4 potential ways to navigate highly appreciated stock option positions from employment

Nobody likes paying more in taxes than they have to. And when it comes to finally cashing out on your stock options after putting in hard earned hours at your employer, seeing the number on your screen get eaten away by capital gains taxes can feel like a gut punch. Despite first appearances, there are ways to help mitigate the potential for your capital gains taxes if your investments are managed with a bit of foresight and some strategic planning. What we’ll go through below are some starting points if you’re looking to potentially sell off some highly appreciated positions you may have gained through employment or other means. Note that we’re assuming in this case that you have already exercised your stock options and are not at liberty to take advantage of strategies that could be employed prior to exercise.

1. Tax Loss Harvesting

Tax loss harvesting is (usually) done annually to sell off any positions in your non-qualified (aka non-retirement) accounts that have a negative capital gain for the year. This benefits you for a few reasons. One being that these capital losses can offset any capital gains. The second being that these losses can be carried forward year to year indefinitely. For this reason it’s important to track and take advantage of these losses as you never know when you may need to liquidate and realize gains in some of your other positions.

Now, assuming you have not been taking advantage of tax loss harvesting and don’t have an immediate need to liquidate your highly appreciated employer positions, your best option is to begin tax loss harvesting assuming you have positions in place to do so. As you build up these losses, you can eventually sell off your appreciated positions to offset some or all of the gains.

2. Donor Advised Funds

Assuming you’re charitably inclined, Donor Advised Funds provide a cost efficient and high impact way for you to make charitable contributions while offsetting potential capital gains. In the case of highly appreciated stock positions, you can donate the appreciated shares to your established Donor Advised Fund and receive an immediate tax deduction. You can then sell an equal amount of shares still held by you personally to offset any gains and diversify the position.

There are quite a few different charitable strategies that can be employed to offset the capital gains incurred, but all involve gifting which may not be appropriate if you’re in need of the funds in the future.

3. Direct Indexing

Direct indexing involves purchasing shares of companies to match the weight of a particular index (such as the S&P 500) and then actively managing the position harvesting any losses. For example, using the S&P 500 index as a benchmark, an asset manager would go out and purchase shares in all companies also in the S&P 500 and attempt to match the weighting as accurately as possible. One of the benefits of this solution is that if you’re more risk tolerant you can customize your weighting accordingly.

As the index inevitably fluctuates in value, the asset manager will actively manage the positions seeking to take advantage of any unrealized losses thus generating capital losses in your portfolio. These losses can then be utilized to offset gains in your employers stock position so you can begin to diversify further. A downside of this strategy is the initial capital required to start this strategy can be quite high often exceeding $100K+ which is not inclusive of your concentrated position.

4. Grantor Retained Annuity Trust

By far, the most complicated strategy mentioned here is the Grantor Retained Annuity Trust (or GRAT for short). Why is it so complicated? Because you’re coordinating with estate planning attorneys, accountants, and your financial advisor to execute on a GRAT.

The high level idea goes like this: you take an asset, such as your highly appreciated stock position, and transfer that stock into an irrevocable trust. An annuity payment is then established from the trust to the beneficiary of the trust for a fixed period of time, say 5 years. That beneficiary over those 5 years will receive an equal payment plus the value of an IRS determined interest rate on the value of the holdings. If there’s appreciation beyond the annuity payments then the remaining value goes to the heirs of the estate. The beneficiary of the annuity payments can end up paying little or no estate / gift taxes when the annuity payments are complete and the trust expires. This strategy can be very popular among very early employees of startups or companies who’s shares have exponentially increased and need a way to mitigate estate tax consequences.

As you can see, there are solutions to the issue of having highly appreciated or concentrated stock positions. But each one has it’s tradeoffs and it’s important to consult with your financial advisor on what your goals are so that a solution can be customized to your needs.

Any opinions are those of the author and not necessarily those of Raymond James. Expressions of opinion are as of this date and are subject to change without notice. There is no guarantee that these statements, opinions or forecasts provided herein will prove to be correct. The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete, it is not a statement of all available data necessary for making an investment decision, and it does not constitute a recommendation. Past performance is not a guarantee of future results. Investing involves risk and you may incur a profit or loss regardless of strategy selected, including asset allocation and diversification.

While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional.

Investments that utilize a direct indexing strategy carry specific risks that investors should consider before investing. In certain market conditions, passive direct indexing investment strategies may lose value or underperform active strategies. Direct indexing strategies have the risk of not closely tracking the performance of the underlying index they seek to replicate. While attempting to track an index, passive investments often do not consider a company's profitability, financial health, or growth potential in their investment selection criteria.

Tax-loss harvesting involves certain risks, including, among others, the risk that the new investment could have higher costs than the original investment and could introduce portfolio tracking error into your accounts. There may also be unintended tax implications. Prospective investors should consult with their tax or legal advisor prior to engaging in any tax-loss harvesting strategy.

Donor Advised Funds - Donors are urged to consult their attorneys, accountants or tax advisors with respect to questions relating to the deductibility of various types of contributions to a Donor-Advised Fund for federal and state tax purposes. To learn more about the potential risks and benefits of Donor Advised Funds, please contact us.