Employer Stock – A Framework for Holding and Liquidation

Many employers encourage their employees to own their company’s stock to align their incentives with those of the firm. A company may do this through stock grants, discounted stock purchase programs, options, or the ability to purchase stock within a qualified plan. There are, however, some drawbacks to owning employer stock like having an undiversified/overconcentrated position as a potentially disproportionate percentage of your net worth. There is also the matter of potentially tricky tax considerations. The purpose of this article is to serve as a framework for deciding when it may be appropriate to hold employer stock, when it may be time to let it go, and some strategies for selling the stock when the time is right.

The Overconcentration and Tax Problems

Stocks inherently have two major sources of risk: market risk and company-specific risk. Market risk, sometimes referred to as systematic risk, refers to the impact that the global stock market has on a company’s stock price. Market risk is generally undiversifiable, and therefore very difficult to avoid. Company-specific risk stems from possibilities such as the threat of a major lawsuit, earnings falling short of expectations, or the company’s CEO being displaced. The list of potential pitfalls is very long, but fortunately most of these risks are easily mitigated by diversifying your portfolio and not having too large a position in any one company.

The first challenge with employer stock is the inherent addition of an undiversified position to your balance sheet. The second challenge is that in addition to the risk on your balance sheet, you also have occupational risk – if the company is struggling, not only can the stock price drop and thereby affect the value of your savings, but your employment (and therefore income) may be at risk as well.

Lastly, there is the consideration of taxes. In most circumstances, income taxes are owed on the value of stock compensation when it vests (can be sold without restriction). These taxes create another potential problem, best illustrated by example:

John is granted an unrestricted (immediate vesting) $50,000 stock bonus in January. Based on an expected 32% tax bracket, $16,000 of stock is withheld, resulting in $34,000 of net stock going to John, which he decides to hold on to. By December, some unfortunate news develops and the value of John’s stock falls to $0. Still, John owes taxes for the year based on the $50,000 value when he first had the right to freely sell the shares. If income taxes were not correctly withheld when the stock was granted and vested, John may have to dip into his other assets to cover the remaining tax bill.

Considering all these challenges, I generally advise that employer stock should not exceed 5% of one’s total assets. There are certainly exceptions to this that I will cover later, but for now let’s discuss the potential limitations to selling employer stock.

Restricted Stock and Other Vesting Requirements

When a restricted stock is granted, there will be a vesting period or holding restriction that needs to be met before it can be sold (typically 1-4 years). As mentioned in the previous section, income taxes on stock grants are due as soon as the stock can freely be sold or transferred.* Thus, the very first step when a stock vests is ensuring that the appropriate amount of income tax is withheld so that there is no potential tax liability in the future. Once the income tax uncertainty is eliminated, the fair market value should be included in the family’s balance sheet and an analysis should be conducted to review the risks/rewards to keeping the stock. Lastly, whether immediately or in the distant future, a liquidation timeline should be created to have a plan for when the stock will be sold.

Restricted Stock Units

Restricted Stock Units (RSUs) are similar to restricted stock, but with two major differences. Firstly, there is no actual stock being granted with RSUs – the recipient is essentially given a promise to receive compensation in the future based on stock performance. The other difference is that it is not possible to make a Section 83(b) election with RSUs.

Stock Options

A stock option is a derivative contract that gives you the option to purchase a stock at a predetermined price**. Typically minimal or no taxes are due when stock options are granted. However, upon exercise of nonqualified stock options ordinary income taxes are due on the spread – the difference between the market value of the stock and the price that the employee exercised at. This is best illustrated by example:

An executive of XYZ company is granted the option to purchase 500 shares of XYZ at $100/share 12 months from now. The current share price of XYZ is $100, and the value of the option today is effectively $0, therefore no income taxes are due. 12 months pass, and the share price of XYZ is now $120. If the executive exercises the options contract in full, she pays $50,000 in cash for $60,000 of XYZ stock. Income taxes are due on the $10,000 of effective compensation (the difference between the market value and the purchase price). The executive’s basis in the stock is $60,000, and the stock can be freely sold going forward.

Stock option compensation can be very lucrative but can also be very volatile. In this previous example, the executive’s compensation from the option grant was effectively $10,000 over 12 months. If the stock price rose to $250 by the exercise date, then her option-related compensation would have been $75,000! However, if the stock price stayed at $100, her compensation from the option would have been $0. Furthermore, the executive initially needed to come up with $50,000 if she decided not to immediately sell the shares after exercise. This could lead to an unfortunate circumstance of having an out-of-pocket loss if the stock price falls after exercising an option. As mentioned previously, once a stock can be freely sold, a timeline should be created for when to actually sell it.

Incentive stock options (ISOs) are a special type of option plan that are subject to different rules and can be much more lucrative from a tax perspective if certain criteria are met under IRS Code Sec. 422. Among these rules are requirements to not sell the stock until at least two years after the option was granted, and for at least one year after the option is exercised – example below. Note that although potentially more favorable from a tax standpoint, the required one-year stock holding period magnifies the risk of potentially having an out-of-pocket loss as outlined in the previous paragraph.

An executive of XYZ company is granted the option to purchase 500 shares of XYZ at $100/share 24 months from now. The current share price of XYZ is $100, and the value of the option today is effectively $0, therefore no income taxes are due upon being granted the ISO contract. 24 months pass, and the share price of XYZ is now $150. The executive exercises her options in full and pays $50,000 for $75,000 of XYZ stock. Unlike the previous example, if this contract qualifies as an ISO, there are no income taxes due on what is effectively $25,000 of compensation (there may still be AMT taxes, however). The executive continues to hold her shares for at least another year before selling. She is then taxed at capital gains tax rates on the difference between the original exercise price ($100) and whatever the stock price is at that time. In effect, ordinary income taxes were entirely avoided in this scenario, replaced by the potentially more favorable capital gains taxes.

Employer Stock in a Qualified Plan

Some employers allow the purchase of company stock inside of a 401(k) plan. If you are in a position with considerable amounts of employer stock inside of a 401(k), then you may have a few tax-efficient options when you choose to diversify. Normally, all withdrawals from a 401(k) plan are taxed as ordinary income – both principal and growth, regardless of whether the growth comes from bonds or equities. Thus, it is sometimes advisable to hold equities in a taxable brokerage account instead of a 401(k), because the growth could instead be taxed at potentially lower capital gains tax rates.

If you have company stock inside of a 401(k), you may also be able to take advantage of Net Unrealized Appreciation (NUA) rules and transfer the stock to a brokerage account where it can later be sold. The basis would still be taxed at ordinary income tax rates, but this way capital gains tax rates can apply to the growth in lieu of ordinary income tax rates. NUA rules are highly nuanced and should be navigated together with a tax professional but may be worth investigating if you have a large position of employer stock inside of a 401(k).

When Holding Employer Stock can be Advantageous

In the words of diversification critic Warren Buffett, “Diversification may preserve wealth, but concentration builds wealth.” It is important to point out that there are several instances when it makes perfect sense to hold onto a large company stock position. If a company’s value is expected to balloon (for example in the case of a pending IPO, merger, or legislative change), the value of your shares stands to appreciate as well. Furthermore, if you are in a position of leadership where your day-to-day performance has a tangible and sizeable impact on the company’s value, the appreciation of your stocks may end up being the greatest portion of your compensation in any given year.

There are also instances when you may not be able to sell your shares. For example, if you have shares in a privately held business, there may not be a readily accessible market through which you can sell them at fair value – in this case, it would be more beneficial to wait until a good selling opportunity arises. Another consideration is whether you are privy to insider information about your company – if so, you may have preclearance trading rules or blackout periods during which you may be ineligible to sell any shares. A qualified wealth management professional can help conceptualize and quantify the opportunities and risks in both your compensation package and existing stock positions, as well as offer insights as to what can be optimized from a cash flow, diversification, and tax standpoint. When selecting a professional, seek one that has experience with equity compensation and also works in conjunction with a tax advisor to deliver the best advice to you.

* The recipient of a restricted stock grant may opt to make a Section 83(b) election within 30 days of the grant date. This allows them to pay ordinary income taxes upfront on the fair market value of the stock at the time of the grant instead of the value at the time of vesting. Any further appreciation between the grant date and vesting date is then taxed at capital gains tax rates when the stock is sold.

** Stock options often allow for a same-day sale – the simultaneous exercise of an option and sale of the subsequent stock. This bypasses the requirement to first purchase the stock, but also comes with unique tax considerations. In the case of same-day sales, the proceeds are reflected on an employee’s tax forms twice – on both their W-2 as well as Form 1099-B. The tax preparer must properly report the transaction to the IRS to avoid a potentially large tax bill.

No investment strategy can guarantee a profit or protect against loss. All investments carry some level of risk including the potential loss of principal invested.

Although stocks have historically outperformed bonds, they also have historically been more volatile. Investors should carefully consider their ability to invest during volatile periods in the market.

This publication is not intended as legal or tax advice. Financial Representatives do not give legal or tax advice. Taxpayers should seek advice based on their particular circumstances from an independent tax advisor.

Northwestern Mutual is the marketing name for The Northwestern Mutual Life Insurance Company, Milwaukee, WI (NM) (life and disability insurance, annuities, and life insurance with long-term care benefits) and its subsidiaries. Leon Baburov is a Representative of Northwestern Mutual Wealth Management Company?, (NMWMC) Milwaukee, WI (fiduciary and fee-based financial planning services), a subsidiary of NM and federal savings bank. All NMWMC products and services are offered only by properly credentialed Representatives who operate from agency offices of NMWMC. Representative is an Insurance Agent of NM, and Northwestern Long Term Care Insurance Company, Milwaukee, WI, (long-term care insurance), a subsidiary of NM, and a Registered Representative of?Northwestern Mutual Investment Services, LLC?(NMIS) (securities), a subsidiary of NM, broker-dealer, registered investment adviser and member FINRA and SIPC.

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