Elliot Shmukler for WealthFront writes: We recently launched the Single-Stock Diversification Service — an easy way to transition from large holdings of a single stock (perhaps that of your current or ex-employer) to a Wealthfront diversified portfolio.
One of the problems we aimed to solve with the Single-Stock Diversification Service is tax-optimization. We knew that many of our Single-Stock Diversification Service clients would have multiple types and lots of employee stock that they would want to diversify. It becomes difficult to know which shares to sell first to get the best after-tax outcome when some of your shares come from RSUs and others from exercised stock options. To make matters more confusing, many of the shares have vested at different times and at different prices.
We built our Single-Stock Diversification Service to eliminate these headaches. With every trade, the Single Stock Diversification Service attempts to make a decision that will ultimately lower your taxes.
Employee Stock Tax Treatment — A Quick Review
We knew our clients would give us two kinds of shares to be sold via our Single-Stock Diversification Service:
- RSUs that had just vested
- ISO Stock Options that were previously exercised
We therefore focused the analysis below on taxes expected to be paid on the sale of these two types of assets. Of course there are many other situations that employees or stockholders of recently public firms may find themselves in — such as being in possession of non-qualified stock options or having options that are yet to be exercised. Although we believe the general principles below still work in many of those situations, other questions also arise, such as when to exercise one’s stock options. As a result, if you find yourself in these other situations we recommend reading our additional blog posts on this topic.
As we have covered before, shares from vested RSUs and exercised ISO Options carry very different tax implications.
The gain from RSUs is taxed as ordinary income at the moment they vest and become free to trade. For reasons that will become important below, that gain is treated as wage income and not as a capital gain. Typically, your company will automatically sell/withhold as much as 45% of your RSU shares to cover this obligation. If you hold RSU-generated shares after they are vested, any increase or decrease in the stock price after the vesting date will be treated as a capital gain or loss.
Let’s look at an RSU example in detail:
You have 50,000 RSUs that will vest when your company’s post-IPO lock-up expiration ends. The company’s stock price on the day of lock-up expiration is $40 per share. On the day of lock-up expiration, you will incur a 50,000 x $40 = $2 million taxable gain on your RSUs. This $2 million gain will be added to your wage income for tax purposes (i.e. it will not be considered a capital gain).
Your company will likely sell-to-cover as many as 45% of your RSU shares to meet your Federal and State tax obligation on this taxable gain. That means the company will automatically sell 22,500 shares (45% x 50,000) to withhold for your expected tax liability. You will be left with 27,500 (50,000 – 22,500) shares-from-RSUs in your account.
Now if you live in California, your $2 million income from RSUs will likely be taxed at a rate close to 12.3% (the highest marginal income tax rate in California, when the 1% Mental Health Services tax is not considered). So you’ll owe California $2,000,000 x 12.3% = $246,000 in taxes. Your company likely already withheld $200,000 for California taxes (10% of your gain) via the aforementioned selling-to-cover, so you’ll likely only have to pay an additional $46,000 to California yourself.
You can usually deduct the State income tax you pay in the same year from your overall income to calculate your Federal tax liability. So, assuming you pay your $246,000 in tax liability to California in the 2014 tax year (usually through company withholding as well as an estimated tax payment), your Federal taxable income will be $2,000,000 – $246,000 = $1,754,000. That means you’ll owe the federal government $694,584 if you qualify for the highest 39.6% federal tax rate (in this case, the AMT does not apply because your AMT tax liability, $2 million x 28% = $560,000, is actually lower than your standard tax liability, $694,584). Because your company has already withheld $700,000 for federal tax purposes (35% of your overall gain), you’re unlikely to have to make any additional federal tax payments.
After the vesting and withholding process is complete, your remaining 27,500 shares from RSUs have a cost basis of $40 per share, the price at which your stock traded on the date your shares vested and were free to trade. So they very much look like stock you just bought at $40 per share.
That means, if you sell the 27,500 immediately at $40 per share, you generate no additional gain or loss (beyond what’s described above).
If you wait a few months and you’re fortunate enough to sell your 27,500 shares at $60 per share, you will have a short-term capital gain of 27,500 x ($60 – $40) = $550,000 and the associated tax obligations.
However, if the stock goes down in a few months and you sell at $20 per share, you will have a $550,000 (27,500 x ($20 – $40)) capital loss. Normally your capital losses can be deducted against your gains to reduce your tax obligation. But in this case, your initial $2 million was wage income (not a capital gain), so the capital losses can’t actually be deducted! (Well, technically $3,000 can be deducted, but that’s it). It may take years to write off the $550K capital loss off other income and gains. This is actually one of the significant dangers of holding on to your RSUs.
The situation is much easier when we add exercised ISO options to the mix. For Single-Stock Diversification Clients, most of the exercised options were exercised long ago and have been held long enough to qualify for long-term capital gains tax treatment.
As a result, the taxable gain from selling exercised options is just the difference between the price at which they are sold and their strike price. The gain will be taxed at the long-term capital gains rate (up to 23.8% Federally). Any previous Alternative Minimum Tax paid upon exercise can be credited against the newly incurred capital gains tax.
A quick example:
Assume you have 50,000 exercised and vested ISO stock options that were exercised more than two years ago at a strike price of $10. The value of the stock at the time was also $10, triggering no taxable event when the options were exercised.
If you sell these options post lock-up expiration at a price of $40 per share, you will have a taxable gain of 50,000 x ($40-$10) = $1.5 million. This gain will be taxed at the highest Federal long-term capital gains rate, so you’ll owe $1.5 million x 23.8% = $357,000 to the Federal government. Note that in this case, when a large portion of your income is long-term capital gains, you’re unlikely to be able to significantly reduce your tax burden by deducting state taxes due to AMT — which effectively limits such deductions (although you may still get a small benefit). Meanwhile in California, there are no special capital gains tax rates, so this income will be taxed at the roughly 12.3% income tax rate (for simplicity, ignoring the Mental Health Services tax), thus you’ll owe $1.5 million x 12.3% = $184,500 in California state taxes. Your company will not withhold any taxes for your option sale and you’ll have to make these payments yourself at tax time (or sooner to avoid penalties).
If you continue to hold these options for a few months and the stock goes up to $60 when you sell, then you will have a taxable long-term capital gain of 50,000 x ($60-$10) = $2.5 million. Similarly, if the stock drops to $20 when you sell, you’ll still have a taxable long-term capital gain of 50,000 x ($20 – $10) = $500,000.
A Simple Rule for Selling Tax-Efficiently
So what happens when you have both RSUs (perhaps at multiple vesting points) and stock options that you are trying to sell in a gradual way? Which do you sell first to minimize your taxes?
We found that a simple rule minimizes your taxes in most cases: Sell the position that triggers the lowest taxable gain first.
Let’s look at a quick example:
Suppose you have both of the types of stock mentioned above. That is, you have 50,000 vested and exercised options with an exercise price of $10 per share. You also have 50,000 RSUs that have just vested. Assume further that the current value of your company’s stock is $40 per share. Because of tax withholding, you only have 27,500 RSUs available for sale.
Therefore you have a total of 77,500 sellable shares. To simplify matters, let’s say you plan to sell them over the course of a year in two phases. You will sell half the shares in May of 2014 (taxed in the 2014 tax year) and the remainder of the shares in February 2015 (thus, the 2nd sale will be taxed in the 2015 tax year).
So what specifically do you sell in the first batch of 38,750 shares to be sold in May 2014?
At a price of $40 per share in May 2014, the 27,500 RSU-generated shares have the lowest potential taxable gain because as we explained earlier their tax basis is $40 per share, the price at the time all the restrictions were released and the stock becomes fully tradable. Meanwhile, the 50,000 shares from options have a large taxable gain (50,000 x ($40-$10) = $1.5 million) although they will be taxed at the advantageous long-term capital gains rate.
So, following the rule above, you would sell all 27,500 RSU-generated shares first as well as 38,750-27,500 = 11,250 shares from options in May 2014. Then the remainder of the option-generated shares (38,750) will be sold in February 2015.
Of course, the stock price may move between the first sale in May 2014 and the second sale in February 2015. So to evaluate this approach correctly, we’ll look at it with three possible February 2015 selling price scenarios — a large increase from the current price ($65 per share), a flat price ($40 per share), and a large decrease from the current price ($15 per share).
Let’s see how much you’ll pay in taxes with this plan.
We first start by computing your 2014 tax liability:
a. Taxable Wages from RSU Vesting: $2 million (per RSU discussion above)
b. Capital Gains from RSU Share Sales: $0 (since we’re selling all the RSUs at $40, which was the price at which they vested)
c. Long Term Capital Gains from ISO Share Sales: 11,250 x ($40 – $10) = $337,500
d. California State Tax Liability (at 12.3% rate, ignoring the 1% Mental Health Services tax): ($2,000,000 + $337,500) x 12.3% = $287,512.50
e. Federal Tax Liability:
i. Capital Gains Tax (23.8% rate): $337,500 x 23.8% = $80,325
ii. Income Tax (39.6% rate, with CA taxes fully deducted): ($2,000,000 – $287,512.50) x 39.6% = $678,145.05
iii. Note: For simplicity we did not apply the so-called “Pease limitation” to the state tax deduction above, instead deducting the state taxes fully.
f. Total Tax Liability in 2014 = $287,512.50 + $80,325 + $678,145.05 = $1,045,982.55
Now let’s look at what happens when we include the sale in 2015 under three scenarios:
Now let’s try the same calculation, except we’ll do the exact opposite of the rule we suggested — we’ll sell all the option-generated shares first (with 38,750 of them sold in 2014) and sell the remaining options and RSUs in 2015. In this way, we’re actually selling the stock with lowest basis and thus the highest taxable gain first.
Let’s see what happens with your tax liability in 2014 under this new plan:
a. Additional Taxable Wages from RSU Vesting: $2 million (per RSU discussion above)
b. Capital Gains from RSU Sales: $0 (no RSUs sold in 2014)
c. Long Term Capital Gains from ISO Sales: 38,750 x ($40 – $10) = $1,162,500
d. California State Tax Liability (at 12.3% rate): ($2,000,000 + $1,162,500) x 12.3% = $388,987.50
e. Federal Tax Liability:
i. Capital Gains Tax (23.8% rate): $1,162,500 x 23.8% = $276,675
ii. Income Tax (39.6% rate, with CA taxes fully deducted): ($2,000,000 – $388,987.50) x 39.6% = $637,960.95
iii. Note: For simplicity we did not apply the so-called “Pease limitation” to the state tax deduction above, instead deducting the state taxes fully.
iv. Note: No AMT applies since 28% x 2,000,000 < $637,960.95
f. Total Tax Liability in 2014 = $388,987.50 + $276,675 + $637,960.95 = $1,303,623.45
And now with the addition of the sale in 2015 under the same three scenarios:
Conclusions
So what can we tell from this analysis?
For one, the pre-tax gains from both selling strategies are identical. As you would expect, selling 50% of your sellable shares at one point and 50% at another produces the same pre-tax gains regardless what particular shares you choose to sell first.
The situation is different, however, if you look at your gains on an after-tax basis.
Although both strategies produce a similar tax liability if the stock stays flat at $40, the sell-RSU-shares-first rule produces a lower tax liability both when the stock rises to $65 and when it falls to $15.
The reasons are simple. If the stock is going to go up, you want to capture as much of that upside as possible using shares that are taxed at long-term capital gains rates (which at 23.8% federally are lower than both regular income and short-term capital gains rates). Thus by capturing most of that gain through long-term shares, the first strategy produces superior results.
On the downside, the outperformance results from the way in which RSU shares are taxed. Because the initial vesting of the shares produces taxable regular income while further movements of the shares are capital gains, the downside case in the sell-options-first strategy encounters a situation where the capital losses from RSU shares can not be used to reduce your tax liability (since there aren’t enough capital gains to match those losses and only a minor amount of capital losses can be deducted from regular income in any given year). As a result, the downside case tax liability in the second strategy is substantially higher.
Although this is a fairly simple analysis, we found that these type of results do hold in a wide range of cases. This is why the Single-Stock Diversification Services uses the “sell-shares-with-lowest-taxable-gain-first” strategy when diversifying your single stock position. And if you are planning to diversify a single-stock on your own, you should consider using that strategy as well.
