Using After-Tax Value to Evaluate Liquidation Priority of Concentrated Equity

Concentrated equity can be defined as owning a substantial position in one company’s stock.  For such concentrated positions, one risk for a single owner may be a lack of diversification*.  Or said another way, having too many eggs in one basket.

However, concentration risk may not be a bad thing. In fact, concentration in one company stock may generate substantial wealth if you invest in the right company and that company stock price skyrockets.  But that is not the result for most people.   Therefore, a good financial plan should take the time to identify concentration risk. Once identified, the appropriate considerations should be given to either retain the risk, shift the risk, or eliminate the risk.

Through this process of risk evaluation, a strategy to liquidate and/or exit from a concentrated equity position should be considered. To effectively develop a plan, many strategies must be considered. One simple strategy for managing concentration risk could be to sell the stock outright  and subsequently redirect the proceeds into a more diversified investment portfolio (or to other personal consumption needs).

More advanced planning strategies of divesting a concentrated equity position may include the gifting of stock to a family member or charity, establishing a charitable trust, or using options or hedging strategies to shift single stock risk.

Today’s article will focus on selling stock of a concentrated equity position. More specifically, it will focus on how selling various forms of company stock ownership may result in materially different after-tax values. Because of this, it may be suggested that the selling of various forms of concentrated equity has a potentially disproportionate impact on diversification.   And therefore, any liquidation strategy should take adequate time to evaluate all forms of employee stock ownership prior to determining which shares have the most impact on overall concentration.

Key Assumptions

To limit the confusion and to help equalize the conversation, we should attempt to find a unified valuation method that will allow us to fairly compare the different types of concentrated equity and how a sale impacts diversification. One such metric we can use is the after-tax value that is generated from the liquidation of the equity positions.

After-tax value is the amount that is generated from the sale of the stock after you account for the payment of income taxes.

To calculate the after-tax value, we will make a simple assumption regarding income tax rates that will be used during the analysis. For our hypothetical illustration, we will assume the following tax rates:

  • Ordinary Income – 33%
  • Short-Term Capital Gains – 33%
  • Long-Term Capital Gains – 15%

Admittedly, these tax rates are far from a complete list of the taxes associated with various types of stock liquidation. However, they can provide a framework to continue the analysis. Furthermore, they will help to illustrate a point.  Liquidation of concentrated equity is not created equal.

In addition to tax rates, we should also identify the types of stock ownership that one may encounter. Each of these are discussed in further detail below:

What’s important to know is that the rules regarding the taxation of these stocks differ. Each should be evaluated and then compared to the others.

A Simple Example of After-Tax Value

As mentioned above, our goal is to calculate the after-tax value of selling concentrated equity positions. We will then use the after-tax value to rank the impact on diversification.

To use a simple example, let’s compare $10,000 of value held in a brokerage account (aka long-only stock) versus $10,000 of value in non-qualified stock options (NQSOs).

On the surface, it would seem that $10,000 equals $10,000. If this were the case, it would seem that by liquidating either the brokerage account or the NQSOs, the client would achieve the exact same reduction of concentrated equity. If we were using pre-tax values of $10,000 for each, I would agree.

But what if we looked at this calculation in terms of after-tax value?

Using the assumed tax rates detailed above (as well as several other simplifying assumptions), and the fact that the difference between the grant price and the exercise price of your stock options is known as the bargain element, we can calculate the following after-tax values:

  • After-Tax Value of Long-Only Stock (This assumes the stock basis is $0.00 and that the shares qualify for long-term capital gains treatment.)

Value x (1 – Tax Rate) = After-Tax Value

$10,000 x (1 – 15%) = $8,500

  • After-Tax Value of NQSO

Bargain Element x (1 – Tax Rate) = After-Tax Value

$10,000 x (1 – 33%) = $6,700

By using after-tax values, we can see there is a significant difference as a result of the calculations: $8,500 compared to $6,700. In fact, the after-tax proceeds of the transaction for the long-only stock are more than 25% higher than the proceeds of the non-qualified stock options.

Using this simple calculation to evaluate stock liquidation and its impact on diversification, one could suggest that when it comes to after-tax value, selling long-only stock has a greater impact than selling non-qualified stock options. Therefore, selling long-only stock would be higher on the liquidation priority list if the goal is to reduce concentration risk (in this hypothetical example).

Using the framework above as our model, it makes sense to explore how all types of stock ownership stack up in terms of after-tax value. We can do this by exploring not only each type of stock ownership, stock option, or stock grant but also the various ways that these may be taxed.

Let’s get started.

Long-Only Stock Ownership

Long-only stock can generally be thought of as stock that you purchased with your personal finances. The price you paid for the stock is your basis (just to keep it simple for now), and the day you purchased the stock begins your holding period.

Long-only stock will fall into one of these four categories:

  • Short-Term Capital Loss
  • Long-Term Capital Loss
  • Short-Term Capital Gain
  • Long-Term Capital Gain

We can cover capital losses together in this post. If you sell something at a loss, the tax rate is zero. You don’t have to pay any tax if you don’t make any money.

Using our example above, we can calculate the following:

Value x (1 – Tax Rate) = After-Tax Value

$10,000 x (1 – 0%) = $10,000

Tax Tip – Capital losses may be eligible to offset capital gains and/or ordinary income. From a tax standpoint, selling at a capital loss may be worth more than simply the value of the shares at liquidation. Unfortunately, though, you do have to first lose money in your assets to obtain this minor benefit.

Short-term capital gains are next on the list. Short-term capital gains taxes are imposed on the sale of capital assets that are held for less than one year. The tax rate on short-term capital gains is 33%—the same as ordinary income. The calculation is as follows:

Value x (1 – Tax Rate) = After-Tax Value

$10,000 x (1 – 33%) = $6,700

The last category is long-term capital gains tax, which is paid on a capital asset that is held for one year or longer. Long-term capital gains may receive preferential tax treatment with a rate of 15%.

Value x (1 – Tax Rate) = After-Tax Value

$10,000 x (1 – 15%) = $8,500

The calculations above illustrate the tax impact assuming stock with a zero cost basis.  As the cost basis increases and/or approaches the current value, the after-tax proceeds become larger.  Individual cost basis can and will impact the final after tax value.

Restricted Stock

Generally speaking, restricted stock is taxed as ordinary income when it vests. After vesting, retained shares will be taxed according to the same rules that govern the long-only stock that was detailed above.

An exception to this rule is when a client implements an 83(b) election. An 83(b) election allows the recipient of restricted stock to be taxed on the value of the shares at issue. Any future gain/loss will be subject to the rules of long-only stock that are detailed above.

The opportunity that an 83(b) provides is that a client can capture stock appreciation between issue and vesting at an advantageous tax rate. The risk of this is that shares will be forfeited prior to vesting or possibly decline in value. Both of these scenarios will cause the taxpayer to pay more in income tax than they otherwise would have.

For our purposes, assuming a $10,000 value post 83(b) election, the gain will be taxed at long-term capital gains rates.

Value x (1 – Tax Rate) = After-Tax Value

$10,000 x (1 – 15%) = $8,500

Keep in mind that at issue, the selection of an 83(b) election may require the taxpayer to pay income taxes at this time. That tax payment will need to come from personal assets. So while the after-tax value here is equal to that of long-only stock, it may be reasonable to assume that the negative cash outlay required to perform an 83(b) is an opportunity cost. Continuing this assumption, it could be concluded that this opportunity cost creates a higher risk for 83(b) stock than it does for long-only stock.

Non-Qualified Stock Options

The tax analysis for non-qualified stock options is simple. The bargain element is taxed as ordinary income upon exercise. Using our hypothetical tax rates from above, we can assume this will be taxed at 33%.

Bargain Element x (1 – Tax Rate) = After-Tax Value

$10,000 x (1 – 33%) = $6,700

If non-qualified stock option shares are held after the exercise, the value of the exercise price is then multiplied by the number of shares to become the cost basis. Further stock fluctuation follows the same rules as long-only stock detailed above. This information may be useful in evaluating a liquidation strategy for a client who has previously exercised and held NQSO shares.

Employee Stock Purchase Plan

The shares of an employee stock purchase plan are taxed according to the same rules as a qualifying or disqualifying disposition.

A disqualified disposition is any transaction that does not meet the year-long requirements of a qualifying disposition. The tax rates on a disqualifying disposition are the same as they are on ordinary income, which in our example is 33%:

Bargain Element x (1 – Tax Rate) = After-Tax Value

$10,000 x (1 – 33%) = $6,700

If shares meet the standard of a qualifying disposition, both ordinary income and long-term capital gains rates may be incurred. In particular, any profit associated with the discount (typically between 0–15%) offered by the employee stock purchase plan is taxed as ordinary income. Further gain in excess of the share price at purchase is taxed at long-term capital gains rates.

For our example, we will assume $1,500 as a discount and $8,500 as long-term capital gain:

Value of ESPP Discount x (1 – 33%) + Gain in Excess of Discount x (1 – 15%) = After-Tax Value

$1,500 x (.67) + $8,500 (.85) = $8,230

Incentive Stock Options

Incentive stock options are easily the most complicated of the lot. Not only do incentive stock options have qualified and disqualified rules like their ESPP cousins, but they may also be subject to the alternative minimum tax.

Disqualifying Disposition

A disqualifying disposition of incentive stock is anything that does not meet the standards set for a qualifying disposition. Under the rules regarding a disqualifying disposition of incentive stock options, the tax treatment is the same as non-qualified stock options.

To review, the difference between the grant price and the exercise price of your stock options (which is known as the bargain element) is taxed as ordinary income upon exercise. Using our hypothetical tax rates from above, we can assume this will be taxed at 33%.

Bargain Element x (1 – Tax Rate) = After-Tax Value

$10,000 x (1 – 33%) = $6,700

Qualifying Disposition

If you meet the standard for a qualifying disposition, the difference between the grant price of the stock and the final sale price is taxed at long-term capital gains rates.

Value x (1 – Tax Rate) = After Tax Value

$10,000 x (1 – 15%) = $8,500

Unfortunately, the taxation of incentive stock options will likely not be this clear and simple. The above scenario details the after-tax value on the difference between the grant price and the final sales price, but it does not account for any potential taxes due upon the exercise of the incentive stock options.

At exercise, the difference between the grant price and the exercise price is a tax preference item for calculating the alternative minimum tax. Without going into too much detail, a large bargain element may cause you to owe AMT in excess of what you would have had to pay had you not exercised and held the incentive stock options. A small bargain element may cause a small (or no) AMT to be owed.

We can illustrate the after-tax values of both a large bargain element and a small bargain element by making some additional assumptions.

Large Bargain Element

If we assume a large bargain element, we can reasonably assume that AMT may be owed upon exercise. AMT is essentially a pre-payment of income tax in expectation of future capital gains. For the purposes of our discussion, we will assume the AMT is 28%.

To continue our example from above, let’s make the following assumptions:

  • Final Sale Value – $10,000
  • Grant Value – $0.00
  • Exercise Value – $9,000

Using these figures and the hypothetical tax rate of 28%, we can calculate our after-tax value upon the final sale of incentive stock option shares:

Step 1 – Exercise Value x AMT Tax Rate = Tax Paid Upon Exercise

$9,000 x 28% = $2,520

Step 2 – (Total Gain x (1 – 15%)) + (Bargain Element x (AMT Rate – LTCG Rate)) = After-Tax Value

($10,000 x (.85)) + (9,000 x (.28 – .15)) = $9,670

As you can see from the above example, the large bargain element created an AMT hit of $2,520. This amount was due for the tax year of exercise. After the final sale of the shares, some or all of this may be received as an AMT credit. In our calculation, the credit is $1,170.

By combining this tax credit with the after-tax value of the liquidated shares, we can determine the total after-tax value of this transaction to be $9,670.

Small Bargain Element

We can further illustrate this comparison by changing the exercise value of the shares to a smaller number. In this second scenario—all else being equal—we will change the exercise value to $1,000.

  • Final Sale Value – $10,000
  • Grant Value – $0.00
  • Exercise Value – $1,000

Using the same calculations as above, we see the following:

Step 1 – Exercise Value x AMT Tax Rate = Tax Paid Upon Exercise

$1,000 x 28% = $280

Step 2 – (Total Gain x (1 – 15%) + (Bargain Element x (AMT Rate – LTCG Rate)) = After-Tax Value

($10,000 x (.85)) + (1,000 x (.28 – .15)) = $8,630

As you can see in our hypothetical example, the smaller bargain element produces a significantly lower after-tax value than our previous large bargain element did.

All else being equal, it could be reasonable to assume that large bargain element incentive stock options may produce a higher after-tax value than low bargain element incentive stock option shares.

However, from a time value of money standpoint, it should be noted that the AMT associated with the exercise in the second scenario was also significantly lower. To put this another way, the first example required the client to “invest” significantly more cash into the transaction than its counterpart did (via a prepayment of taxes). This is something that should be actively considered as part of the planning.

While I use disclaimers on my site often, it should be noted again that these hypothetical examples are intended to illustrate a point and are not intended to be a complete tax analysis or used as part of an individual plan. The tax rates on all the transactions discussed can change based on your personal situation.

Employer Stock in a Retirement Plan

It’s possible to own employer stock in a company-sponsored retirement plan, more specifically, in a 401(k) plan or an ESOP.

In its simplest sense (and assuming they are qualified), any distributions from a retirement plan will be taxed as ordinary income for the recipient. Assuming our same $10,000 value, the after-tax value will be as follows:

Value x (1 – Tax Rate) = After-Tax Value

$10,000 x (1 – 33%) = $6,700

Net Unrealized Appreciation

Prior to distributing company stock in a retirement plan, it may make sense to first consider net unrealized appreciation. Net unrealized appreciation allows for a distribution of company stock from a retirement plan into a non-IRA investment account in lieu of a direct rollover. Upon distribution, the basis of the company stock (what you paid for it) will be taxed as ordinary income, and the gain will then be taxed at the long-term capital gain rate.

To illustrate, let’s assume the following:

  • Value at Final Sale – $10,000
  • Cost Basis of Shares – $1,000

Using these figures, we can calculate the following:

Cost Basis x (1 – 33% +(Final Sale – Cost Basis)) x (1 – 15%) = After-Tax Value

$1,000 x (.67) + ($10,000 – $1,000) x (.85) = $8,320

As the cost basis approaches the final sale price, the after-tax value of net unrealized appreciation decreases as more money is attributable to a higher tax calculation.

Conclusions and Observations

As discussed at the very beginning of the article, it may not be as important to consider the pre-tax value of stock as it is to consider the after-tax value when determining the liquidation impact on diversification.

To further evaluate the point, we can summarize the material above into a chart that illustrates the after-tax value created by the sale of $10,000 of value in various forms of company equity.

Capital Loss $10,000
Short-Term Capital Gain $6,700
Long-Term Capital Gain $8,500
Vesting Restricted Stock $6,700
Restricted Stock 83(b) $8,500
Non-Qualified Stock Options $6,700
ESPP – Disqualified $6,700
ESPP – Qualified $8,230
ISO – Disqualifying $6,700
ISO – Qualified, Large Bargain Element $9,670
ISO – Qualified, Small Bargain Element $8,630
Retirement Plan – IRA $6,700
Retirement Plan – NUA $8,320

The figures above reflect the values as calculated based on our hypothetical example above. Figures can and will vary based on personal details.

By further reordering the chart, we can rank the calculations from highest after-tax value to lowest.

Capital Loss $10,000
ISO – Qualified, Large Bargain Element $9,670
ISO – Qualified, Small Bargain Element $8,630
Long-Term Capital Gain $8,500
Restricted Stock 83(b) $8,500
Retirement Plan – NUA $8,320
ESPP – Qualified $8,230
Short-Term Capital Gain $6,700
Vesting Restricted Stock $6,700
Non-Qualified Stock Options $6,700
ESPP – Disqualified $6,700
ISO – Disqualifying $6,700
Retirement Plan – IRA $6,700

If the goal is to diversify concentrated equity, and we identify the after-tax value of a liquidated equity position as a unifying metric, we can then suggest that a higher after-tax value will result in a greater concentration risk than a lower after-tax value. Using our chart to illustrate, a long-only equity position with a capital loss ($10,000) can be deemed (in our example) as riskier (as defined by impact on diversification) than a retirement plan with no net unrealized appreciation ($6,700).

Therefore, liquidating capital loss stock would have a greater impact on reducing your equity position than liquidating anything else (all else being equal).

The least impactful assets to liquidate would be anything that would receive ordinary income tax treatment.

Planning for Diversification

From a financial planning standpoint, this analysis can be used to further evaluate the options for liquidating concentrated positions. More than anything, it should be noted that all liquidation is not created equal in terms of tax impact or diversification. Simply put, the after-tax value has a material impact on how much concentration risk is eliminated (or not).

Furthermore, a complete initial financial planning analysis would help to identify the goals and objectives of the concentrated equity position. Is the goal to liquidate, retain, and redeploy assets for personal use and/or retirement funding? Or is the goal to gift assets to a charitable remainder trust that produces an income stream and provides a tax deduction? Or what if the goal is to gift assets to family members?

These financial planning questions should be the first addressed when evaluating how much company stock to own, how it fits into your plan, and what the best option for its disposal may be.

*While there is no guarantee that a diversified portfolio will produce better returns than an undiversified portfolio, and it does not protect against market loss, a diversified portfolio may reduce a portfolio’s volatility and potential loss.

Tax services are not offered through, or supervised by Lincoln Investment, or Capital Analysts. None of the information in this document should be considered as tax advice.  You should consult your tax advisor for information concerning your individual situation.

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4 Responses to Using After-Tax Value to Evaluate Liquidation Priority of Concentrated Equity

  1. akash May 27, 2017 at 10:19 pm #

    Hey Daniel,

    Interesting post on looking at post tax values. Perhaps its disingenuous to include the full pre-tax value of my retirement accounts in my net – worth, since I have yet to pay taxes on them!

    I’ll definitely take a closer look at the post tax value of my portfolio going forward

    -Akash

  2. Vijay Kapoor May 31, 2017 at 6:12 am #

    Great post about after tax value. This will help me in planning my money in better way. I would like to know that, Is this plan useful for huge amount?

    • Daniel Zajac, CFP®, AIF®, CLU® May 31, 2017 at 8:06 am #

      Thanks Vijay – The concept of after-tax value can be applied to amounts small and large. As for how it plays into a specific plan, that is an answer that likely takes a detailed analysis of everything.

      I think the post may help in evaluating one part of the process, which may be which equity can be/should be liquidiated (based on personal goals)

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