There was once a man who sat down in my office and gave me advice on how to treat him. He said “I have a certain way of doing things, and I am too old and too stuck in those ways to change. I already know what you are going to say, and I am going to give you a few rules of thumb about me that you need to know.”
He paused. It could have been for theatrical effect. Maybe he was still trying to collect his thoughts. Part of me hoped he was about to distill some deep, decades-in-the-making kind of wisdom.
It was a fairly lengthy pause. It gave me time to reflect a little more on what he said.
Part of me respected that he was at least self-aware enough to admit he was stuck in his ways. Part of me disliked that he assumed he already knew what I had to say.
Part of me wondered if I was in for a good old mansplaining session.
The pause went on. It started to cross over from theatrical to uncomfortable.
He finally cleared his throat and said “I kind of lost where I was going there.”
I reminded him he was about to share rules of thumb for dealing with himself. And he replied “Oh, I didn’t forget what I said. I just realized what I was going to say won’t work, and that I don’t have a good way of dealing with someone like me. You are going to have to wing it.”
It turned out he was a business owner. For today, let’s name him Jerry. Jerry had owned his business for over thirty years, and he was getting ready to retire. Like many small business owners I have met, he hadn’t invested much outside of his business. Almost everything he had was wrapped up in the thing he walked into every day and knew inside and out. It occupied most of his thoughts, gave him the comfort of control, and had even served as the backdrop for raising his two now adult children.
But Jerry had a problem.
Someone else, seemingly completely different than this gruff, self-made man, shared the same problem.
She was not a business owner. She was thirty four years old–Jerry had run his business about as long as Julie had been alive. She had no children, no intention of retiring any time soon, and no preconceived notions to impress upon me for how she ought to be treated. Let’s call her Julie. For the last decade, Julie had worked as a software engineer at one of the largest tech employers in the Pacific Northwest. Between her stock grants, contributing to her employer’s stock purchase plan, and the company’s strong growth, she had amassed a small fortune in her company stock.
Julie said “I have a problem.”
It turned out they both shared the same problem:
Their wealth was uncomfortably concentrated in a single company, but they felt stuck.
The business owner recognized the time had come to separate his financial success from his business–he wanted to sell. But he felt like the business wasn’t ready to be sold, didn’t know how to prepare, worried about taxes, and didn’t know what life would look like financially afterwards. He was already grappling with the personal implications of leaving his business, customers, and staff that he had spent many years devoted to. He felt stuck.
The software engineer, on the other hand, had no intentions of leaving her employer; she simply wanted to reduce her risk. Her net worth, income, and benefits were all heavily tied to the same company. She believed in her company’s products, leadership, and capacity to continue to innovate. She thought her company would even outperform the rest of the stock market.
But Julie also was smart enough to step outside herself and recognize her own bias. She told me she “woke up” when her company’s stock price fell nearly 20% in a week while the rest of the market barely moved. It ricocheted back up a few weeks later, but it didn’t matter.
She said “Conner, that could have been 20% of my future house. Or 20% of my vacations, evaporated for an unknown length of time, however long it takes for people’s opinions to change again.”
She also had friends who worked for other companies, including competitors, and they also fervently believed their own companies were destined to trailblaze and further capture market share. She recognized that she might be drinking the company’s Kool Aid–and that she didn’t want her financial future to be purely dictated by the fortunes of this company. Her life plans were too important to risk it on one ticker symbol.
But Julie also felt stuck. The gains in her RSUs and other stock were so high, she was worried about the capital gains tax she would pay. Even with long term capital gains treatment (more preferential than short term), she was looking at a 23.8% tax. Washington doesn’t have a state income tax (yet), or it might have been even more.
I don’t claim to have solved all of Jerry and Julie’s problems. Jerry will need to reinvent his daily routine if he doesn’t work in his business, and he seriously needs to work on the Jerry User Manual.
Meanwhile, Julie might have to contend with the thought that if her company exceeds expectations, she might be worse off despite having made a rational decision given the knowledge she had at the time. She also suspects her current job may not exist in ten years, and that she may need to reinvent herself.
I can talk through those problems with them, but some of those challenges are theirs to solve.
But one place where I can almost certainly help is the fear of taxes. There are ways to minimize, defer, and generally soften the tax liability from divesting from a large stock position–whether you own the business as a sole proprietor or as a passive investor in a trillion dollar Magnificent 7 company. Let’s walk through how to dispel the fears:
Quantifying your liability: the first step is understanding how scared we really should be. Jerry’s business fell under the qualified small business tax exemption, known as the QSBS Exclusion. It lets some business owners exclude up to 100% of capital gains tax when selling their company. The tax break depends on when the business was formed, but for Jerry it was capped at $10 million.
Explaining this to Jerry about blew his mind: in his world, he just found a couple million dollars in his jeans pocket. The fear in his mind of losing his life’s work to Uncle Sam suddenly shrank.
Understand your options: for Julie, she figured that as a “simple W-2 employee”, she didn’t have many choices for lessening her tax bill.
But after a conversation, the world opened up for her. We talked about spreading her sales over time to keep her within lower tax brackets.
We talked about how her tax brackets could change if she decided to formally marry her long time partner. She had always thought marriage would mean she’d pay more in taxes, but in her case it was the opposite.
After evaluating her stock in detail, we realized she could sell almost 18% of her total position in the company without paying a dollar in capital gains. There were positions with either losses or little gains from periods when she purchased stock at relative highs.
We talked through investment strategies that could help offset her capital gains. Tax loss harvesting was something she never realized could meaningfully offset gains from selling her company stock. We talked about using direct indexing to magnify tax loss harvesting while also specifically excluding further investment in the company she already owned too much of.
This wasn’t unique to Julie, either–Jerry’s business was large enough that he still would owe some capital gains, but these could also be offset using tax loss harvesting. I think I blew Jerry’s mind a second time when he realized you could have growth in investment accounts while realizing substantial losses on the tax front.
Something Julie could explore that Jerry could not, however, was an exchange fund. Exchange funds, not to be confused with exchange traded funds (ETFs), can allow an investor to exchange their concentrated stock position for a few dozen other stocks. A key benefit is that you avoid realizing capital gains.
Granted, it isn’t perfect–there are a lot of strings attached. Many exchanges require that you be a Qualified Purchaser, which can require over $5 million in investable assets. There is almost always a 7 year holding period, and you often need to allocate $100,000-500,000 to the funds. And while Julie’s publicly traded stock was a great candidate, Jerry’s small, privately held company stock was not.
Adjust how you think about the solution. Julie had assumed the only way to reduce her risk was to sell part of her stock. While some of the potential solutions to her stated goals involved exactly that, there were other options as well…literally.
One way to manage her risk was to create an options overlay for her stock. Options are generally misunderstood creatures: used properly, they can actually limit risk.
In Julie’s case, for example, she could buy puts to limit her downside risk. Puts guarantee that Julie could still sell her stock for a certain price. And if the stock price shoots up, Julie never has to sell and pay tax.
Granted, there are limitations. Puts don’t last forever–they expire. And you pay for them. In a sense, you are buying stock insurance. The higher the floor price or the longer the puts last, the more expensive they get. And if Julie’s puts expired and the stock had dropped to $202, she would be in a pickle–down 23%, down the price of the put, and still unable to take advantage of the put! And buying new puts at similar levels would be really expensive.
This is only the tip of the iceberg. There are all kinds of complicated methods and combinations to create the right outcome for clients who want to unwind concentrated wealth. Prepaid variable forward contracts, long/short strategies, charitable remainder trusts, family gifting strategies, cost segregation combined with short term rental properties…there are a dizzying number of possible strategies.
But the point isn’t to try and use all of the fanciest methods and complicated techniques to solve a problem. The point is to stop feeling stuck. Jerry and Julie both felt like their wealth wasn’t helping them–it was actually making them feel trapped in their circumstance.
We opened their possibilities–not by throwing the kitchen sink of strategies, but by listening to their challenges, understanding deeply what they wanted, and creating a simple, elegant path forward. We want clients feeling confident and secure that we have a plan to address their needs.
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These are case studies for illustrative purposes only and should not be construed as a recommendation. They may not be representative of your experience. Conestoga Wealth Partners does not provide legal or tax advice. You should consult a legal or tax professional regarding your individual situation.