An Innovative Perspective on Capital Gains Taxes and Concentrated Positions

An Innovative Perspective on Capital Gains Taxes and Concentrated Positions

I was recently helping a client with $1 million of highly appreciated employer stock in the company for whom they work. The concentrated position had a $500,000 unrealized gain.

Managing a Concentrated Position

Minimizing taxes is one of the first things we try to do—it’s a huge part of my day. In this case, however, the client also had a significant percentage of their net worth in this one company. Diversification is another problem we must solve in this situation. Single-stock concentrated positions are particularly risky right now with uncertainty in the macro-environment. Idiosyncratic regulatory issues could also arise for the company this client is so heavily invested in. Many investors are aware of firms like Enron and WorldCom that resulted in disasters for employees who kept their investable assets in employer stock.

The Risk of Owning Too Much Company Stock: GE Case Study

It doesn’t take shenanigans and corporate scandals to bring down a company’s stock price, though. One of my favorite stocks of yesteryear was General Electric. The conglomerate giant, pioneered by legendary CEO Jack Welch, nearly went out of business during the Great Financial Crisis. The stock price, which had its heyday in the go-go 1990s, fell a whopping 90% from its peak at the turn of the century. GE has been abysmal for many long-term investors who thought its business lines were diversified enough for the stock to act like a mutual fund. Just picture employees in the late 90s shifting all their investments (401(k), IRA, college savings) into GE shares.

General Electric Drawdown Chart (top) and Market Cap History (bottom) (Koyfin Charts)

Do I have your attention yet?

Out of curiosity, I looked at GE again, and it has lost more than 2% per year for the past 15 years (that includes dividends). For perspective, a diversified position in the stock market has been up more than 11% annually. Those returns translate to $1 million becoming $706,000 (before inflation) over 15 years vs. $4,850,000 in the broad stock market.

General Electric and US Stock Market Performance History (Morningstar)

Grab the Free Lunch

The academics will tell you that diversification is one of the only "free lunches" when it comes to investing. Sure, you might get lucky holding a concentrated single-stock position, but that adds a huge risk uncompensated risk to your portfolio. You can reduce your risk by holding a basket of companies with similar return characteristics. Concentrating your holdings in just one stock without inside information (which is illegal!) is not wise.

I want to help families accomplish their goals. Reaching retirement, funding a college education, and creating multi-generation wealth is what I strive for. I take that job very seriously. Taking unnecessary risks is not something I willingly seek out.

Analyzing Taxes & Market Risks

Back to this situation—the client knows that a quarter of their investable assets are at the whim of the company’s performance and how investors view the firm’s future. So, what do we do to manage risk? Let’s dive into the details.

Their income tax bracket is unfavorable as they are subject to 24% capital gains tax. Minnesota also takes a 10% cut of the gains. If they were to sell it all today, that’s a 34% haircut. Since they already paid tax on the $500,000 cost basis, it’s just the $500,000 of gains that are subject to tax. (34% on $500,000 is $170,000 of tax liability or 17% of the total position.)

Now let’s compare that 17% tax hit with the reality that the stock market regularly drops 60% during the worst bear markets. An individual stock can fall even further. Just in the last three months, the client’s stock has fallen more than 20%. A 17% tax haircut, while unfortunate, painful, and undesirable, is not as bad when put in proper context. But there are still better ways to do it. Let’s explore that further.

A Savvier Strategy

A structured sell program over time can make more sense. Whether the stock goes up or down, gradually reducing the position to 5% or 10% of the portfolio is probably the wise move. While it’s not my money, but a personal decision for the client, I’ve seen so many concentrated stock positions have devastating outcomes. Thus, it’s wise for me to re-frame the situation to give clients the perspective that it might be wise to bite the tax bullet to reduce the family’s risk.

Planning Ahead

It’s not an all-or-nothing decision, however. We don’t have to sell the whole million dollars of stock right away. Perhaps the thoughtful answer is that we don’t want more than 5% or 10% of the portfolio in a single stock. The happy middle-ground is to target 10%, then keep it under that limit even if the stock continues to perform well. That way, if the stock doubles or triples, we’ll still participate while not adding undue risk to the family.

At ISC, we often craft and execute a structured sell program over time to reduce the tax burden and reduce the portfolio’s risk through diversification. This aspect of financial planning helps clients sleep at night while minimizing regret. The good news is we can use the liquidity to invest in other assets with high expected returns.

That’s probably enough tax minutia for today. As you can see, we love this stuff!

Thanks for taking a look.

Tom