Avoid Liquidity Event Tax Traps

Frequently, new clients come to us asking for help managing their money after they’ve received a huge payout from a liquidity event at work. While we’re still able to help them develop a financial plan and invest the proceeds, if they had come to us before the event, we could have helped them keep more of the money to fulfill their next big dreams.

As an entrepreneur or executive, you’ve been working hard toward that big day when you can turn your sweat equity into wealth — whether it be through a merger or acquisition, recapitalization or an initial public offering. With liquidity events, time is your most valuable asset. The earlier you start planning what you want your life to look like afterward, the more opportunity you have to implement tax-efficient strategies that allow you to maximize your hard earnings for the long term.

If you have registered stock units (RSUs), qualified small business stock (QSBS), incentive stock options (ISOs) or other types of deferred compensation, it’s best to work with your financial planner at least six months in advance of the big payout to be sure it is a success.

Here are some things that should be done before, during and after a liquidity event to avoid common tax traps.

Before

Define your goals

As the liquidity event approaches, you need to prioritize your goals. First, decide how you’d like to use the proceeds. Will this form an important part of your retirement plan? Do you intend to use this as an opportunity to transfer wealth to your children? Will it allow you to support a valued charitable cause? Deciding where you want the proceeds to be directed in advance can increase the tax efficiency of the transaction and may help guard against a spending spree.

File for an 83(b) Election

Elect 83(b) treatment for stock awards and ISO exercises when the restricted or unvested shares are received. By filing this important tax declaration within 30 days of receiving the shares, you will pay ordinary income or alternative minimum tax on the initial stock value, but future gains will be taxed as capital gains.

Often, 83(b) elections are made when the value of the equity is close to zero. Dropping the tax rate on the appreciation from the highest ordinary income tax rate of 39.6% to the 20% capital gains rate would cut your tax bill in half.

An election followed by a decline in value will result in a capital loss upon sale. However, if the stock price declines after you file for an 83(b) election and you leave your job before the shares vest, you can only claim a loss for the amount paid for the stock.

Understand your QSBS

Ask your employer if the shares issued to you are QSBS. Only shares issued before the first $50 million of capital is raised, borrowed or earned by the company will qualify as QSBS. If they are and you hold them five years or longer, you may be able to exclude up to $10 million of QSBS capital gains (or 10 times your cost basis, if higher) from federal income tax.

Save taxes while giving

Set up tax-advantaged trusts or a donor advised fund for the benefit of your heirs or favorite charities. Transfers to these types of vehicles must be executed sufficiently before the deal closes so that the proceeds don’t count as taxable income to you.

Giving securities with high potential for appreciation to family members can offer the greatest opportunity to leverage your lifetime gift tax exclusion. Securities that have already experienced significant appreciation are better candidates for charitable giving as that appreciation avoids income tax and is allowed as an income tax deduction.

During

Define an investment strategy

After deciding where the proceeds will go, you next need to define an appropriate investment strategy. Now that liquidity has occurred, do you want to take fewer risks with these funds or look to maximize returns? Are you comfortable with the increased risk that accompanies a more aggressive investment stance? Your risk appetite is likely different depending on whether you want to use the money for your own retirement or as a foundation for younger generations.

Project your income tax bill

If your employer is a public company, you may owe an additional tax on “windfall profits” under a tax regulation known as 280G, or “golden parachute.” If any portion of your profit is capital gain or carried interest, you should be taxed at the preferential capital gains rate.

Also, determine whether additional estimated tax payments will be required. This is something that appears to be commonly overlooked or misunderstood as the IRS, reportedly, is penalizing 40% more Americans who have not paid or underpaid their estimated taxes. Depending on the timing of the liquidity event, you may benefit from using either the prior year safe harbor or the annualized income method of determining quarterly payments for the year.

After

Be disciplined

Once the deal has closed and proceeds are in your account, you should execute your plans in a disciplined manner. Implementation of an investment plan should be methodical and follow a schedule. 

Check your titles

Many times vesting of employer stock or corporate transactions close in the name of an individual. Ensure that the proceeds are transferred to an account properly titled in the name of your living trust for asset protection purposes. 

Save wisely for future taxes

Any proceeds earmarked to pay taxes — for either next quarter or next April 15 — should be set aside in an investment that has no expectation of volatility. Bank CDs (up to the $250,000 FDIC insurance limit) or Treasury bills offer security and a certain maturity date before the tax payment is due.

By taking concrete steps ahead of time to apply a range of tax-advantaged financial tools, you may be able to more than double the amount of money you take home from a liquidity event. A wealth management firm with tax professionals who are experienced in handling liquidity events can help get the plan in place so you can focus on enjoying the fruits of your labor and have fun.

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