California IPO Tax Bonus: Factors Complicating the Equation

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The blockbuster EspaceX The IPO and possible upcoming public offerings for OpenAI and Anthropic could create a tax windfall for the state of California. Still, the revenue increase could be lower than previous tech IPOs – at least relative to company valuations – given the specific nature and tax treatment of current tech compensation.

After its IPO last week, SpaceX is now valued at $2.5 trillion, making many of its employees who live and work near its office in Hawthorne, California, millionaires, at least on paper. California-based companies Anthropic and OpenAI are also expected to IPO later this year, at valuations that could approach $1 trillion.

The explosion of technological wealth has given rise to comparisons to Menlo Park-based Facebook’s 2012 IPO, which generated $1.3 billion in taxes for the Golden State, according to the California Department of Finance’s estimate. Facebook’s valuation at the time was only $104 billion, suggesting the new crop of super-IPOs could theoretically generate billions more.

But the impact on revenue could be mitigated, because of the way these employees’ stock compensation has been structured and because tech employees today have more tools to mitigate their tax burden, experts and financial advisors told CNBC.

As companies have stayed private longer and reached sky-high valuations, financial institutions have increasingly catered to the needs of stock-rich, cash-poor startup employees with tax strategies that were traditionally only available to founders.

For example, employees of some startups can get a tax deduction by donating private shares before the IPO to a donor-advised fund, according to Richard Lowry of wealth manager Cresset. He added that such donations were generally limited to the ultra-wealthy just a decade ago because few charities were equipped to accept or manage these assets.

“Historically, the only people who had equity in a private company and were certainly able to divest it were the millionaire or billionaire founders who already had their own controlled structures, like a private foundation, where they could decide what they accepted,” said Lowry, managing director and head of tax strategy at Cresset. “There’s a cottage industry now that allows people to take advantage of it.”

There is also a temporal consideration regarding the SpaceX windfall.

The tax revenue generated by an IPO comes largely from two sources: ordinary income taxes on restricted employee stock, or RSU, when they vest and capital gains taxes paid when shareholders sell appreciated stock.

SpaceX uses a unique stock-based compensation structure that could have generated tax revenue on employee stock vesting. In most privately held companies, RSUs vest once two conditions are met: continued employment with the company and a liquidity event such as an IPO or acquisition. This dual-trigger RSU structure results in an explosion in taxable income on IPO day.

However, many SpaceX employees have been paying taxes on their RSUs for years because vesting of the shares was only tied to employment and not a liquidity event.

This stock compensation structure made it difficult to estimate tax revenue associated with SpaceX’s IPO, according to the California Legislative Analyst’s Office.

“Total revenue will depend more on financial decisions made by employees and investors who hold SpaceX stock and stock options prior to the IPO,” AJO wrote in a statement. “Compared to past IPOs, tax revenues from the SpaceX IPO will likely be less immediate and more unpredictable.”

The LAO, which advises state lawmakers on budget and tax policy, has not released tax revenue estimates for IPOs from SpaceX, Anthropic or OpenAI. That said, the LAO’s statement to CNBC was cautiously optimistic that the market debut would fill state coffers.

“Previous major IPOs in the technology sector have generated significant tax revenue for the state and these upcoming IPOs certainly have the potential to do the same,” the release said.

The California Department of Finance also has not released revenue estimates for IPOs, citing the risk that companies will frequently delay their IPOs during market downturns. OpenAI and Anthropic, which each filed confidential S-1s in recent weeks, could do the same.

The ministry has reason to be cautious, as market fluctuations have already compromised its revenue forecasts. He had to revise his estimate of revenue from Facebook’s IPO from $1.9 billion to $1.3 billion after the social media giant’s shares fell.

The department’s budget report noted another factor that could limit the benefits of IPOs: the growing trend of private companies allowing their employees to sell shares before taking them public, thereby reducing the backlog of shares taxed at IPO.

Employees at SpaceX, Anthropic, and OpenAI had ample opportunity to cash out a few tokens well in advance of a public offering. In October, OpenAI completed a secondary stock sale totaling $6.6 billion in which current and former employees could sell their shares. at a valuation of $500 billion. CNBC previously reported that OpenAI plans to facilitate a tender offer at a post-money valuation of $852 billion.

Tender offers have gained popularity as a way to reward employees and investors as the exit timeline has lengthened, according to Hamza Shad, chief insight officer at startup equity management firm Carta.

Gains on those sales are still taxed, but selling earlier moves those tax revenues forward and makes them less predictable for regulators, he said.

“In the past, when pre-public liquidity was not as prevalent, tax revenues came in all at once at the IPO and afterward,” Shad said. “But now it’s up to each company to decide whether or not they want to run takeovers, how big they want to be, and how often they want to do them.”

However, the purchase offers come with many conditions, such as a percentage cap on employees’ share of equity. can sell. And wildly lucrative takeover deals and secondary sales are largely limited to the “best of the best startups,” according to Michael Ewens, a finance professor at Columbia Business School.

What’s most likely to eat into potential tax revenue is if employees choose not to sell at all but instead take out loans, said Will Gornall, an associate professor of finance at the University of British Columbia.

By taking out a loan on their shares instead of selling them, shareholders save money by paying interest rather than taxing capital gains. This so-called “buy, borrow, die” strategy is used by SpaceX founder and the world’s first billionaire, Elon Musk, who took out loans against billions of dollars of Tesla stock. This strategy also has the benefit of allowing employees to stay invested and benefit from future stock appreciation.

As financial maneuvers to avoid taxes have become more sophisticated, the California Franchise Tax Board’s auditing methods have also become more sophisticated, according to Robert Willens, a longtime tax and accounting analyst, who added that the agency is notoriously aggressive.

“It really depends on when the shares are earned. The taxable event is the acquisition of the shares, and if you’re a California resident, there’s not much you can do about it,” he said. “I think California is looking forward to a very large infusion of funds.”

Of course, IPOs are a one-time revenue boost, and there is a potential downside to charging high bills. Ewens told CNBC he was concerned that a heavy tax burden could drive these newly wealthy and often entrepreneurial employees away from the state.

“It’s not something California should lower its taxes on now, but I think it needs to keep in mind that taxes have long-term consequences on people’s entrepreneurial decision-making, and that’s a big driver of wealth in the state,” he said.