Company Stock

Introduction

Sometimes people find themselves holding significant positions in a single stock. Usually, it is the stock of their current or former employer (“company stock”). The stock may be held in their 401k. Or they may have stock options. Or they may have restricted stock units (RSUs) or other stock awards. The purpose of this article is to provide guidance for those with this “problem,” though it is certainly a good problem to have! 

I will discuss in some detail the following forms of company stock ownership. I suggest that you skip to the section that applies to your situation:

• Company stock in 401k plans
• Employee stock options
• Restricted stock units and stock grants

Concentrated Stock Positions

If you have received company stock as an employee or as non-employee compensation, it is likely that the size of your company stock position may be large relative to the rest of your overall investment portfolio. The larger your company stock holding as a percentage of your overall portfolio, the more stock-specific risk you have. Modern portfolio theory asserts that investors are not compensated for “diversifiable risk” such as stock-specific risk. Only “systematic risk,” or the non-diversifiable risk of holding a diversified portfolio, is compensated. You may believe that you have special insight into your company stock. You may have emotional ties to the company and its stock. However, it is not prudent to hold too large a position. 

How much concentration in a single stock is too risky? While some experts posit that 5% is a good limit, others suggest 10% or even 20%. The most widely-cited recommended maximum is 10%. 

The most common way that people end up holding company stock is through their 401k plans. Often, employers make their 401k contributions to employees in the form of their own stock rather than cash. Although most experts suggest that 401k participants immediately sell company stock and reinvest the proceeds in a diversified portfolio, sometimes that doesn’t happen for whatever reason, be it inertia or loyalty or concern for appearances.

The simplest way to reduce concentration risk is to trim back on the large position and reinvest in a diversified portfolio. Typically, company stock is held in a tax-deferred account, so there are no tax consequences to simply selling the stock. (Please read the section below before doing any selling, however.) If the stock is held in a taxable account, any sales of stock will result in capital gains taxes. One method of managing the tax costs of realizing capital gains is with "direct indexing,” a type of account that we offer at Sapient Investments. It may be optimal to combine taxable company stock positions with a taxable portfolio of individual stocks that will provide the flexibility needed to “manager around” the company stock position by owning stocks that will diversify the company stock. For example, a directly indexed portfolio may avoid owning stocks in the same industry or sector as the company stock.

There are also other more complicated techniques that can be employed to control exposure to company stock, such as hedging with options, futures, or ETFs. The main point for purposes of this article is to emphasize that single stock positions should probably be less than 10% at most of your overall portfolio, and something less than 5% would be even better.  

Company Stock in 401k Plans

It is very common to have some amount of company stock in your 401k plan. If you have company stock in your 401k plan, please read this section carefully. You may be able to save money on taxes by utilizing the IRS rules concerning “net unrealized appreciation (NUA)” in company stock. The savings could be considerable.  

Net Unrealized Appreciation (NUA)

According to Charles Schwab, “NUA refers to the net appreciation of employer stock over its cost basis (the price at which the stock was bought or acquired) while inside the company’s retirement plan. If you distribute the employer stock out of the retirement plan and into a brokerage account, then the tax code allows you to switch the taxation on the stock’s NUA from ordinary income tax to more favorable long-term capital gains tax. The capital gains tax is deferred until you sell the stock. Once the stock is inside the brokerage account, any additional gains (or losses) beyond NUA are taxed as short- or long-term capital gains (or losses) when sold,” depending on how long the stock has been held.

With an NUA distribution of company stock, there are two potential benefits: 

(1) You pay some of your tax at more favorable federal long-term capital gains tax rates (0%, 15% or 20%) on the stock’s net unrealized appreciation versus likely higher ordinary income rates that would otherwise apply to distributions out of a 401k/IRA, and 

(2) you are allowed to defer taxation on the stock’s appreciation until the stock’s sale and you will not be forced to distribute it out under the required minimum distribution rules governing IRA accounts—you can hang on to the stock as long as you want and could even pass it on as an inheritance to your beneficiaries.

NUA Rules

To do an NUA distribution of company stock out of your 401k plan, you must follow three requirements: 

1. In-kind transfer. Employer stock must be distributed directly from the retirement plan to a taxable brokerage account (known as an “in-kind transfer”). The company stock cannot be sold within the retirement plan then distributed as cash, nor can the stock be rolled over to an IRA.

2. Lump sum distribution. The qualified retirement account (e.g., the 401k account) must be distributed in its entirety (known as a “lump sum distribution”) within the same tax year. To do a lump sum distribution, any non-employer stock assets must be rolled over to an IRA, a new employer plan, or taken out completely as cash. Otherwise, any company stock distributed with the intention of applying NUA treatment will be taxed entirely as ordinary income. (Note: Non-deductible contributions used to purchase company stock will not have their cost basis taxed. Also, Roth 401ks to not qualify for NUA treatment.) 

3. Triggering event. NUA can only occur after a triggering event, which could include: 

• Reaching age 59½ 

• Retiring, quitting, or otherwise separating from service from the employer (excludes self-employed individuals) 

• Becoming totally disabled (only for self-employed individuals) 

• Death 

After a triggering event occurs, the window to execute a company stock distribution using the NUA rules remains open until a distribution from the company retirement account occurs, at which time the lump sum distribution requirement will apply (see requirement #2 above). If you do not take a lump sum distribution in the same taxable year, then the NUA tax treatment window closes. However, you could have another chance at using NUA treatment if another triggering event occurs. 

Ideally, 401k plan custodians will have kept track of the cost basis and date of purchase for each lot of company stock purchased. However, according to a comment on Ed Slott’s website, “most plans use an average cost basis per share for the NUA shares… You cannot split out the various purchase prices unless you have written documentation provided by the plan what your purchase price was for various lots of shares. You cannot break this out yourself without documentation from the plan that you could provide to the IRS if they ask. If you have that documentation you would also have to provide your breakdown to the [receiving] broker, if such broker would accept several different cost basis figures for various lots of shares. If the broker accepted your figures, you would then have to use specific identification when selling shares.”

NUA Strategy

A fine-tuned NUA strategy requires that you have cost basis and purchase dates for each lot of company stock you purchased. That will enable you to know the tax implications for transferring each lot of shares into the brokerage account initially, as well as the tax implications for selling specific lots in the brokerage account in the future. However, if the only information available is the average cost basis for all of the company shares in your 401k account, it is still possible to use the NUA strategy by treating 100% of the company stock as a single tax lot.  

Distributing company stock out of a 401k and into a taxable brokerage account under NUA rules involves a tradeoff. Only the unrealized appreciation in the company stock gets favored tax treatment and a delay in paying taxes. Income tax will be due immediately when the NUA transfer takes place on the amount of the cost basis (the amount you originally paid for the company stock.) Ordinary income tax rates will apply, not more favorable long-term capital gains tax rates. On the other hand, company stock kept in an IRA account will continue to grow without any taxes being paid up front. Only when cash is distributed out of the IRA account will income taxes be due, which often does not start until “required minimum distribution” (RMD) rules force a distribution. The tax rate on these distributions will be the applicable ordinary income tax rate for the tax filer for that year. 

The graph above illustrates three different NUA situations. In the “Low Cost” example, the cost of the company shares is 10% of the current market value, so the NUA is 90%. In the “Medium Cost” example, the cost basis is 40% of the market value and the NUA is 60%. In the “High Cost” example, the cost basis is 70% of the current market value and the NUA is 30%. The NUA strategy is very attractive when the cost basis of the company stock is only 10% of the market value because 90% of the value will be NUA subject to the lower long-term capital gains tax rate. The NUA strategy may still be attractive when the cost basis of the company stock is 70% of its current value, but it is not as compelling because 70% of the stock value will be immediately subject to taxes at ordinary income tax rates and only 30% will be deferred and subject to long-term capital gains tax rates. 

The table below provides a sample illustration of the two key factors in deciding whether or not to use an NUA strategy:

1. The percentage cost basis of the company stock compared to current value. A lower cost basis percentage will mean lower immediate income taxes due (at ordinary income tax rates) and more of the current value subject to long-term capital gains treatment.

2. The expected holding period for the stock before it will be sold, either out of the taxable brokerage account (paying capital gains taxes) or out of the IRA account (paying ordinary income taxes). 

The “tax savings” in the table below is the taxes due if the company stock is held in and IRA account minus the taxes due if the company stock is distributed out to a taxable account under NUA rules as a percentage of the current value of the company stock. 

Note the assumptions in the table above. Many people have a relatively high income in their last year of employment, pushing up their income tax rates (32% in the example above). However, later in retirement, their income may decline, resulting in a lower tax rate (24% in the example). Most people pay long-term capital gains at a 15% rate. (In 2025, that rate applies to income for married taxpayers up to $600,050, or $533,400 for singles.) The company stock is assumed to have a compound growth rate of 8%. (These assumptions matter quite a lot. You will want to use assumptions that apply to your specific situation in your own analysis.)  

If you expect to sell the company stock soon after executing the NUA strategy, the cost basis is of paramount importance. If you examine the taxes saved with the NUA strategy under the 0 and 1 year holding period columns, you will see that the taxes saved becomes negative once the cost basis excess 50%-60%. On the other hand, if you plan to hang on to your company stock for 10 years, you will save on taxes even if the cost basis is more than 100% (i.e., the company stock is currently selling for less than you paid for it). Even though you have to pay immediate income taxes of 32% on the cost basis of the stock, you will benefit in the long run because the growth of 8% compounds to a high value that will be subject to the much lower long-term capital gains tax rate of only 15%. The alternative is to keep the company stock in an IRA account for 10 years and pay an ordinary income tax rate of 24% on the ending value.  

To simplify the analysis in the table above I have assumed that all tax payments occur at the end of the holding period. Therefore, the calculations in the table do not reflect differences in the timing of the taxes paid. The NUA strategy will necessarily involve paying some taxes immediately. Paying taxes later is preferable to paying taxes sooner, but estimating the economic impact of these difference requires the assumption of a discount rate, which I have ignored for purposes of this analysis. I am also assuming that 100% of the company stock will be invested for the entire holding period whether in the NUA strategy or the no NUA strategy (keeping the company stock in an IRA account).  

Stock Options

A stock option is “the right, but not the obligation” to buy or sell a stock at a certain price (the “exercise price”) on (“European” options) or before (“American” options) a certain date (the “expiration” date). The value of an option consists of two components: 

1) “intrinsic value” and

2) “option value” 

A stock option’s intrinsic value is based on the difference between the market price of the stock and the exercise price of the option. For “call” options (the only kind given to company employees), if the market price is below the exercise price, the option is “under water” and the intrinsic value is zero. (“Put” options become more valuable as the stock price declines below the exercise price.) The call’s option value is derived from the fact that while there is time remaining before the expiration date, there is the possibility that the market price of the stock will rise above the exercise price. The more time that remains, and the higher the volatility of the stock, the higher the option value. 

Typically, employee stock options have a 10-year life, and are granted “at the money” with the exercise price equal to the stock price at the time of the grant. Options typically have a vesting schedule, such as 25 percent per year at the end of each of the first four years. When employees exercise their options, they receive shares in exchange for paying the exercise price. Because they are typically exercising with the intent of selling the stock to reduce risk and/or increase liquidity, most employees sell the shares soon after option exercise. 

Once upon a time, companies and their employees valued stock options based only on their intrinsic value. However, in 2004, the Financial Accounting Standards Board (FASB) issued FASB Statement 123, which required companies to expense the “fair market value” of options using a mathematical option model such the Black-Scholes Model. Previously, the common practice was to expense only the “intrinsic” value of option awards. Since their exercise price was usually equal to the current stock price on the award date, the intrinsic value was booked at zero. 

The key issue for employees with stock options is when to exercise them. Using the Black-Scholes Model, it is mathematically optimal in nearly every case to delay the exercise of an option until at or just before its expiration date. The only exception would be the case of a stock that is paying a high dividend shortly before the expiration date. In that case, it may be optimal to exercise the option a bit early in order to collect the dividend. 

Unfortunately, custodian’s statements with employee stock options generally show only their intrinsic value. This is highly misleading and may encourage option owners to assume that their options’ market value is equal to intrinsic value. Option value, which may actually constitute the majority of the option’s overall market value, is ignored, probably because showing both the intrinsic value and the option value is mathematically complex.  

It appears that many option-owning employees do not understand option valuation. Studies have shown that early exercise is quite common. This behavior appears to be based on psychological factors, such as: 

• loss aversion (having a much greater sensitivity to losses than to gains), 
• overconfidence (believing you can forecast the future), 
• illusion of control (believing you can control the future), 
• miscalibration (the tendency to underestimate stock volatility and its positive contribution to option value) 
• mental accounting, (putting assets into different mental/emotional buckets) and 
• anchoring (assessing the value of an asset using a readily available but irrelevant bit of information). 

As applied to employee stock options, anchoring may include heuristically comparing the current stock price with its price when the option was granted (which typically coincides with the exercise price). Regardless of the time to expiration, there is a tendency for some option holders to exercise when the stock price reaches a certain multiple of the exercise price (such as 2x or 3x). Continuing to hold the option may be viewed as unacceptably “risky.” One study finds that some employees exercise immediately upon vesting, often losing an enormous amount of value. And in direct contradiction of the positive value that stock volatility makes to option value, employees tend to increase their early exercise as stock volatility rises. “Employees commonly sacrifice as much as half of the theoretical Black–Scholes value of the option by exercising early, suggesting significant risk aversion.”

The following graphs illustrate the impact on option value of three key factors:

1. Exercise price
2. Time to expiration
3. Stock volatility

This graph above illustrates the two components of the total value of an employee stock option:  1) intrinsic value and 2) option value. Here, the variable in focus is the exercise price. All three other variables (expiration date, stock volatility, and stock price) are held constant. Note how the option value increases and intrinsic value decreases as the exercise price increases towards the stock price. At an exercise price of $50 (equal to the stock price), 100% of the total value for the option is “option value.”

In the graph above, the focus is on the time to expiration, with all three other variables held constant. In this example, stock price = exercise price, so there is no intrinsic value in the option. 100% of the option’s value is “option” value. Note how dramatically the option value increases with the time to expiration. 

In the final graph above, the focus is on volatility, with the three other variables held constant. Higher volatility increases option value, but not dramatically so. 

Above we briefly covered the basics of option valuation. The key takeaway is to hold on to your options until the expiration date. Below we will discuss the differences in the tax treatment of the two major types of employee stock options: 

1.         Incentive stock options (ISOs)

2.         Non-qualified stock options (NQSOs)

Incentive stock options (ISOs). 

Incentive stock options (ISOs) are stock options issued by a corporate employer which meet the requirements of §422 of the IRS Code. Except for alternative minimum tax ("AMT") purposes, in general, ISOs do not create taxable income for the employee, either at the issuance of the options or at their exercise. The amount of gain for AMT purposes is the difference between the exercise price and the fair market value of the stock on the date of exercise.

Qualifying sales of stock acquired through exercise of an ISO result in long term capital gain to the employee. The long-term capital gain equals the difference between the exercise price of the ISO and the sales price of the ISO stock. Stock acquired through an ISO must not be sold for at least two years after the option was granted and for at least one year after exercise. 

In order to qualify as an ISO, the terms and conditions of the incentive stock option plan and the option itself must meet the following requirements: 

• Maximum 10 year term;
• The exercise price of the option must be greater than or equal to the fair market value of the stock on the date the option is granted;
• The option must be non-transferable, other than at death;
• The option must be exercisable, during the lifetime of the optionee, only by the optionee;
• The aggregate fair market value (determined at the time the option is granted) of the stock with respect to which incentive stock options become exercisable for the first time by any optionee during any calendar year may not exceed $100,000. To the extent of such excess, the options are treated as NQSOs, and
• Subject to minor exceptions, the option must be exercised within three months after the optionee’s employment terminates (longer in cases of death or disability).

These restrictions, and particularly the $100,000 cap on grant value, have made ISOs much less popular. The majority of outstanding options are now NQSOs. 

Non-qualified stock options (NQSOs)

In the event an option does not meet the requirements of an ISO under IRC §422, the tax treatment is governed by IRC §83. Under IRC §83(e)(3) and (4), the tax consequences to the optionee and the company largely depend on a determination of when the option (not the stock) has a readily ascertainable fair market value. Under the Regulations, the option has a readily ascertainable fair market value at the time it is granted only if traded on an exchange. Many employee stock options are for start-ups, private companies, or public companies with limited stock liquidity. Even employee stock options for publicly traded stocks with listed options generally only have expiration dates within the next year. Employee stock options generally have expirations dates much further into the future. In addition, the expiration dates of the employee options may not coincide with those of the exchange-traded options. For all of these reasons, very few NQSOs have a “readily ascertainable fair market value.” In those rare cases where the option has a readily ascertainable fair market value, the option holder realizes compensation either (1) when his right in the option becomes transferable or (2) when his right in the option is not subject to a substantial risk of forfeiture. Thus, in virtually all other cases, the tax treatment of the option is determined at the time of exercise of the option as discussed below.

1. Grant. In most situations, the grant of a NQSO is not a taxable event, because it does not have a readily ascertainable fair market value. As noted, only in the rare case of certain publicly traded stock options will the grant of a NQSO result in immediate taxable income to the employee.

2. Exercise. Exercise of an NQSO results in ordinary income to the employee equal to the difference between the amount paid for the NQSO and the fair market value of the NQSO stock on the date of exercise. 

3. Sale of Stock. Sale of stock acquired through exercise of an NQSO results in capital gain to the employee equal to the difference between the employee's basis in the stock and the sales price of the stock. The gain may be long- or short-term depending on the holding period for the stock. The optionee’s basis in the stock is equal to the sum of (i) the amount paid for the NQSO stock plus (ii) the amount of income recognized by the employee upon exercise of the NQSO.

Restricted Stock Units and Stock Grants

In the wake of the 2004 accounting change applied to stock options mentioned above, most U.S. corporations have shifted away from awarding stock options in favor of restricted stock units and stock grants. 

• Restricted stock units (RSUs) are a type of substitute for actual stock grants, and you typically receive units that will be exchanged for actual stock at a future date based on certain criteria such as time or performance. 
• You normally don't have any immediate tax liability when you receive an RSU, but you will typically have to report income and pay taxes (at ordinary income tax rates) when the RSU vests and you receive actual stock shares. 
• Stock grants typically provide you with actual stock shares, but they often come with a vesting period during which you may still lose the rights to the stock. Like RSUs, you're normally not liable for income tax (at ordinary income tax rates) until the grant vests. 
• When you sell the stock you received through an RSU or a stock grant, you will owe capital gains taxes to the extent that the sales price exceeds your tax basis in the shares (based on the price at the time of vesting, for which you already paid ordinary income taxes). 

Section 83(b) Election

In some circumstances, it may be advantageous to pay taxes on grants of stock early because the current stock value is low relative to the expected value when the stock grant will vest. Section 83(b) election allows an “electing shareholder” to recognize ordinary income at the time the shares are received even though they are restricted shares. This ordinary income will equal the fair market value of the shares less the amount, if any, paid for the shares. This election is often most attractive for start-up situations when the initial value of the shares is extremely low. This means that no income will be recognized when the shares become unrestricted. When the shares are ultimately sold, any income above the initial cost will be taxed as a capital gain. A statement of election for a Section 83(b) election must be filed within 30 days of the date the shares are transferred, and a copy attached to the tax return of the electing shareholder, with a copy submitted to the shareholder’s employer. Note that because the shares are restricted, and subject to forfeiture, electing to pay taxes early under 83(b) entails substantial risk. 

Summary and Conclusions

• Individual stocks over 10% of your overall portfolio entail too much stock-specific risk. In fact, it is better to keep stock concentrations at under 5%. 
• Company stock held in a 401k plan can be delivered out to a taxable brokerage account at the same time that other 401k assets are rolled over into an IRA account. Although income tax (at ordinary rates) will be immediately due on the amount originally paid for the company stock, the “net unrealized appreciation” (NUA) above that will be taxed as a long-term capital gain, and tax will not be owed until the stock is sold. 
• In general, the lower the cost basis for company stock in a 401k relative to its current market price, the greater the tax savings from the NUA strategy.
• Stock options should be held until the expiration date in order to maximize their “option value.” 
• Restricted stock units and stock grants become taxable income (at ordinary rates) when vested, but further appreciation is taxed as a capital gain.  
• For start-up companies, it may be advantageous to make a “Section 83(b) election” to pay income tax on restricted stock immediately, if the current stock value is much lower than the expected stock value later. The election means that no further income tax will be due upon vesting, and that any ultimate stock sale will be taxed as a capital gain.