Executives & Wealth Building
High-level executives commonly receive more than half of their compensation in company stock, aligning the success of the employee with the success of the business. Equity compensation can be a powerful tool for wealth creation, and if you are like most execs you probably appreciate the sense of ownership, and upside that company stock can provide.
While there may be big potential benefits, there are also pitfalls to consider including:
• Company imposed lock-ups / limited trading windows
• Infrequent reporting
• Confusing plan documents and statements
• Unclear tax ramifications
• Concentration risk
In this article we will provide a plain-language overview of this complex subject including:
• Why periodically trimming company stock is important, and how to employ a strategy for managing your exposure
• Common forms of equity compensation and the rules that apply to each
• Strategies to minimize taxes while selling
• Tax mitigation opportunities using other investments
The Upside and the Downside
Stocks can go up or down, sometimes in dramatic fashion. As an executive you may have much of your wealth tied up in company stock. We’ve seen that go terribly wrong at times.
In late June of 2002 while Pat and his wife were on their honeymoon in Maui, they stayed in a beautiful resort that was hosting an incentive trip for employees of WorldCom. After experiencing strong growth through the 1990’s, WCOM reached a peak in 1999 amidst the .com mania, and many fortunes were made among employees holding options and stock. But when the tech bubble burst the stock began falling until - while top members of their salesforce were in Hawaii being rewarded for their efforts - the company announced billions of dollars of improper accounting. A month later WorldCom announced what at the time was the biggest chapter 11 bankruptcy in history. Anyone still holding equity was wiped out.
Unfortunately that tale of woe is not terribly uncommon. It is risky to concentrate your net worth in a single stock, even if the company is a great one. There was a time when General Electric was the most impressive business in the world, renowned for its brilliant management and dominance across a number of industries. But after a period of spectacular performance GE stock peaked in 2000 and began a decades-long slide it has yet to fully recover from, despite a recent period of strong performance.
Or consider Microsoft, currently among the “Magnificent Seven” of top-performing tech stocks. No matter what happens from this point forward Microsoft will stand among the pantheon of most influential and successful companies of all time. But after hitting a peak in late 1999 during the internet bubble, their stock didn’t recover to that level until 2016. Nearly two decades of nothingness from the perspective of late 90’s stockholders and optionees.
On the other hand, we had a client who acquired a lot of shares in a company over a period of years that turned out to be one of the best performing stocks of the early 2000s. Every year we advised him to sell at least some of the stock, because it represented his entire investment portfolio. He had - as the saying goes - all his eggs in one basket. It was not a prudent approach, but he wouldn’t take our advice to diversify. He never sold a single share and eventually the company was acquired and shot up even higher, making him a millionaire many times over. It was a gamble he was willing to take, and for him it paid off.
We used the word “gamble” in that instance on purpose, because that’s what a concentrated stock position is. Our role as wealth advisors includes giving investment advice, not gambling advice. So with the remainder of this article we will outline a strategic approach to managing your company stock holdings that will allow you to take advantage of the upside, while mitigating the downside, with an eye toward tax efficiency.
Complexity
Deciding to trim exposure to company stock is wise, although we will soon discuss why even that step can be a challenge. Beyond that complexity rises as there are multiple forms of equity compensation, each with different rules in terms of vesting and taxation. In the next section we will describe the common forms of equity compensation and how they work. And finally, we will suggest a strategic approach to managing it all from a risk and tax perspective.
The Optics of Selling Company Stock
Depending on your role in the company or the amount of stock you own, you may be required to publicly report your purchases or sales of stock. Officers (such as CEOs, CFOs and COOs), Directors, and holders of large amounts of stock of public companies must announce their trading activity via Form 4 or Form 144 filings. We won’t delve into the nuances of such filings here, but the key takeaway is that if you have a big role or ownership stake in the business, you need to let the market know when you are buying or selling.
Because of the reasonable assumption that officers or big shareholders have a clear view of where a business is headed, the market will perceive “insider” buys as a good sign, and sells as a negative sign. You may be tremendously optimistic about the direction of your business and seek to sell stock just to prudently keep your allocation within a targeted level, but the market might still be concerned about your activity and drive the stock price lower in response.
The good news for executives who want to keep their concentration risk in check is that insider buying is more predictive of future performance of a stock than insider selling . The all-knowing market is more likely to reward insider buys than to punish insider sales. So an announcement of sales by an insider (assuming the magnitude isn’t huge relative to overall holdings) is not typically problematic in terms of forward performance of the stock. Put another way, smartly protecting yourself via systemic diversification should not cause problems for the company or other shareholders, no matter how big your role or holdings are.
One way to navigate insider selling restrictions and assuage market concerns is to implement a 10b5-1 plan. These simple legal agreements are a schedule of planned selling based on certain price targets, time frames, and number of shares. Drafted by attorneys and executed by brokers, these plans describe and announce a schedule of sales. By telling the market in advance that an insider is implementing a scheduled selling program, it hopefully reduces any sense that the selling signals trouble ahead for the business.
In any case, we urge you not to put all of your eggs in one basket, even if you are one of the people holding the basket and feel like you have a really good grip on it.
Separation from Service
When executives leave a company – voluntarily or not – they may lose some equity or be forced into a shortened window to execute options. We will discuss the details different kinds of options and equity compensation next, but understand that if you leave the company it is important to understand the rules of your comp plan when it comes to separation. You may find yourself with a 90-day window to exercise options before they expire without value.
If you decide to leave or are forced out at a time when the stock happens to be low, it could mean leaving a lot of money on the table. And consider the fact that a period of poor stock performance could actually be the impetus for personnel reductions.
Which raises another issue in terms of diversification… if your source of earned income and the bulk of your investment holdings are the same business, there is a risk that both will go sideways at the same moment. Bear that in mind when setting an allocation target for your company stock.
Types of Equity Compensation
Stock Options
Stock options give you the ability to purchase stock at a pre-determined price. When it comes to options there are elements you control, and some you do not. Understanding the rules for each kind can help you maximize results. Here are some important definitions:
• Granting – when your employer gives you the options
• Strike price – the price you will pay when converting the options to shares of stock
• Vesting - when have the ability to exercise the options
• Exercise – when you choose to turn the options into shares of stock
• Sale – when you choose to sell the stock
• Expiration when the option contract becomes invalid and you can no longer convert them to stock (clearly the goal is to avoid having options expire worthless, but if the stock price doesn't cooperate you might be out of luck
Those elements are common to both types of employee stock options - non-qualified and incentive - but the rules governing both are very different.
Non-Qualified Stock Options (NSOs)
NSOs are the most common and straightforward form of options. As the name suggests – they are “not qualified” for preferential tax treatment – which has some drawbacks. Let’s consider an example where your employer grants you NSO options with a strike price of $10 that vest one year later while the stock is trading at $20. You are not taxed when you are granted the options or when they vest. But if you exercise – purchasing stock worth $20/share for $10/share – you realize $10 of taxable income.
Bear in mind that ordinary income tax rates are generally higher than long-term capital gain (LTCG) rates. Whenever possible, you want to obtain LTCG treatment rather than income (or short-term capital gain which is the same) treatment. With non-qualified options, as in our example above, you will initially face income taxes when you exercise your options.
What happens next depends on when you sell the stock, and it’s the same as if you purchased stock in the open market: sell for a gain in a year or less from your exercise date, and you will incur short-term capital gains (taxable as income). Hold for greater than one year and you will incur long-term capital gains (or realize a loss) based on the difference between the price at exercise - $20 in our example – and the price at sale.
Let’s continue our example and say you exercise at $10 while the stock is at $20, then sell the stock over a year later at $35. At exercise you incur income taxes on $10, upon sale you realize long-term capital gains of $15. Or if you didn’t wait a year, you would realize short-term capital gains of $15, taxed at your income rate.
Incentive Stock Option (ISOs)
ISOs are better for the employee than NSOs. Think of the positive term “incentive” as a reminder that they are the more desirable of the two. ISOs are a sign that the company really values you, and they are willing to incur a higher cost to compensate you.
Like NSOs you are not taxed when you are granted ISOs. But unlike NSOs, no tax is incurred when you exercise the options either. There is an important caveat here. If you are subject to Alternative Minimum Tax (AMT) the difference between the strike price and market price upon exercise is included in the AMT calculation. The details of that are beyond the scope of this article, but it underscores the importance of having a good CPA or financial advisor to model the implications of ISOs and their impact on AMT. Exercising gradually over time may help mitigate the problem, but careful planning is called for.
Let’s revisit our example above but assume this time the options are ISOs. As with NSOs there is no tax impact when you are granted the options. Unlike with NSOs, there is also no impact when you exercise them at $10 while the stock is trading at $20 (unless you are subject to AMT ). Once you convert the options to stock, you need to hold for more than a year from exercise - and two years from the grant date - to obtain LTCG treatment. LTCG rates range from zero to 23.8% depending on your level of income. If your company is giving you ISOs, there’s a good chance that you are in the high end in terms of cap gain rates, but that’s still better than paying income tax rates.
Restricted Stock Units (RSUs)
Restricted stock units are a form of compensation tied to the value of company stock (but are not actual shares of stock themselves). We should note the distinction between these units of compensation and “restricted stock”, which are shares of stock subject to SEC restrictions on sale under rule 144.
While the vesting of options is typically tied to a time schedule, RSU vesting comes in a variety of forms. The units can vest over time, but they may vest all at once (“cliff vesting”), or upon attainment of certain corporate or employee performance targets. In some cases there may be accelerated vesting – sooner than originally scheduled – resulting from a merger or separation from service.
Depending on the plan – this is an instance where careful attention to the plan agreement is important – employees may be able to choose between being paid upon vesting with stock or cash, and they may have the ability to defer the vesting to avoid immediate recognition of taxable income. With RSUs, vesting creates an immediate taxable event. The entire value of the units is taxable as income in the year they vest. If RSUs are paid to you as stock upon vesting, the usual holding period rules apply (hold the stock for more than a year to receive LTCG treatment on the difference between the sale price and the vesting price).
RSUs sometimes constitute as much as 30% of executive compensation, so paying close attention to plan rules, within the broader context of financial planning, can be critical. If your RSUs distribute as shares of stock rather than as cash, you may end up with a large concentration of company stock. Either way, you should consider whether or not you would choose to use the same amount of cash compensation to buy company stock. If not, consider selling.
From a strategy perspective, since the vesting of RSUs immediately creates taxable income no matter what, taking cash or selling the stock right away might be a good way to diversify concentrated company stock holdings. More on that in the next section on strategy.
Employee Stock Purchase Plans (ESPPs)
These plans allow employees to obtain company stock at a discount, often 15%. If you immediately sell upon purchase, you will pay ordinary income tax on the discount. If you hold the stock for two years from the grant date and one year from the purchase date, you will face income taxes on the discount, but LTCG rates on the gain. As with RSUs, since the worst of the tax impact is immediate upon receipt of the stock, an immediate sale might make sense if you need to lighten up to keep to your target allocation.
Equity Compensation Strategy
Hopefully you accept that it’s not a good idea to bet all or most of your wealth on a single stock, no matter how promising the business appears. But believing that and having a plan for harvesting stock gains are not the same thing. Let’s talk about putting some guardrails in place so that you:
- Participate in the upside of company stock
- Protect yourself from the downside
- Take the guesswork and stress out of deciding when to sell
The first decision you need to make is how much of your overall investment portfolio - including stocks, bonds and other investments held inside and outside of retirement plans - to keep in company stock. 5-10% is a good rule of thumb. Rules of thumbs are basically educated guesses. They aren’t precise, but they are based on a mixture of common sense, theory, and historical data.
Studies suggest that to diversify away company-specific risk you need a portfolio of 15-30 stocks, which argues in favor of keeping your allocation to company stock below 6.66%. But we allow for the fact that if a lot of your compensation is in stock, it can be hard (and tax-inefficient) to keep the allocation that low. And for top executives, it is understandable to want to demonstrate financial commitment to the company. In fact, from that perspective maybe 10% is too low, but whatever the number you should establish a target allocation and use it to guide your handling of equity compensation.
In any case, let’s assume 10% as the target, which is going to achieve two things for you. The first is obvious: it prevents you from betting too much of your portfolio on one company. The other benefit is more nuanced but perhaps equally important. Setting a firm target eliminates the stress of guessing when to sell.
One of the hardest things about selling a stock under any circumstances is the uncertainty involved. Should you get out now, should you wait a bit longer, what’s going to happen next? If you sell and the stock keeps rising there will be inevitable regret and second-guessing. But the odds of you selling at the exact right time are low, so why drive yourself crazy in a failed effort to do so? When the stock exceeds your target allocation sell enough to get it back in line, period. Don’t worry about it before, and don’t wallow in regret after, even if the stock rockets higher. Remember, you still own the stock, but you have wisely skimmed some profits off the top, confident that you are following a smart process.
Tax Considerations
So, you have resolved not to overcommit to company stock, and have chosen an allocation target to guide your trading (in fancy terms you have adopted a “sell-discipline”). Here’s where things might get complicated.
As described above, different kinds of equity compensation come with varying rules and tax treatments. Selling in the most tax-efficient way will require some forethought. In this section we’ll discuss ways to approach sales from a tax planning perspective.
NSOs – These are pretty straightforward. You will pay ordinary income tax upon exercise (on the difference between exercise price and stock price at the time). If your tax bracket varies year-to-year due to fluctuating income you may want to time the exercise accordingly. On the other hand, if the stock price is high and expiration is approaching, you may want to exercise your NSOs to avoid having the options expire worthless if the stock falls for some reason.
Exercise and hold: If you are not overallocated to company stock already, have cash available, and believe the stock is likely to rise, consider exercising the stock and holding it. If you choose to hold stock after exercise, be thoughtful as to your holding period. As long as you sell more than a year after you exercise, you will receive LTCG treatment.
Exercise and sell: You may want to exercise and immediately sell the stock for cash. Either to reduce your exposure to company stock, to invest in something else, or for other purposes.
Cashless exercise: With this approach the broker managing the option plan lends you money to buy the stock, then sells just enough shares to cover the purchase price, and you keep the rest of the shares without putting any money up. Let’s say you have 100 options at $10, and the stock is selling at $20 (ignoring transaction costs and taxes to keep things simple). The broker would exercise the options, then sell 50 shares at $20 to cover the cost, and you end up with 50 shares.
While we left taxes out of the example above, it should be noted employers are required to withhold taxes on the difference between the exercise price and the price of the stock at the time of exercise. If the stock is sold, the broker will cover the tax liability using some of the proceeds. If the stock is held, the taxes can be withheld from your next paycheck. Either way the gain will show on the W2 as income.
ISOs: These are better but are more complicated. For one thing, there are two “clocks” to consider in terms of LTCG. You have to hold two years from grant, and one year from exercise. There is also AMT to consider (if you are subject to it). In light of that you may want to exercise as soon as possible if you think the stock is headed higher, because AMT applies on the difference between exercise price and market price (plus that starts the clock on the-12 month holding period).
If you are overallocated to company stock, you’ll want to sell off some stock as soon as it becomes eligible for LTCG (providing funds that could be used to exercise newer grants of options). In this way you create a cycle of benefiting from new option grants while trimming older holdings to keep concentration down.
Employers do not have to withhold taxes on ISO transactions, unless there is an early exercise or other disqualifying disposition.
Stock Swaps: This is a tax-efficient way to exercise options without selling stock or coming up with cash. Instead, you pay for the options with shares of stock you already own. Let’s say you have options on 1,000 shares of company stock with a strike price of $10, and the stock is trading at $20 per share. If you already own shares you could trade in 500 of them to cover the exercise cost, and you end up with 1,000 shares. There is no taxable impact at the time of the swap (although the newly issued shares do have a 12-month holding period until LTCG status, regardless of how long the swapped shares are held). Be aware that that not all plans support stock swaps, you will need to check with your plan administrator.
RSUs and ESPPs: With each of these there is an immediate ordinary income tax hit upon vesting. So you can let concentration be your guide. If you don’t think the stock is headed higher, or you are above your concentration target, take the money and run upon vesting. If you like the stock’s prospects and are not overallocated, keep the stock for just over a year to obtain LTCG treatment.
Tax Mitigation Strategies
Since inevitably you will realize some capital gains via your equity compensation – hopefully substantial gains! – you should consider ways to offset or otherwise mitigate those gains via other investment holdings.
Tax Loss Harvesting
If you hold other stocks in taxable accounts, considering selling positions that are down from their purchase price to realize taxable losses, which can be used to offset gains realized in company stock / options. Just be aware that if you sell to realize a loss you must wait more than 30 days before repurchasing the same (or related) security. Otherwise, your loss will be deemed a “wash sale” and will be disallowed from a tax perspective. Similarly, you cannot have made a purchase of the same stock within a 30-day window prior to the sale.
Direct Indexing with Tax Loss Harvesting
Direct indexing means that rather than purchasing an index fund, you own all the stocks in the index. So for example, instead of owning an S&P 500 index mutual fund or ETF, you would have a portfolio containing all 500 stocks that make up the index.
There are managed portfolios you can invest in that pair direct indexing with tax-loss harvesting. Even in years when the index is up, some number of stocks within the index will be down. By periodically harvesting losses in stocks that are down each year, you can have a portfolio that is making you money but still throwing off losses that can be used to offset your gains.
Exchange Funds
These funds allow you to contribute a large stock position while receiving back a diversified portfolio of stocks of equal value in exchange… without realizing a capital gain. As long as you hold the fund for a year or more, you will incur long-term capital gain treatment on the sale. Your cost basis caries over from the original stock.
Example: Let’s say you contribute $1 million worth of company stock with a cost basis of $200,000 to an exchange fund. Upon entry into the fund you now own a diversified portfolio and have eliminated the concentration risk, with no impact from a tax perspective. If you sell the fund a seven years later (the holding period requirement) for $1.2 million, you will realize a LTCG of $1 million ($1.2 million of proceeds less your $200,000 cost basis). If you never sell the fund, your heirs will receive the same step-up in cost basis as with individual stock.
Be aware that the minimum contributions for such funds are typically fairly high ($1 million is not uncommon), and your stock has to be approved by the fund manager (because their goal is to build a diversified portfolio of quality stocks).
Qualified Opportunity Zone (QOZ) Funds
In 2017 as part of the Tax Cuts and Jobs Act a program was initiated that created powerful tax incentives for building projects in areas designated as in need of economic development. If you realize a capital gain (either via stock sales or business sale or anything else), and within 180 days reinvest the proceeds into real estate development projects in QOZ-designated zones, the gain is deferred and in some cases reduced. Moreover, as long as the investment is held for ten years, any growth in the value of the real estate would be tax free.
There are a number of QOZ funds – typically managed by real estate development companies – that allow investors to take advantage of this powerful tax incentive. Tax legislation in July of 2025 has extended the benefit but has also added additional complexity. Consult a CPA or financial advisor familiar with the program for guidance.
Net Unrealized Appreciation (NUA)
If you have highly appreciated company stock in a 401(k) and you either leave the company or attain age 59 ½, the NUA strategy allows you to obtain LTCG treatment on the appreciation. The company stock is distributed from your 401(k) into a taxable brokerage account, at which point you will incur ordinary income taxes on the cost basis. But when you sell the stock – either immediately or down the road – you will realize long-term capital gains rather than income.
Example: Let’s say you purchased $10,000 worth of company stock in your 401(k) and it’s now worth $100,000. Taking an NUA distribution means you will have to pay ordinary income tax on the $10,000 when you file your taxes that year. But whenever you sell, LTCG will apply.
Getting Help
Ideally good financial planners and CPAs can work in tandem to create a structured approach to managing equity compensation within the context of your tax situation, other investments, and overall financial plan. For example our team uses specialized software to analyze tax returns, providing a clear picture of where a client stands relative to important tax levels (see sample below).
In our experience, not all advisors are well-versed on options and equity compensation. If your wealth-building relies heavily on company stock, when seeking professional help we suggest you make knowledge of the subject a key element of your vetting process.
With or without outside advice, we urge prudence when it comes to concentration, awareness of the tax rules with an eye toward obtaining LTCG treatment whenever possible, and a structured approach to remove some of the stress and guesswork from the process.
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Our process seeks to provide families with investable assets of $1 million and above a service model and investment methodology typically available only to ultra-high-net-worth investors. Our approach is collaborative, utilizing a network of experts inside and outside of Baird including attorneys, accountants, a trust company, insurance specialists, lenders, and more.
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The information offered is provided to you for informational purposes only. Robert W. Baird & Co. Incorporated is not a legal or tax services provider and you are strongly encouraged to seek the advice of the appropriate professional advisors before taking any action. The information reflected on this page are Baird expert opinions today and are subject to change. The information provided here has not taken into consideration the investment goals or needs of any specific investor and investors should not make any investment decisions based solely on this information. Past performance is not a guarantee of future results and diversification does not ensure a profit or protect against loss. An investment cannot be made directly in an index. All investments have some level of risk, and investors have different time horizons, goals and risk tolerances, so speak to your Baird Financial Advisor before taking action.