Demystifying Share Buybacks: A Guide for Private Company Stockholders
You work for a private company, and you’ve been earning stock. Most commonly, your stock is earned in one of two ways: RSUs (restricted stock units) and/or stock options. Many companies establish stock plans to incentivize employees to participate in the growth of the company. However, if you work for a private company, you don’t have the luxury of being able to ‘cash out’ whenever you want to. Private stock is illiquid, and much more complicated to sell than public stock, which trades on a public exchange. Furthermore, as an employee of a private company, you are likely restricted from selling, even if you were to find a third party who was willing to purchase your shares.
Because of this illiquidity, companies structure their stock plans with double trigger vesting (i.e., your shares do not vest until there is a liquidity event), or using stock options. Double trigger vesting ensures that a tax event does not occur until there is a liquidity event, so you’re not left with a tax bill but no shares to sell. Stock options give you the right, but not the obligation, to purchase shares when you want, so you can control when the tax liability occurs. In both cases, the goal is to delay the tax impact until you’re able to sell, since otherwise you would have to pay out of pocket for taxes on money that you can’t actually touch.
The IPO market is quiet by comparison to where it was a few years ago. This has brought rise to companies offering liquidity in a different form: share buy-backs. A share buy-back is an internal transaction, whereby the company repurchases shares from shareholders. What does this mean for you? You have a new opportunity to get liquidity, or turn your stock into cash.
What is a share buyback?
Share buybacks, also known as stock repurchases, occur when a company repurchases its own shares from existing shareholders. The purpose of share buybacks can vary depending on the company's objectives. One common reason is to return excess cash to shareholders when the company believes its stock is undervalued. By repurchasing shares, the company reduces the number of outstanding shares, effectively increasing the ownership stake of the remaining shareholders. This can lead to an increase in earnings per share and potentially boost the stock price. Additionally, share buybacks can be used to offset dilution caused by employee stock plans. Overall, share buybacks can be a strategic tool for a private company to optimize their capital structure and enhance shareholder value.
What are the tax implications?
Before diving into the taxes on a liquidity event, let’s start by reviewing what’s actually most important: how each of the aforementioned stock types are taxed when earned or exercised.
RSUs: Taxed as ordinary income upon vesting, based on the gross amount earned (number of shares x share price). Vesting is defined by the stock plan agreement. If you have double trigger vesting, this typically means that vesting does not occur until there is an IPO (or other major liquidity event like the sale of the company to another private company). RSUs with double trigger vesting typically have an expiration date 7-10 years after the shares were granted. If double trigger vesting is removed, this means that your shares vest based on time passed, and the expiration date is removed. For example, if you were granted 100 shares on a 4 year vesting schedule and two years had passed, 50 shares would be vested.
Stock options: Taxed as ordinary income upon exercising, based on the difference between the price you pay (the exercise price) and the amount you receive. Most employees may exercise at any time ahead of the expiration date, which is typically 7-10 years after the shares were granted.
We wrote a blog called “I have RSUs but didn’t sell any. Why is my tax bill so crazy?”. This blog covers your options as an employee of a public company, where you have the ability to sell on a regular basis. We’d highly recommend reading this blog if you aren’t familiar with RSU taxation, but the TL:DR is below.
As RSUs vest, or you exercise stock options, you are taxed on the money you earn as ordinary income. Let’s say you have 1000 shares, and the stock price is $150, you’ll be taxed on $150k of income. If these were stock options and the exercise price was $10, you would be taxed on $140k of income ($150 share price minus price you pay of $10 equals $140, times 1000 shares equals $140k).
If we stick to the RSU example, an extra $150k will be run through your payroll, and you’ll be taxed on this money. However what is so important, and what is often overlooked is that it is very possible that there is a difference between the amount of tax that is withheld on your pay stub, and the amount of tax you actually owe. The IRS and every state has mandatory withholding rules, whereby the tax authorities require money to be withheld for tax purposes when you earn supplemental income (e.g. bonuses or stock compensation). The IRS requires 22% to be withheld on supplemental income up to $1 million. Every state will vary, but two examples are California is 10.23% and New York is 11.7%. As a California employee, your $150k of vested RSUs would be withheld for taxes as follows:
Federal taxes (IRS): 22%, or $150k x 22% = $33,000
State taxes (CA FTB): 10.23%, or $150k x 10.23% = $15,345
Social security taxes: 6.2%, or $150k x 6.2% = $9,300. Social security taxes are only on the first $160,200 of income, so if you’ve already earned over this amount so far this year, you would not be subject to this tax.
Medicare taxes: 1.45%, or $150k x 1.45% = $2,175. If you earn over $200k, you’ll pay an additional 0.9% of medicare taxes, or $150k x 0.9% = $1,350.
There won’t be any issue on over or underpaying social security or medicare taxes, however, the withholding assumes everyone falls within the 22% tax bracket for Federal taxes, and 10.23% for State. This is rarely the case. We’ll focus on federal taxes, because the differences can be more extreme, and the calculations are the same for State taxes, using the state tax brackets. Below we’ve included the 2023 federal tax brackets from The Tax Foundation.
We’ll give three examples of individuals earning $150k in RSUs. In each example, we are assuming that the salary and bonus income is net of any 401k contributions and other pre-tax deductions.
Married couple who is expecting to earn $500k on salary and bonus income in 2023 excluding stock compensation. This couple will owe 35% tax on all $150k of RSUs, because $500k + $150k is $650k, which falls within the 35% tax bracket for married individuals filing joint returns. This means that their total federal tax on RSUs will be $52,500, resulting in them owing $19,500 more than was withheld by their company.
Single mom who is expecting to earn $500k on salary and bonus income in 2023 excluding stock compensation. This individual will owe 35% on $78,100 ($500k + $78,100 puts her at the top end of 35% tax bracket) and 37% on $71,900 (the remaining stock earned of the $150k). This means her total taxes owed will be $53,938. Since only $33k was withheld, she will owe an additional $20,938 in taxes.
Individual who is expecting to earn $180k on salary and bonus income in 2023 excluding stock compensation. This individual will owe 24% on $2,100 ($180k + $2,100 puts at the top end of the 24% tax bracket), 32% on $49,150 (full 32% tax bracket), and 35% on the remaining $98,750. Total tax equals $50,795, resulting in an additional $17,795 of taxes owed.
As you can see, in many financial situations, the taxes that are withheld upon earning stock are not actually enough. The burden is on you, the taxpayer, to ensure your taxes are paid in full. Some companies will give you the ability to increase your withholding to align with your personal tax situation, but if they do not, you have two options: 1) pay out of pocket for taxes owed, or 2) sell shares to cover your tax liability.
Should I sell my shares?
In most buybacks, companies will advise the amount of shares they are willing to purchase. We view this as an upper limit, e.g. you may sell (up to) 25% of your vested shares. There is always a dollar amount that the company is willing to buy back, so if more employees / shareholders sign up than expected, the amount that is available for sale on an individual basis could be dialed back.
In any case, your decision around selling doesn’t have to be all or nothing. In fact, it can range from keeping everything invested to selling as much as you can. Let’s walk through some important considerations.
Sell at least enough to pay your taxes: For many, there will be tax consequences. Not necessarily from the buyback, but from the shares vesting due to the double trigger event being removed, or stock options being exercised. There’s no guarantee that you’ll have future buybacks to rely on, and the closer the buyback is to the vesting date, the more certain you can be that your sales price will be close to the vesting price. Let’s say you’re in the 37% tax bracket, we would highly suggest selling 15% of the gross value of your shares for tax purposes. In the case that the stock price goes down, you haven’t sold any shares for tax purposes, and you don’t have savings specifically earmarked for taxes, this can get ugly. We’ve witnessed this on a number of occasions, and don’t want to see you fall into this trap! Like we said, it’s not all or nothing. It’s absolutely OK to sell just enough for taxes, if you’re looking to remain invested in your company for the longer haul.
Be mindful of your concentration risk: How much of your net worth (your assets minus your liabilities), or your investable assets is represented by your company stock? If it represents a large portion, it’s worth considering selling and diversifying your investment risk. How a large portion is defined depends on your financial situation. Consider the possibility that this investment goes to zero. How does it make you feel? If this makes you feel anxious, it’s likely that you have a big position! We’re not saying that your company is likely to go bankrupt, but when investing in a private company, there’s no guarantee of future liquidity. The other aspect to consider is that you are naturally concentrated in your company as an employee of that company. When things go bad, the stock price typically drops, bonuses get taken away, and layoffs occur. Because of these confounding factors, we lean towards reducing this concentrated risk.
Give meaning to your money: Money is a tool that can be used to help achieve your greatest goals and dreams. Are there any big goals that you’re saving towards, which require extra cash? Perhaps you’ve been considering making an investment in your home, continuing education, or impact investments. If so, this could be a great opportunity to invest your money in a way that is additive to your life. We also approve of a fun (but measured) spending splurge - remember, you’ve worked hard for this day, and it’s ok to treat yourself.
What are the tax implications to selling my shares?
If the buyback occurs on the same day as vesting, there actually aren’t any additional tax consequences to what we already described. In our example, we assumed your stock price is at $150. Because you pay taxes on the vesting at $150, the cost basis of the shares that you receive is $150. If you then sell the shares at $150, you pay no additional capital gains taxes.
Now let’s say the price moves between the time of vesting versus the time of the buyback. Then, you would owe capital gains taxes on the difference between the current price and the vesting price. If the price drops after vesting, you will be able to include a capital loss on your tax return. Up to $3,000 of capital losses are eligible to be offset against ordinary income, and the remainder would be carried over to future years.
Capital gains tax rates are dependent upon the length of time between vesting or exercising, and sale. If the length of time exceeds one year, taxes will be subject to long term rates. If less than one year, taxes are subject to ordinary income rates. Long term capital gains rates are preferential, ranging from 0-20% depending on your income. For high income earners, you can expect to pay 20% plus 3.8% net investment income tax. State capital gains taxes vary, but for California and New York, both short and long term capital gains taxes are the same as ordinary income rates.
Should I be excited about a share buyback?
In our view, yes! This opportunity offers you options that you didn’t have before.
We also know that determining what’s best for you is a complicated decision. In these cases, we encourage you to talk to others, but also recognize that the decision should ultimately be based on your personal financial situation and goals. To make your decision easier, it’s a good idea to get organized as soon as possible, understand the tax implications for your unique circumstances, and be cognizant of the deadlines set by your company.
Stock buybacks give you an opportunity to turn your hard-earned company stock into cash, which in turn can help you achieve your goals, or diversify investments to help you build wealth. If you don’t know exactly what you want to do with the proceeds, investing in a diversified portfolio is a great way to balance the risks of your company stock investment. If you’re able to take on the concentrated risk, it’s also okay to remain invested. However, what we want to convey in this blog most is an understanding of both sides of the equation: the risks and the rewards. Having this knowledge should empower you to hold better conversations, make more realistic considerations, and guide your decision-making process more steadily.
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Stephanie Bucko and Cristina Livadary are fee-only financial planners based in Los Angeles, California. Stephanie is the Chief Investment Officer and Cristina is the Chief Executive Officer at Mana Financial Life Design (FLD). Mana FLD provides comprehensive financial planning and investment management services to help clients grow and protect their wealth throughout life’s journey. Mana FLD specializes in advising ambitious professionals who seek financial knowledge and want to implement creative budgeting, savings, proactive planning and powerful investment strategies. As fee-only fiduciaries and independent financial advisors, Stephanie and Cristina never receive commission of any kind. Stephanie and Cristina are legally bound by their certifications to provide unbiased and trustworthy financial advice.