As I sat across the desk from one of my clients, I could tell he was conflicted by our conversation. The founder and CEO of a successful startup, my client was starting to get serious about retiring. We were working through various scenarios to come up with a financial blueprint as he prepared to begin handing the reins of the company he had built to his successors.
I could feel the tension beginning to mount as I started to talk about how much of my client’s net worth was presently concentrated in his company’s stock. His brow furrowed, and his “active listening” comments became fewer and less enthusiastic. He crossed his arms on his chest and frowned.
Finally, he looked up at me and said, “Kimberly, I get it: I’m over-exposed with my equity in the company. But the thought of liquidating it feels like cutting off part of myself. I just don’t know what to do.”
Obviously, my client is an intelligent person and an astute business thinker—you don’t successfully take a company public unless you’ve got talent, leadership ability and good instincts. But it was just as obvious to me that my client’s emotional attachment to his company had the potential to pose a significant obstacle to the type of financial structure we needed to build in order to facilitate the retirement lifestyle he claimed to want.
My job, as his advisor, was to figure out how to bring him around to a more strategic, goal-aligned way of thinking.
Thinking Through the Issues
When our clients come to us to help them sort through their choices around equity compensation, they are depending on us to help them navigate terrain that presents both tremendous opportunity and a fair number of potential pitfalls. Equity compensation packages can be complex. It’s up to the advisor to be prepared with answers that take into account not only the rules and requirements, but also the client’s unique financial situation, goals and priorities.
We need to be prepared to do everything, from helping them understand basic terminology to crafting tax-efficient strategies for dealing with capital gains. And, in the case of situations like my client, we may even need to put on our “counseling” hat as we help the client work through the emotional implications of unwinding a business relationship that they may have spent years putting together.
The list of topics we need to be prepared to discussed may include — but is certainly not limited to:
- Incentive stock options (ISOs), non-qualified stock options (NSOs) and restricted stock options (RSUs), and the differing attributes of each.
- Issue and exercise dates, grant or strike prices, vesting schedules, and the implications of each for the client’s specific compensation package.
- Capital gains and tax implications (in coordination with the client’s tax advisor).
- Concentrated positions and the risks involved.
And, maybe most importantly, we need be prepared to discuss how the client’s thinking must shift as they utilize the value of their options to further their personal financial strategies.
Communicating the Basics
As advisors, we must first gain a thorough understanding of the nature and composition of the client’s equity compensation within the context of the client’s overall financial situation.
For example, if the client has ISOs, will exercising them trigger alternative minimum tax considerations? If the client exercises NSOs, the gain based on the difference between the grant price and the market price will not qualify for long-term capital gains treatment — so, how will this affect their tax bill in the year they exercise the options?
While it is typically not our place as financial advisors to provide specific tax advice, we should have these conversations with our client and their tax expert to ensure that tax efficiency is addressed adequately.
When company stock is held within a 401(k)
Here’s another discussion point: If the client has accumulated company stock inside their 401(k) — a common offering for many employer-sponsored plans — should they consider a net unrealized appreciation (NUA) approach? NUA allows the investor to roll over the shares to a taxable account, at which time they recognize and pay taxes on the investor’s cost basis (calculated on the grant price).
If the client holds the shares in the account for at least a year before selling them, they would be responsible only for the gain between the time of the rollover and the time of the sale. Further, this gain would qualify for more favorable long-term capital gains treatment.
For some clients, dealing with the tax implications of their stock holding in this way could be more advantageous than simply rolling the shares into a traditional IRA. The latter would require paying taxes on the entire amount of appreciation all at once, when shares are liquidated to meet RMD rules.
Again, you should be prepared to coordinate such discussions with your clients and their tax advisors, with an appropriate view toward the client’s best interests.
Concentrated Positions — Financial and Emotional
Talking with clients about what should be done with their holdings of company stock can sometimes feel like mentioning the elephant in the room. Your clients may have spent years or even decades building their company into something of significant value. Or perhaps they have served the company faithfully for years as a key employee and feel intense loyalty because of what that service has allowed them to achieve. Now that it is time for them to capitalize on that value, your client may feel they are betraying the company. Or they may feel like they are surrendering or even denying their basic identity.
Additional Reading: Encourage Your Clients to Watch the ‘Sunset’
In such situations, it’s important to help your client understand that they are moving from one role to another. Until now, “success” has looked like serving the company: giving everything they have to help the company become and remain vibrant. Going forward, however, it is time for the company to give something back to them. Your client could even think of it as a financial gift of appreciation from the company for all they have given to it.
The point is, we must help our clients shift their primary concern for the company’s welfare to their own personal goals, dreams and needs. If we can help them make that important emotional shift, then it can become much easier to discuss the best ways to unwind a concentrated position and reduce the risks that go along with it.
Focus on What Client Wants to Achieve
There are several ways to help clients disperse holdings from a concentrated position. Foremost, we must thoroughly understand each client and what they are hoping to accomplish as they transition into a new phase of life. For example:
- Do they have philanthropic aspirations? If so, why not talk to them about placing shares in a charitable remainder trust or, if they don’t need the income, in a donor-advised fund (DAF)?
- Look at tax-loss harvesting. Are there unrealized losses elsewhere in the client’s portfolio that could be used to offset capital gains from liquidating company stock?
- If the concentrated shares are held within a tax-advantaged account, they could be sold without current tax implications and the proceeds could be reallocated within the account. This would create greater diversification for the client.
- Do they want to leave a legacy for their family? It may be time to bring in an estate planning specialist to discuss trusts and other means of shifting ownership of the stock out of the client’s taxable estate.
Having too much net worth tied up in a single asset can be risky. By employing our professional knowledge and our empathy and insight from knowing each client, we can help them reduce their financial risk and emotional vulnerability. They are depending on us.
Kimberly Foss, CFP, CPWA, is a senior wealth advisor with Mercer Advisors, practicing in the Sacramento Valley area. The opinions expressed by the author are her own and are not intended to serve as specific financial, accounting or tax advice. Mercer Global Advisors Inc. is registered with the SEC and delivers all investment-related services. Mercer Advisors Inc. is a parent company of Mercer Global Advisors Inc. and is not involved with investment services. Click here for a full disclaimer.
