Stock in your rising company can present a once-in-a-lifetime opportunity to build wealth. To make the most of it, however, it’s important to understand the nuances involved in buying, selling, and tax planning. Once you’re holding vested shares, you face important decisions around when to sell, which and how many shares to sell, and how to manage the tax consequences. In this article, we’ll outline some of the main factors to consider when answering these questions.
Do you have material, nonpublic information about your company?
Trading stock while you have access to material, nonpublic information about your company could subject you to criminal liability for illegal insider trading. Penalties can include prison time and substantial fines, so it’s wise to take every precaution to eliminate any appearance of illegal trading. Many investors do this by establishing a 10b5-1 trading plan.
10b5-1 trading plans are legally binding contracts. To provide an affirmative defense to allegations of illegal insider trading, a 10b5-1 plan must either
- Specify the quantity of shares to be traded (by number or market value), the price at which trades will be made, and on what dates or
- Define a method, such as an algorithm, that will determine the quantity, price, and timing of trades.
Under the plan, trades must be made by someone other than you (typically a broker, whom companies sometimes designate for their employees), and you are prohibited from attempting to influence their trade decisions once the plan is in place. Attempting to use the plan to evade insider trading prohibitions is also illegal. Because of the strict requirements of Rule 10b5-1, it’s important to work with an investment advisor who has experience creating these plans.
Have you satisfied applicable holding periods?
Short vs. Long-Term Capital Gains
Generally speaking, long-term capital gains rates apply to gains from the sale of shares held longer than one year; for shares sold one year after they’re acquired or sooner, short-term capital gains rates, which are equivalent to ordinary income tax rates, apply. You could realize substantial tax savings by satisfying the long-term capital gains holding period; however, this shouldn’t be the only factor in your decision of when to sell.
ISOs and QSBS
Some types of equity compensation receive special tax treatment if you hold them for a specified period. If you exercised incentive stock options (ISOs), the difference between the price you paid at exercise and the fair market value at the time may be subject to preferential tax treatment—but only if you hold them for at least one year after exercise and at least two years after the option grant. If your shares meet the requirements for qualified small business stock (QSBS), up to 100% of the gains from sale may be excluded from capital gains tax, but you must first hold them for at least five years.
Which shares do you want to sell?
It’s likely that you’ve acquired your company stock at various times, for example, through a vesting schedule or periodic purchases through an employee stock purchase plan (ESPP). If you don’t specify which shares you’re selling, the default “first in, first out” (FIFO) rule will make the determination for you. This may or may not be the most beneficial choice. Ensure you’re getting the greatest overall value from the sale by consulting an advisor with a firm grounding in both equity compensation and tax planning.
Have some of your shares lost value?
If you have a mix of shares, some with current market value above your cost basis and some whose value is below, this gives you an opportunity to take advantage of tax-loss harvesting. While it may be counterintuitive to sell shares at a loss, selling these shares first can provide a distinct advantage: the resulting losses can then be used to offset gains. Even if you realize losses beyond your capital gains, you can deduct up to $3,000 of the remainder from ordinary income and carry over anything left to future tax years.
When engaging in tax-loss harvesting, however, it’s important to avoid running afoul of the wash-sale rule. This IRC provision stipulates that if, within 30 days of sale, a taxpayer acquires substantially similar securities to those sold at a loss, the loss will not be immediately deductible. Instead, it will be added to the basis in the newly purchased shares.
Do you understand the tax consequences of the sale?
The tax code is complex, and many factors can affect how a transaction is taxed. For example, the alternative minimum tax (AMT) limits the potential benefit of many tax preference items and often impacts those with ISOs. The AMT is an alternative tax calculation used to ensure that high-income taxpayers pay at least a minimum amount of tax. It does so by eliminating many tax preference items. Careful planning can often allow investors to avoid having to pay the AMT, but this is not always possible. In these cases, an experienced advisor can design a financial strategy to minimize its overall impact.
Does the sale support your overall financial plan?
While building wealth can be useful, it’s probably not your life’s purpose. Consider how gains could make the greatest impact on your life and the lives of others you care about. For example, selling at a certain time might help you take a sabbatical, purchase your vacation home, or make an impact through philanthropy. Putting market movements ahead of your real-life priorities to capture a better price for your shares can cause you to miss out on opportunities like these—and you still may never be able to sell at the price you’re hoping for. If you don’t already have one in place, make sure to create an overall financial plan, and use it to inform your investment decisions.
Capitalize on your Pre-IPO or Post-IPO financial strategy
WRP specializes in helping pre- and post-IPO employees navigate the complex landscape of equity compensation. Providing complete wealth management, we can help you create a financial plan that serves your unique goals and priorities, make wise investment decisions, and keep your tax liability under control. Feel free to browse our free resource library or blog for more insights about making the most of your employee stock.