How Executives Can Mitigate Single-Stock Risk With Tax Efficiency

For executives of public companies, a large source of wealth is derived from stock options, performance shares, restricted stock, and other stock-based compensation. In these inherently complex structures, long-term financial success for an executive and their family often depends on a strategy rooted in careful accumulation, income tax efficiency, and protection against overconcentration.

The hard truth is single-stock concentration can be the most significant risk to an executive’s financial future. A market sell-off at the wrong time or a significant drop in the company’s share price, for any number of reasons, can result in financial loss. Across my 40-year career working with executives at many large public companies, I’ve seen inadequate preparation result in significant losses—and once it’s gone, recovering value can be difficult if not impossible.

Fortunately, there are several strategies that can mitigate the risk of overconcentration.

Selling shares

A direct way is to sell shares and reinvest the proceeds, but this strategy needs to align any with ownership guidelines imposed by your company and insider trading rules. If you are a company insider, a 10b5-1 plan allows you to preschedule sales on a structured timeline—providing an affirmative defense against insider trading concerns.

Tax efficiency

Another meaningful planning consideration with selling shares is tax efficiency. A transaction generates capital gains on the difference between the shares’ tax basis and the sale price. The tax bill can be significant, but executives can increase their tax efficiency in a number of ways. A common approach is spreading sales over several years and timing them to coincide with realized losses from other underperforming stocks, allowing the gains and losses to offset one another.

NQSOs, ISOs, and AMT

If you hold nonqualified stock options (NQSOs), a thoughtful exercise strategy can be used to build diversification over time. It’s important to avoid exercising too early and forfeiting the options’ time value, and to use a cashless exercise where the plan allows.

A cashless exercise allows you to exercise your options without paying the exercise cost out of pocket. Instead, a portion of the shares is sold simultaneously to cover the exercise price (and often the associated taxes), and you keep the remaining shares or proceeds. This can be beneficial because it requires little or no cash up front, and by selling some shares immediately, it can also help reduce concentration in a single stock. The spread between the exercise price and the fair market value on the date of exercise is taxed as ordinary income, which is subject to higher rates than long-term capital gains, so tax planning will play a big role in how much of that gain you’d actually get to take home.

If you hold incentive stock options (ISOs), they avoid taxation upon exercise but create income for Alternative Minimum Tax (AMT) purposes if not sold in the same year. Again, tax planning needs to sit alongside economic considerations when developing a strategy for ISOs.

Using philanthropy to increase tax efficiency

Aligning the sale of shares with philanthropic goals also opens up some additional strategies. Gifting shares directly to a charity eliminates the capital gains tax. The charity can sell the shares to access the full value and you get a corresponding charitable deduction, so long as you itemize on your tax return. Using a donor-advised fund (DAF) can enhance this strategy by consolidating the tax deduction of multiple years of giving into one year where you itemize. Gifts to charity out of the DAF can then be spread over time.

A charitable remainder trust is another strategy executives can consider, especially if they are near retirement. Shares can be transferred into the trust and sold without immediate capital gains taxes. The capital proceeds that were embedded in the shares will be pulled out of the trust as an income stream for you, and whatever is left in the trust at the end of the term passes to charity. As a result, the gains are spread over many years, minimizing the pain of paying the gains taxes all at once. A charitable deduction in the year shares are transferred to the trust can offset some of those future gains taxes.

Shielding concentrated wealth from volatility

If an executive isn’t looking to sell or gift their shares, a variety of option strategies can be used to hedge the downside risk of concentrated equity. These strategies require skill and experience in options trading. Keep in mind, some companies prohibit executives from hedging with options—but if this strategy is available to you, it can be a powerful tool to protect against significant value loss.

Exchange funds are another strategy for executives to consider. These funds contain a diversified basket of stocks, along with roughly 20% invested in a different asset class. Think of it like a mutual fund, but shares can be used to make the initial investment rather than cash. After holding the fund for seven years, your tax basis in the original shares carries over to the diversified basket of stocks. As a result, you have diversified your concentrated position without incurring the gains taxes that would otherwise come from selling to diversify.

All of these strategies have unique complexities when they’re deployed for executives. Financial planning that fits your objectives, minimizes taxes, and aligns with both your company’s ownership guidelines and insider trading rules requires specialized knowledge. Working with a financial advisor who has experience in executive compensation and benefits can help you navigate these complexities.

Don’t wait until it’s too late to develop an effective strategy. Mitigating the risk of having all of your eggs in one basket can be accomplished by working with the right financial advisor on one or more of these techniques. Reach out to your Cerity Partners advisor or request an introduction today.