Year-End Equity Comp Playbook With John Owens (EP.230)

0:28We all need to make smart decisions with our money. and we are going to break down year-end planning for people with equity compensation. Now, this can sometimes be a tricky topic because there are so many different types of equity compensation and so many different nuances to the complex tax planning involved with those different forms of equity compensation. And so we try to keep it high level while digging in piece by piece. So hang with us as we get through RSUs, stock options, ESPPs. We talk about how to unwind concentrated stock positions, how to use 10B51 plans, and even walk through some charitable strategies to help you improve your outcomes.

1:06So if you've ever wondered what to prioritize prior to December 31st, this conversation gives you concrete order of operations. And if you want some help navigating your equity compensation or maybe even diversifying your company's stock position in a tax-efficient manner, you can schedule a call with me by visiting callwithpeter.com to learn more about becoming a Plaincorp client. And now, here is my conversation with John Owens.

1:35Welcome to The Long-Term Investor. Today, I'm excited to have my friend John Owens, managing partner of Brooklyn FI. Hi, John. Thanks so much for joining the show. Peter, thanks for having me. Glad to be on the Long-Term Investor. Well, we were speaking, I think it was a few weeks ago, over dinner, and we're talking about year-end tax planning. And listeners of the show know that sometimes I can talk about taxes like I'm in a play. I hear the terms a lot. I sort of know the rules. But my real expertise comes on the investment realm. and your firm in particular focuses so much on RSUs, on options, on ESPPs.

2:14And I thought it would be good to dive in. But before we do, I want to let the audience recognize how hard a task this can be, where there's so many different types of equity compensation and we could go down deep rabbit holes on all of them. So we're going to attempt, after speaking to John over a long, lovely dinner, I realized I think he's our guy where we can touch on a lot of the important issues. And I thought maybe, John, a good way to start is just to give us an anecdote of a way in which maybe you've helped people through the year with this type of planning, just to give a sense of the type of work advisors do for people with equity compensation.

2:51Yeah, it's one of the most complicated problems that advisors have to solve for clients. And, for example, there were situations in the past where a client exercises their stock options early in the year. They trigger what's called an AMT bill or alternative minimum tax bill, let's say a$50 ,000. That made sense in February when they pressed the button. We were locked in on that strategy. What happens? The company struggles. They're public now. The earnings come out. The stock price tumbles. They drop 40, 50, 60%. All of a sudden, that stock is worth less than the$50 ,000 AMT bill that they have.

3:28And so we do year-end tax planning for those clients. we determined that it actually makes sense for the sell the stock now, get rid of that AMT bill, and pay some ordinary income tax, as opposed to having a tax bill that's worth more than their company stock. And it's unfortunate, but I've literally seen this happen in practice, Peter. It's not fun. And that is a huge value add when you're a newly public company and your valuation isn't changing quarterly. Your valuation is changing every time the market's open, every time one of those tickers moves. And it's a quick example of, I feel like whenever I encounter somebody with stock options, I'm typically brought into the meeting to help talk a little bit about concentration risk.

4:07And I hear our CFPs and our CPAs talk about the different tax items. And again, I can maybe repeat some like I'm in a play, but ultimately there's just so many moving parts. So tell me, John, this is sort of peak year end tax planning time. If you decide to start December 15th, it's almost too late. It is too late. It isn't almost too late. It's too late. It is too late. Yeah. The custodians say it's too late. I say it's too late. Your advisors say it's too late. Your CPA is going to say it's too late. Just to be clear. Don't call John or I on December 15th. With the expectation of us doing anything, call us, though, if you'd like to work with us long term, obviously.

4:41But when someone shows up in October, November, they have RSUs, they have ISOs, they have ESPP. Like, what is the order of operations here as you're trying to get your arms around somebody with different equity compensation options? Yeah, I think that's a great question. Because a lot of people do punt on this until the fall, right? Oh, I had this, my income went up. I got this new equity stuff going on. My company went public earlier this year. And so they are in this spot where they put this off. And now it's the end of the year. The rubber's been there. And they're like, oh, crap. I don't know who's going to do my taxes and what's going to happen with everything.

5:14And so we're really trying to triage some things there. Because there's a limited amount of time at this point in the year, especially by the time this podcast is airing, and the end of the year to get stuff done. And I'd love to say that you're going to get an entire trading plan, financial life plan, everything put together before we all break for the holidays. But let's be real here. It requires some time. And so first thing, let's get an inventory of your equity situation. Let's get an understanding of everything that's happened so far this year in particular, because that's what's going to drive tax situation this year.

5:46Then let's go a little bit deeper and understand some high level goals. Do you plan to stay at the company a little while longer? That can impact exercise strategy. Is there anything big changing your tax situation this year versus next year? Right now, we are dealing with the fact that H.R. 1, a.k.a. the one big beautiful bill, is changing tax law between 25 and 26. And so half of those provisions coming in now, half of them coming in later. So we have this kind of external factor that's impacting equity comp planning. But ultimately, we want to understand what have you done so far? What's the low-hanging fruit that is a no-brainer to deal with before the end of the year?

6:24And so maybe that's selling some RSUs because your tax withholding is too low. Maybe that is ISO shares that are eligible for long-term capital gains. Maybe you should enroll in your ESVP. You're in an enrollment period, and you can buy your stock at a 15 % discount, and we should sign up for that. It really depends on the circumstances. But I think sometimes these podcasts sound like an advertisement for adult diapers. It depends, depends, depends. based on your circumstances, what you're trying to do. But ultimately, Peter, understanding what you've done so far, what you have to work with, and what is going to be changing year over year is a great starting point.

6:59That all makes sense. There's all this time-sensitive, date-sensitive items, things that just have to be decided before December 31st. The bigger decisions, as you mentioned, around the financial plan, like how much of this stock do we want to own long-term? What documents do you need to save and get ready for the tax planning stuff. Also, so I have some options in a startup company and it's my least favorite part of my tax return because I'm never sure if I'm doing something correctly at all. And actually exercised some ISOs and some non-qualified stock options this year for the first time in my life.

7:31And there's all this stuff I got to keep. And you walk in, I guess, help me out. So, and I'm thinking of, I'm going to be a little selfish thinking of my own situation. Like there's RSU withholdings that I think probably a lot of listeners have. There are ISO exercises. Those things sort of trigger the AMT tax stuff. So how do you go about looking at those options so you don't get burned by AMT in the first place? Yeah. So let's just take a step back here. What the hell is AMT, right? Most people that are listening to this are not tax experts. They might not know what AMT is. AMT is the alternative minimum tax.

8:05It is a parallel tax system, right? And so everybody's used to the regular tax. I've got some income. I got some deductions or I take the standard deduction. I pay this much in taxes, right? Maybe you have a kid, you get a child tax credit, you have some dividends that show up on there, whatever. That's one tax system, fairly familiar with it, the rates go up over time. Not to give a long history on AMT, there's another system called the alternative minimum tax, which basically is a separate way to calculate your tax bill. And the old joke is like, oh, well, I'll just pay the alternative minimum tax, I don't want to pay all this regular tax, right?

8:36If there's an alternative minimum that you can pay, it sounds like a good thing. It is not, folks, okay? Let's be very clear, you don't want to pay AMT. It's a parallel system. You pay the greater of the regular tax or AMT. And so let's just kind of set that out there. You really want to work with a professional with AMT because here's why. 10, 20 years ago, a lot more people are paying AMT. 50 years ago, a lot more people were paying AMT. We've simplified the tax code. I'm going to use that in air quotes. And we made it that many fewer people are paying AMT because we got rid of a lot of deductions that were adjustments for.

9:06But ISOs are one in particular. So ultimately, though, you're looking at it here at your end. you want to understand how do you figure out what's going on? You want to have records of what did I exercise? What was the price when I exercised of the stock? What did I pay to exercise? That spread, the difference between the two is going to help figure out if you have to pay AMT at all. And related to that, there are times when you can exercise incentive stock options and not trigger any AMT. And so that is some of the planning that you can do to say, hey, what's my break even? Where do I end up paying AMT?

9:41And then you start to set budgets to say, okay, well, I'm willing to spend$10 ,000 to exercise the stock and I'm willing to spend another$20 ,000 in AMT. And so where does that get me from a cashflow and liquidity perspective? Because most of the time, Peter, much like you mentioned, this is private company stock. There's not a liquid market that you can sell it into and get money out of it. And I promised myself, I'd be more clear at assigning certain questions to certain types of equity compensation, but we focused, I believe, because you're the expert and I don't want to misquote, like we're focused on incentive stock options right now, where the bargain element of it is what triggers AMT.

10:17What about RSUs? I feel like I actually see RSUs more frequently with public companies. What about you? So primarily see RSUs at public companies or companies on that trajectory. And so what we actually see in the journey of a private company is that, OK, initially your founders get restricted stock, which is different from RSUs. Then you get some options. Then these employees who are coming on your Series C, Series D, Series E, they're starting to get RSUs because the plan is liquidity and going public. And the tax plan that we run into with RSUs a lot is less around discretion, right? With options, it's do I want to exercise this year?

10:53How much do I want to exercise this year? RSUs you don't have control over. They vest their tax then. But the big problem is that the first million dollars in RSU income that you have, and I'm hoping there's some listeners with more than a million dollars in RSU income, you can come find me. The first million dollars in RSU income that you have is only withheld typically at 22 % for federal tax purposes. And the fact of the matter is that most people with RSU income in the six figures are not in the 22 % bracket, right? It's fairly standard. And so there's normally a big tax price that comes with RSUs that people overlook.

11:26And that's so funny because when you get your bonus, typically the maximum withholding is made. And so for RSUs to have this lower withholding can be misleading. And again, it's already, I think just from watching others and again, through my own experience, it's just confusing to begin with. And so you're talking a little bit about with these two things, like you're looking at some scenarios, you're picking a path, you're trying to make taxes predictable, cashflow comfortable. What about ESPPs? So someone shows up to you, they have access to it, It's year end. What are sort of the things you're looking at?

12:00Yeah, I mean, I think ESPPs are interesting because they're probably the most accessible form of equity compensation that we have, right? You can just sign up for it. Even if you don't have RSUs, maybe you're not in a role that has options, other types of equity. You can just buy company stock, typically at a 15 % discount or so, and get some exposure there. And I think what we do with ESPP in part is contingent on what the rest of your equity exposure is to the company. And so if you're at a company, you don't have options, you don't have RSUs, maybe you're early on in your career, or you're just kind of more of a rank and file employer, not a director, senior director in a corporate executive type role.

12:37But you want to have some exposure to that company. You're working really hard. You can buy stock at a discount. You can hold on to some of it. You just want to be mindful of that relative to the rest of your investable assets. But if you are somebody, and who we typically work with is folks who have a mix of other equity compensation, and between unvested and vested equity, you just have a ton of exposure to the company. I'm a big advocate of selling those ESPP shares as soon as you can in a disqualifying disposition. Lock in that 15 % discount. You're gonna pay some ordinary income tax on it.

13:05Too bad, so sad. There aren't many investments where you buy at 15 % discount and then can get out of it essentially right away. That's a pretty damn good deal. Just keep an eye on the plan though because there are some plans that have like six month holding periods. And if you have to already hold it for six months, then you might as well try to hold it for a year and get a qualifying disposition. So you have to weigh those two things. I tend to agree with you on the selling the ESPP right away, but I'd like to dig in more on your perspective of it. Is it because you view it as, hey, this is compensation, like because you're being paid in stock rather than cash, don't be confused.

13:38Just get your cash. Or is there something else there? I think it's primarily that that it is compensation. It's kind of a, dare I say, almost guaranteed rate of return in terms of that discount. I hope the compliance people don't listen. But if you thread the needle on the timing and you sell immediately, then it does kind of function that way. And yeah, I don't really think people who have close to 100 % of their income tied to one company should be doubling down necessarily, especially if it's a public company, doubling down on buying more of it every six months. Well, talking about the concentration in general, a lot of times employees will build up a position in one stock.

14:16It also happens to be the company that's paying their bills, like your regular paycheck, a lot of concentration of a balance sheet when you get paid in equity in some form. So how do you turn a big position into some sort of like rules based sell plan? Yeah, there's a few factors that come into play there. And so the first thing, like I said, let's get the inventory. Let's understand what they have. Let's understand the various tax lots. Let's understand like the mix of like our issues that are vested. Maybe they just vested and have a very high cost basis versus options they exercised several years ago at a low price, right?

14:49Because that very different tax consequences of getting out. And ultimately, I like to start with the destination in mind. Where are we going? We ultimately want to get to a spot where maybe let's say 10 % of your investable assets, less than 10 % of your investable assets are tied up in this company stock. And today it might be 80 % of your investable assets, right? You don't look at it that way because you're like, oh, I've got my 401k, my brokerage, that's diversified. And I have, that's$200 ,000 that's diversified. I have 800 ,000 over here of company stock. You look at them as separate buckets, but when we look at it all together, it's like this is potentially the vast majority of your assets.

15:24So with that in mind, you have to go and say, okay, the real destination is 100 ,000, let's say, of company stock instead of 800 ,000. The analogy I use, Peter, it's a terrible analogy, but it's like you're standing at the steps, at the top of the steps, and you've got a couple of young kids, right? You've got a laundry basket in your hand. There are toys all over the steps. And you also got these young kids to take care of. So if you slip and fall with this laundry basket from the top of the stairs, it's going to be a really bad thing. And so if you have 800 ,000 in the company stock, and your company is a target of the SEC accounting investigation, then we got a problem.

16:03You're going to have a much less concentration risk because the 800 ,000 is going to be worth 100 ,000 overnight and you didn't get any value out of it. So how do we get you down the steps as fast and as safely as possible? So taking that inventory, finding out how we can sell off bigger dollar amounts of shares at a smaller tax bill. I think that's a really key component of it. And so is there 400 ,000 of higher basis stock that we can sell right away? And then we chisel away at the other 400 ,000. But ultimately, agree on the destination, agree on the timeline to get there, and then find the most tax efficient way to get there that's aligned with your goals and what else is going on in your life.

16:39I really like that. You mentioned, hey, let's maybe try to get that single stock down to 10%. But if you've worked at multiple companies, and you're sitting on multiple stocks, and maybe even have a portfolio of individual stocks that you've just been picking for fun, and you kind of look at it as like, well, my serious money's in my retirement plan. And then, hey, John, that's what I'm asking you to manage. But this stuff over here is just found money and fun. What do you say to that? Yeah. I mean, I think that that fun money cannot be what your retirement plan relies on, what your financial independence plan relies on.

17:12And so I talk to a ton of prospects all the time about what they're doing with their investments and how that works. And I think that ultimately, if you want to have a sandbox account where you're playing, that's great, but let's make sure that your plan isn't living and dying by that. And I don't know if you know anything about these things, Peter, but somebody who has like that mix of like company stocks, not just one, there's like this 351 exchange thing I've heard a little bit about. I don't know if... John's poking fun at me because he knows how much I love the 351 exchange. I was going to say, you setting me up to set you up there?

17:43That wasn't planned, but 351, I think is probably the name of the game. Yeah. I mean, that's definitely been a great tool. And I want to read a couple stats on just individual stock returns. And this is pretty much where I contribute to the conversation. PlanCorp is just saying like, hey, like single stocks are risky. One of my favorite papers that has come out in the last several years is from Hendrick Bessenbinder. I think he goes by Harry though. Not that we know each other personally, but I don't know how you get to Harry from Hendrick is all I'm saying, but I'm pretty sure he goes by Harry.

18:12He looked at the total returns of U.S. common stocks from 1926 through 2016. So this is not through present, but certainly a long period. So the median stock generated a return of negative 3.66 % per year. Only 42.6 % of individual stocks had lifetime returns that exceeded that of one-month treasury bills, which is sort of a proxy for cash. So over 40 % of stocks are going to lose to cash. But here's the big one. There are nearly 26 ,000 stocks that have traded in the U.S. publicly. Over the course of history. Over the whole period, since 1926. the top 4 % of the stocks accounted for all of the net worth creation going back to 1926.

18:52And of that, of those top 4%, only 90 companies out of the 26 ,000 accounted for more than half of that. Now, there's all this stuff about how there's permanent losses in individual stocks. But I mean, like I operate from a place in building portfolios of probability and like base rates and such. And I think what's really important in these conversations, if you're listening to us still, It means you must have equity compensation because we've already gone down the rabbit hole. Sometimes the hard part is people see what was said at investor day or they're an executive themselves and feel like they have control over the price.

19:25I think you just have to remember that it is not a 50-50 shot at beating the market. I think sometimes even when people see an individual stock go up, they assume, oh, yeah, I won. It's like, well, the opportunity cost was the market. So that's the only place I can contribute to this conversation, John. So I appreciate getting to read some stats. But yeah, I mean, like you have to have a plan and you want to be tax efficient. But at the end of the day, if it plays out like the averages, the taxes are the least of your problems. Correct. Yeah. If it plays out like the average, you're screwed is basically what your data set said, right?

19:56Technical term, but. Yeah. So let me pivot a little bit because the diversification piece I feel strongly about. There is a strategy, I think it's just for executives, called a 10B51. I dare anybody listening to repeat the letters and numbers I just said in the correct order. I know that to be an important strategy for a certain type of employee. Tell me what you know about that. Yeah. So a 10B51 plan is essentially a predetermined selling plan that you enter into with kind of your company and the brokerage firm that oversees the company stock plan that says on these dates at these times, I will sell this number of shares.

20:35I'm signing a contract based on that, and I don't have discretion over it anymore. So once I agree to this, like it's going to happen. They are fantastic tools to take the emotion out of selling your concentrated stock. They are also really nice tools to allow you to sell shares at other times of the year beyond when you're just in a trading window. So the wonderful thing about a 10B51 is that as long as you enter into it in an open trading window and there's some sort of cooling off period between when you set it up and when the trades start to take off, you can often sell outside that windows.

21:12Maybe you're selling monthly instead of quarterly. You can also get really creative with them sometimes to say, hey, I have a, and I don't encourage, I'm a big advocate of like, we're selling every quarter, whatever the hell the price is. If the price is really high and you want to sell more power to you. But like there are ways sometimes, for example, the company stock is much higher when you're not in a trading window than it is when you are, especially there's a lot of employee share transactions happening. And so with the 10B51, you can say, okay, well, if the price hits$150 a share, regardless of when it happens, as long as it's during this plan, I would like to sell 50 % of my shares.

21:47And if that doesn't happen, I'm selling 10 % a month for the next 10 months. So those are some of the ways that they can be leveraged. And I think the biggest benefit, though, is a behavioral finance element. Let's take the emotion out of this and the, oh, I need to log in. Oh, do we still want to do that much? Oh, the earnings could have been better. the market didn't react. We beat on our EPS, but the market still sold off because of our guidance. Don't get caught up in all that crap. It's out of your control. Well, that's, I think, why I like them. And I mean, am I wrong? Are they not available to anybody?

22:17Do you have to be at a certain level of employative access? It depends on the company. And so if you work at like a Google, one of the big tech companies, a lot of times, and their investing is typically monthly at Google, a lot of times rank and file folks can set up like a predetermined trading plan. It's not going to be as sexy, perhaps, to some of the 10B51 characteristics I just talked about. But most other companies that are not like huge Mag7 big tech, you have to be at a certain level on kind of the org chart, basically, to be eligible for it. And it's really for those people, Peter, to be clear, that like in a normal trading window might still have some sort of inside information.

22:53Because if you're the CEO of a company, CFO, high-level director, you know of this M &A thing that could be happening three quarters from now. You know about this new tool that you thought was going to be great that has all the capex, but it's really struggling. And like you always have some sort of inside information. Yeah, that makes sense. And so we're talking a lot about divesting of our concentration selling. The other thing that we see at your end is charitable gifting. Not everybody's chariably inclined. Donor advised funds, when we go back to like the Tax Cuts and Jobs Act of 2017, like donor advised funds and bunching gifts was like a go to strategy.