It’s been a wild year of tech IPOs.
For our team at Schmidt Financial Group, we couldn’t be more grateful for the opportunities we’ve had to work with clients navigating these exciting circumstances.
As reported by The Information, the last quarter of the year has been filled with IPO lockup expirations. This means employees at a number of tech companies are now able to sell their equity on the public markets.
Unfortunately, the market reception has been decidedly chilly for a number of companies which has resulted in their share prices dipping well below their market debuts. For our clients at Lyft and Uber with RSUs, that has created capital losses.
And for that reason, we’ve consistently heard the same question in client meetings “should I be doing anything with losses before the end of the year?”
To answer that question, we’ll first need to establish what a capital loss is.
What are capital losses?
Unrealized capital losses occur when the value of your equity is less than the cost basis. For Restricted Stock Units (RSUs), the cost basis is the value at the time of vest. In the context of this discussion, this happened primarily when Lyft and Uber went public earlier this year because of the now ubiquitous liquidity event clause.
But unrealized capital losses only exist on paper - meaning they don’t have a tangible tax impact because the loss hasn’t actually occurred. You must first sell your equity for less than the cost basis in order to realize a capital loss. And once you do, the losses can then be used to offset gains. More on that to come.
The ugly, the bad and the good
At Schmidt Financial Group, we’re realists so let’s get the ugly out of the way first.
RSUs are taxed as ordinary income, which tends to be a high tax rate for executives and tech professionals. This means Lyft and Uber employees with RSUs will likely have outsized W2 income this year. That can feel very unfair now that the share price for both companies has materially dropped.
Now onto the bad.
I’ve heard a number of Lyft and Uber employees say that having a high offering price was a sweetener of sorts because withholding was done when their equity was worth more - meaning fewer shares were potentially sold to cover taxes.
To evaluate this assumption, I’ve included a simplified example. It compares two scenarios, the actual offering price with a hypothetical (as in not real people) lower offering price. That way we can clearly see which one allows Lyft and Uber employees to keep the most shares net of taxes.
In this first section, we see that a higher offering prices creates a lot more income recognition. As mentioned earlier, dual vesting meant that RSUs were taxed at vest, which was when both companies went public. No surprises here.
But in this second section, since withholding is a percent of earnings, we see that the number of shares sold to cover are the same. You may find that your withholding is more, which would be great from a cash flow perspective, but it won’t change the fact that more income recognition is a product of the offering price. That is why the number of shares sold to cover is proportional in both scenarios.
This leads us to the final section where we sell more shares at a later date so there’s cash set aside to pay for the taxes not withheld. What we see here is that the larger income recognition from the higher offering price requires more shares to be sold in aggregate. And that’s obviously a bummer.
So it would seem that if the perceived benefit of a higher offering price is that employees keep more shares net of taxes, we may need to call Mythbusters.
In our experience, it’s uncommon to see adequate employer withholding in the tax year of an IPO, which is why we suggest creating a tax projection prior to April so you aren’t left with a large tax liability outside of a trading window.
Finally, the good!
Those capital losses we discussed earlier aren’t just an accounting exercise, they have a purpose. Once realized, the IRS allows you to use them to offset realized capital gains. And really, who doesn’t have those in this historically long bull market?
What’s the takeaway?
Even though a capital loss is by definition a bummer, there are advantages.
For example, even if you don’t have enough gains to justify selling a significant number of RSUs, it’s still a logical starting point for a diversification plan. So if you’re still not sure exactly how much equity you will sell and when, you might consider harvesting enough losses to offset your realized gains and estimated capital gains distributions. This will help to keep your out of pocket expense in April more manageable. And if your company went public this year, you’re probably going to need it.
But there’s not much time. You gotta get on it!
Just keep in mind, that in our opinion, there’s no substitute for doing the hard work of creating a thoughtful diversification plan. So if you haven’t done that, be sure to take advantage of all the free IPO planning resources we have on our website.
If you’re a current employee of Lyft or Uber you’ll need to be mindful of trading window restrictions before placing any sale orders.
Please review our disclosures and discuss your situation with a financial professional before making any investment decisions.