appreciated and concentrated stock for a gain equal to the loss.
5. Use the proceeds to diversify or for personal goals.

Professionally done, the tax-loss harvesting process evaluates when an investment has lost enough to be harvested. It also evaluates what is a similar investment that would not fall under the IRS rule of a wash sale.

Tax-loss harvesting requires significant dips in the markets. The opportunity may come once or twice a year only. To effectively use tax-loss harvesting on the entire position requires patience, time, and attention. Because a truly successful tax-loss harvesting process requires so much attention and tax knowledge, most people choose to delegate this strategy to a professional.

Option 3 Completion Portfolio: Manages Risk and Tax

Pros

• Get’s you closer to your ideal portfolio while controlling taxes.
• Can significantly reduce risk.

Cons

• Requires a portfolio of assets outside your highly appreciated and concentrated stock position.
• The portfolio will continue to have strong divergence from the ideal portfolio.
• Requires a strong understanding of asset classes, sub-asset classes, industry, and sector categorization.

Summary

Out of all the risk reduction strategies, the completion portfolio seems to get written about the least. A completion portfolio requires three steps. First, it requires you to properly categorize your current vested stock based on the asset class (stock vs bonds), sub-asset classes (large, mid, small, growth, value, domestic, international, etc.), sector (such as tech), and industry (such as cloud). Then it requires you to invest the remainder of your portfolio in investments that complement your stock holding. Finally, it asks you to rebalance these complementary investments from time to time around your vested stock.

Managing concentrated stock positions through a completion portfolio allows you to get closer to your ideal portfolio and level of risk without having to recognize any tax. You can get closer the more other assets you have. So if you have a healthy 401k, retirement accounts, cash that needs to be used, or brokerage accounts you can put it all to work.

On the other hand, if you don’t have outside assets you can decide the balance of risk and tax by selling some of your vested stock and investing it into your completion portfolio.

The biggest challenge to a completion portfolio is company risk. You may be able to reduce the risk that the domestic stock market will go down by buying bonds or the risk that the tech market will go down by buying value companies but until you sell your highly appreciated company stock you will never get rid of the company-specific risk.

Option 4 Short-Selling Hedge Strategy: Manages Risk

Pros

• Can isolate some company-specific risk.
• Can use the proceeds from the short to buy complementary positions.

Cons

• Per IRS rules can’t own the stock and short it directly.
• Shorting has a borrowing cost that can reduce returns.
• Can increase loss if you are wrong on your company and the shorts.

Summary

Diversifying concentrated stock positions can be done by simply protecting against loss. Shorting has received a lot of media attention recently. While shorting can certainly be used to take bets a company will go down in value it can also be used to hedge, or protect against, loss in certain industries, sectors, etc. The idea here is to sell short stocks or ETFs that are economically related to your concentrated stock and will likely have similar returns.

Here is how the short-selling process works:

1. You borrow shares of a stock or an exchange-traded fund from your brokerage firm.
2. You sell them.
3. Collect the cash (Steps 1-3 are all done in the same transaction)
4. Hope that the value goes down.
5. Buy them back at a lower price.
6. Return the stock.
7. Keep the difference in cash. (Steps 5-7 are all done in the same transaction)

When you collect the cash and before you buy the shares back you can also use that cash to invest in other investments. This operates similar to a completion portfolio but with the added benefit of downside protection from the short position.

While shorting sounds like a phenomenal option it is very complex to execute properly, can be costly, and can go horribly wrong.

For starters, you can’t short the same stock that you own. That is called short against the box and has been prohibited by the IRS.

Shorting is also not free. To borrow shares you need to pay an interest rate. If it is a very in-demand stock or fund to bet against you can have shorting rates as high as 30% a year and higher!!!

Finally, you can experience the worst-case scenario of your stock going down in value and all the investments you shorted going up in price. As an example let’s say your company CEO is committing fraud and your company stock prices plummets, at the same time the rest of the tech industry is having blockbuster earnings. You lose money in your stock and you lose money betting against its peers.

Option 5 Options Strategy: Manages Risk

Pros

• Can almost fully protect you from loss.
• Easy to implement.

Cons

• Is a short-term solution.
• Has costs that can continue to deteriorate your portfolio.
• Tax inefficient strategy.

Summary

Options, just like shorting, can be used for two purposes. One is to make speculative bets. Take a look at Reddit’s popular subreddit r/wallstreetbets if you want a taste of this. The other purpose is to protect from loss. Options to protect from loss are essentially insurance contracts.

To protect yourself from loss you would buy put options on your concentrated and highly appreciated stock. There are a few decisions you will need to make when making this investment. First, how long do you want to cover yourself from this potential loss? Unlike shorting a stock there is a timeline on the option. Options will expire and so will your protection. You can hold options as long as a year, few months, or days. Next, you want to decide how far you would be willing to let your stock drop before the protection kicks in? This is called the strike price in an option. Finally, you want to think about how much of your vested stock you want to protect? Each option contract covers a 100 shares. So if you have 1,000 shares you need 10 options contracts.

As far as risk reduction strategies, using put options can be very simple to execute. You simply buy the put options and you are done. You can also buy enough put options to cover your entire holding. However, options expire and cost money. So if you use put options to protect yourself and the stock doesn’t drop in value then you will have simply paid for insurance that was never used. On certain stocks, this insurance can be very expensive.

Furthermore, if you profit from an option you held for less than one year you will be taxed at ordinary income rates. This means you potentially traded long-term capital gains taxes on your stock for less advantageous ordinary income taxes.

If you are still employed by your company and holding your vested stock you need to be careful because more likely than not you can not buy put options. Please consult your HR or read your employment agreement before executing this strategy. If you can’t buy it on your employer stock you may be able to buy put options on an industry or sector ETF.

Option 6 Gift to Charity: Manages Risk and Taxes

Pros

• Big tax win if you are already charitably inclined.
• Itemized deduction for taxes.
• Avoiding capital gains entirely.

Cons

• You don’t personally get the economic value of the stock donated.

Summary

If you are already donating to charities or have intent to donate then donating your appreciated employer stock is the best option. When you donate appreciated stock to a charity or a Donor Advised Fund you get to write off the contribution on your taxes in the form of an itemized deduction. In addition, the charity does not recognize any capital gains when they sell your stock. It is a win/win for both you and the charity.

A strategy you can use when diversifying concentrated stock positions by donating them is to buy that stock right back with the cash you would have used to donate. Through this process, you are swapping the cost basis from a low one to a higher one. This allows you to continue participating in the upside of the stock, implement your charitable desire, reduce your ordinary income tax, and reduce your future capital gains tax.

The only downside, and an important one, is that once you have donated the stock it is a permanent reduction in your net worth. This strategy is only worthwhile if you are interested in charitable donations.

Option 7 Opportunity Zones: Manages Risk and Taxes

Pros

• Can defer, offset, and completely eliminate some capital gains.
• Can help you diversify into real estate.

Cons

• In order to reduce or eliminate capital gains, you must hold the investment for a long time, making it illiquid.
• Opportunity zones invest in underdeveloped and untested areas which can bring high investment risk.

Summary

Opportunity zones were created as part of the 2017 Tax Cuts and Jobs Act. The goal was to incentivize investors through tax savings to invest in struggling communities. The Secretary of the U.S. Treasury has delegated areas in all 50 states that fall under the Qualified Opportunity Zone (QOZ). Most QOZ properties are abandoned lots, old manufacturing areas, warehouses, etc. The hope is that this initial investment and development of this area will encourage others to invest in the nearby area and spur economic growth.

If you want to invest in an opportunity zone directly you must be an accredited investor that can meet many specific guidelines. Most investors can get access to opportunity zones through a fund that pools investor money and invests in these properties.

The benefit that you receive from an opportunity zone can be significant. First, you get to defer the capital gains on your vested stock when you sell and buy into the opportunity zone within 180 days. Currently, as an investor, you can defer those taxes until 2026. Second, the longer you hold your assets in the opportunity zone the more capital gains on your original investment you can eliminate. If you hold for five years you can reduce capital gains by 10% and for seven years you can reduce capital gains by 15%. Finally, if you hold the opportunity zone investment for 10 or more years the appreciation of the opportunity zone is completely tax-free.

While these benefits are tempting it is important to keep in mind that to get the best benefits you will need to hold the investment for 10 years. Most funds require a minimum investment of $100,000. It is important to make sure that you don’t need access to those funds for a decade. You also need to be aware and comfortable investing in largely unproven and undeveloped areas. These areas would not be the first choice for many investors if they didn’t bring with them significant tax benefits.

Option 8 Exchange Fund: Manages Risk and Tax

Pros

• Ability to defer tax consequences of selling stock.
• Provide diversificaiton.

Cons

• You are locked in for multiple years.
• The investment management fee can be significant.

Summary

Exchange funds are limited partnerships consisting of limited partners who contribute shares of their highly appreciated and concentrated vested stock and general partners who are responsible for managing concentrated stock positions of the limited partners. The more limited partners with diverse holdings the better this risk reduction strategy works. When you contribute your shares you get a slice of the pooled fund. This will provide you with a basket of investments that have the same cost basis as the shares of the stock you contributed. Because this is not a sale, but rather a swap, tax is not recognized. When the investor decides to leave the exchange fund they receive a collection of the investments that were pooled by other limited partners.

Because there is no tax recognized in the swap your investment can continue to grow for years to come without the initial drag of taxes. This is the same benefit provided by tax-loss harvesting. You will eventually have to pay the tax but you get extra years to “borrow” money from the IRS as capital for additional growth. Exchange funds also give you instant diversification. Your performance and risk will now depend on the basket of investments rather than your sole position.

Exchange funds have a variety of downsides. First and foremost you must hold the exchange fund for at least 7 years. This makes the investment illiquid. It is important to plan accordingly for those funds to make sure you don’t need to draw on them. Second, exchange funds have upfront fees and a management fee of up to 2% a year going forward. Finally, when you leave you end up with the investments that the limited partners contribute. This also includes a mandatory 20% holding of a nonliquid asset such as real estate.

Option 9 Charitable Remainder Trust: Manages Risk and Tax

Pros

• Provides income.
• Ability to spread the tax bill across many years, at potentially lower tax bracket rates.
• Provide instant diversificaiton.
• Get a large charitable deduction in the first year.

Cons

• Complicates or prevents legacy goals for family members and loved ones.
• Complex investment management, legal, and tax execution.

Summary

Charitable Remainder Trusts (CRTs) come in two flavors, Unit Trusts and Annuity Trusts. Both CRTs have two beneficiaries. The income beneficiary and the remainder beneficiary. Usually, CRTs are structured to pay you or your beneficiary of choice income for a lifetime or predetermined amount of years. Once the income stream ends the remainder of assets get passed on to a charity or charities of your choice.

CRTs usually start with a donation of an appreciated asset. In this case, an appreciated stock. At which point it is sold in the trust. Once it is sold you have the opportunity to invest the proceeds in a diversified portfolio. With a CRT, capital gains are not recognized immediately. Instead, they are spread out over the course of the distributions. Instead of recognizing one large capital gains bill, you may recognize 20 or more smaller ones, depending on the length of the CRT. Furthermore, the calculated value of the donation at the end of the CRT’s lifetime gets passed on to you as a current-year charitable deduction.

CRTs are very useful vehicles even if your primary goal is not charitable. Between income, instant diversification, spread-out capital gains, and charitable deductions the tax savings and risk reduction can be substantial.

However, CRTs are not great if you desire to leave a legacy for your children, grandchildren, or other family members. Furthermore, when you set up a CRT you now owe a fiduciary duty to the charity you selected. This means that you need to manage the money in such a way that the charity is going to have a high chance of receiving the donation at the end of the trust’s lifetime. CRTs also have complex and unfavorable distribution rules for taxes. Distributions are entirely considered ordinary income first, then long-term capital gains. Requiring you to choose investments carefully and manage short-term capital gains. Finally, the tax filing requirements are very particular and could nullify the CRT if not done correctly. Requiring an experienced, and usually pricey, tax attorney.

Option 10 Variable Prepaid Forward: Manages Risk and Tax

Pros

• You receive instant liquidity from your vested stock.
• You get to defer taxes on the sale until a later period.

Cons

• Draws strong IRS attention and scrutiny.
• You can miss out on the upside of the stock price.

Summary

A variable prepaid forward is a contract made between you and a brokerage firm. The contract locks in a future sale price of your stock between a maximum and a minimum. This contract then allows you to borrow money –  anywhere between 75% to 90% of the current value of the stock. This creates instant liquidity and a deferral of taxes for a future date.

The benefit is twofold. You get access to capital which you can use to invest elsewhere or spend on other goals. You also get to defer paying any taxes until the date when the contract expires and you need to sell your stock.

Most individuals that will use variable prepaid forwards are executives and founders. They draw heavy scrutiny from the public and regulatory authorities including the IRS. So much so that those that have used these contracts have been accused of violating corporate ethics. While the sale is not final until the contract expires you lock in the decision now. This means that if the stock performs strongly you will have no choice but to part ways with your vested stock.

Conclusion

Diversifying concentrated stock positions and managing for taxes can be done in many different ways. For most investors, a combination of these strategies will make the most sense. Some of these strategies allow you to diversify a few thousand dollars of your vested stock while others require a very large commitment. No strategy is perfect and your choice will come down to your unique situation.

This blog is a great introduction to these approaches, however, the execution is a different story. If you need help with your highly appreciated and concentrated investment then don’t hesitate to set a free consultation with us using the link below.

GET YOUR QUESTIONS ANSWERED