Many Lilly employees have accumulated a large amount of Lilly stock due to equity compensation, including Performance Awards and Restricted Stock Units. And many Lilly employees are much wealthier than they were five years ago because of having received these equity awards and the increase in the price of Lilly stock over that time. While this is a good thing, it can be risky if you have too much invested in one stock. The concentration in one stock helps create wealth, but it can also wipe out wealth. If you have a lot of your portfolio in one stock, you have a greater risk of a sharp decline in portfolio value than if you are diversified. When that one stock happens to be your employer’s stock, you have even more at risk. If the company were to come upon trying times that drove down the price of the stock, the same issues that cause the stock to go down could also cause you to lose your job and your income.
Reduce the risk of too much company stock
Those with concentrated stock positions should consider plans to diversify the company stock to preserve their wealth. There is usually an emotional attachment to the company because it’s your employer and because it’s helped you create wealth. This emotional attachment may be the biggest obstacle to creating a practical plan to diversify. Another obstacle is capital gains taxes. That is, the sale of shares to diversify out of the concentrated stock will generally result in a capital gain equal to the difference between the sale price and the tax basis in the shares. People have a tendency to want to postpone that tax liability, rather than realize it in the present.
Eliminate capital gains tax on appreciated stock
Let’s look at one simple, yet effective, way to diversify away from Lilly stock concentration and avoid the capital gains tax liability when the stock is held in a taxable account. If you are making donations to charity, you can use Lilly stock to fund your current or future charitable goals, generate an immediate tax deduction and avoid the capital gains tax liability. It can also help you avoid the 3.8% net investment income tax (NIIT).
You can donate shares of stock directly to the charity(ies) of your choice. Your donation amount is the value of the stock on the date of the donation and is the amount you would use toward your itemized deductions.
Let’s assume you donate $30,000 of stock, your cost basis is $10,000, your income tax rate is 35% and your long-term capital gains rate is 20%. Let’s also assume you itemize deductions.
If you sold the stock, you would pay $4,000 in tax on the $20,000 gain. You’d also pay another $760 in net investment income tax.
If you donate the stock to charity, you pay no capital gains tax or net investment income tax on the $20,000 of gain in the stock, thus saving $4,760. You also save $10,500 in income tax from the deduction of the $30,000 charitable contribution.
One thing to be aware of is that the charitable deduction will only provide a benefit if your total itemized deductions are more than your standard deduction. The standard deduction doubled in 2018 from what it was in 2017. For 2019 it is $24,400 for married couples filing jointly and $12,200 for single taxpayers.
If your itemized deductions are less than the standard deduction, there is still a way that you can implement this strategy of donating appreciated stock to charity. It’s referred to as “bunching”. With bunching, you are taking charitable contributions that you would have made over multiple years and instead bunching them into one year. By consolidating the charitable donations into one year, you benefit from being able to itemize deductions in that year, while taking the higher standard deduction in the other years. This strategy helps improve your overall tax deductions over several years.
Here’s an example. Let’s assume you and your spouse want to donate $10,000 of Lilly stock to charity. Let’s also assume you have no mortgage interest or medical expenses to deduct and you will deduct the maximum $10,000 of state and local income tax and real estate tax. Your itemized deductions total $20,000. This is less than the $24,400 standard deduction. While you would still avoid the capital gains tax on the gain in the stock, you would not receive a tax deduction for the donation because you would take the standard deduction of $24,400 instead of itemizing deductions.
With bunching, using the same assumptions above, you would donate $20,000 to charity in appreciated stock (an amount equal to two years of your planned charitable giving). Your $20,000 charitable gift plus your $10,000 deductible state income and real estate taxes means you could take a $30,000 itemized deduction in year one for federal income taxes. In year two, because your only potential itemized deduction would be $10,000 in state income taxes and real estate taxes, you would take the higher $24,400 standard deduction. Over the two years, you would receive deductions of $54,400 compared to $48,800 without bunching. You would also avoid the 15% or 20% capital gains tax on the gain in the Lilly stock.
Increase itemized deductions
But bunching doesn’t have to be used only to get you above the threshold to itemize deductions. It can be very beneficial for those whose total itemized deductions are already more than their standard deduction. Here’s how.
A couple typically gives $30,000 annually to charity. They will deduct the maximum $10,000 for state and local income tax and real estate tax. They have no mortgage, so they have no mortgage interest deduction, nor do they have any deductible medical expenses. They have $40,000 in total itemized deductions for the year. Let’s assume they did this same exact thing for a total of three years. They would have a total of $120,000 in federal income tax deductions over that three-year period.
Standard deduction = $24,400 (married filing jointly)
By bunching their contributions – front-loading them to the first year – they can increase their total deductions. The couple would donate $90,000 (three years of their planned gifts) in appreciated Lilly stock in year one, either directly to the charity(ies) or to a donor-advised fund that would allow them to dole out the gifts to the charity(ies) over multiple years. Their total itemized deduction in year one is $100,000; $90,000 of appreciated stock plus $10,000 of state and local income tax and real estate tax. In years 2 and 3 their only itemized deduction would be their state and local income tax and real estate tax of $10,000, so they would take the higher $24,400 standard deduction in both of those years. Over the three years the total deduction received through bunching would be $148,800. Compare that to the $120,000 in deduction over that same three years without bunching. The couple increased the amount of their deduction by $28,800 by bunching their gifts.
Whether they bunch their contributions or not, they would still avoid the capital gains tax on the appreciated Lilly stock because of their donation of the stock to charity.
For those who are charitably inclined and own appreciated Lilly stock, donating stock to charity can be an excellent tax-planning strategy to eliminate the capital gains tax on the gain in the stock, and at the same time, help reduce the risk associated with a portfolio that is heavy in company stock. It can prove especially valuable for those in higher tax brackets subject to the 3.8% net investment income tax and/or the 20% long-term capital gains rate. Additionally, bunching of charitable gifts can help increase tax deductions over multiple years compared to a more traditional approach of gifting the donations annually.
Oaktree Financial Advisors is neither endorsed by nor affiliated with Eli Lilly and Company.
Oaktree Financial Advisors does not provide legal or tax advice. You should consult a legal or tax professional regarding your individual situation.
Diversification does not assure a profit or protect against loss in declining markets, and diversification cannot guarantee that any objective or goal will be achieved.