Because of the recent rapid growth in many stocks, employees who receive some form of equity in the company they work for as part of their compensation may now have a large percentage of their net worth tied to the value of the company. This is in addition to the company being the source of their future income. The highly concentrated stock position is especially common for employees of companies in high tech, biotech and life sciences. Or you may have been lucky and purchased shares of a company a long time ago which have soared in value recently. Having signficicant assets, and potentially your income too, all riding on the performance of one company is a situation which is uncomfortably risky for most people.
What Is A Highly Concentrated Stock Position?
The definition of a highly concentrated stock position is somewhat subjective, but a general rule of thumb is if you have more than 10% of your total investment portfolio in a single stock or a single company, then you have a highly concentrated stock position. It applies to a single stock only, not to holding in a diversified pool of stocks like a mutual fund or an exchange traded fund (ETF). The total investment portfolio includes all your investable assets, but would not include the house you live in.
Why Does It Matter If I Have A Highly Concentrated Stock Position?
Just as stocks can soar to new high values, they can also drop in value. Sometimes the change in value is expected, but often there are many events which are impossible to predict beforehand. And sometimes the drop happens very quickly. An example is the global financial crisis of 2007-2008, or the steep drop in stock values in March 2020. Many stocks rebounded after the March 2020 downturn, but that isn’t the norm after a steep decline. According to a study conducted by J.P. Morgan, about 40% of all Russell 3000 companies have lost at least 70% of their value, permanently, down from their peak since 1980. For technology and biotech companies, the number is even worse. If you think about a significant and quick drop in value for the company you are highly concentrated in, how would that effect your financial security? If it makes you nervous, it may be time to reduce your highly concentrated stock position.
While investors may be tempted to hold a highly concentrated stock position with the hope of greater profit still to come, they often don’t understand that they are not being adequately compensentated by the stock market for taking on the risk associated with holding the stock. Riskier investments should provide higher returns than lower risk investments to compensate the investor for absorbing the additional risk. However, the risk/reward premium turns against the investor when too few stocks are owned, and especially when the investor hold a single dominant position.
Not Wanting To Reduce A Highly Concentrated Stock Position
Many people have a highly concentrated stock position as a result of receiving compensation from their employer through Incentive Stock Options, Restricted Stock Units, an Employee Stock Purchase Plan, or some other form of equity compensation. If the company is doing well, the stock is going up in value, and everyone is feeling good, it can understandably be very hard to sell some of the stock to reduce your concentrated position. Or you may not want to sell stock because you may not be too keen on paying taxes on the sale, or you may be restricted from selling whenever you want because you are a high level employee.
Making an intentional plan to reduce your risk to a level which is more appropriate for your finanical goals is a smart move. It will prevent your financial plan from taking on more risk than is necessary or advisable. You can still participate in the growth of the stock, you can manage the tax impact of a sale, and you can file a 10b5-1 trading plan to set a plan for selling stock over time if you are a high level employee. And you will be able to sleep at night knowing your financial goals will not be sacrificed if there is an unexpected downturn in the value of the company.
Solutions for Highly Concentrated Stock Positions:
While a large increase in value for a stock you own is a good problem to have, it’s not without it’s challenges. The primary options to reduce your overall risk while managing the tax consequences are as follows:
- Sell shares and pay the capital gains tax. Care needs to be taken to manage the timing of the sales, both from managing the risk associated with holding the securities and for managing the tax impact of the sales.
- Keep the share until the death of the owner and the heirs will receive a step up in the cost basis upon the owner’s death, resulting in no capital gains recognized for income taxes. This is as the tax law stands now, and it may change in the future. There is the additional risk that the stock value may decrease significantly before the owner passes.
- Use put and call options to reduce the downside risk, but it also limits the upside potential. The timing needs to be managed to mitigate tax consequences and it has additional costs associated with the options.
- Use an Exchange Fund to diversity your holdings and not incur capital gains tax. An Exchange Fund will pool investments with other people who have highly concentrated stock positions to achieve diversification, similar to a mutual fund. However, there are significant costs and restrictions involved with this strategy.
- Donate shares to a charity, either directly or through a Donor Advised Fund or a Charitable Remainder Trust. You will potentially receive a tax deduction for a charitable contribution and you avoid paying capital gains tax on the donated stock. There are costs and restrictions involved with this strategy as well, especially if you choose to set up and fund a Charitable Remainder Trust.
- Use a Protection Trust to manage the downside risk of the stock losing value. It is similar to an Exchange Fund, but each investor also contributes cash in addition to stock to limit the risk associated with the pool of stocks losing value. There are significant costs and restrictions to be aware of with this strategy as well.
- A combination of the solutions for highly concentrated stock postions listed in items 1 through 6 above.
Each possible solution has it’s advantages and disadvantages. Professional advisors which may include an accountant, financial advisor and attorney, should be consulted to decide which option is right for your situation.
Tax Consequences of Equity Compensation:
The nuances of the tax consequences for various forms of equity compensation are important to keep track of because there are significant advantages that can be lost if transactions are not executed correctly. A highly concentrated stock position can be diversified, but careful attention needs to be paid to the tax advantages of different type of equity compensation before a diversfication plan can be put into place.
For investment education, the Fidelity website has plenty of helpful information. If you want a more structured approach, Next Generation Personal Finance has on-line courses to learn more about investing and personal finance topics and a free on-line resource to learn more about investing from the agency which regulates the investment industry, FINRA, is here.
Disclaimer: This article is provided for general information and illustrations purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult with a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Tricia Rosen, and all rights are reserved. Read the full disclaimer.