California IPO tax windfall: Factors complicating the equation

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blockbuster SpaceX IPOs and upcoming potential IPOs for OpenAI and Anthropic could create a tax windfall for the state of California. But given the specific nature and tax treatment of today’s tech compensation, revenue growth may lag behind previous tech IPOs — at least relative to firms’ valuations.

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

Explosion of tech wealth sparks comparisons to the 2012 IPO of Menlo Park-based Facebook, which brought $1.3 billion in taxes to the Golden State, the California Department of Treasury estimates. At that time, Facebook’s valuation was only $104 billion. The new super crop of IPOs could theoretically generate billions more dollars.

However, the income effect may be blunted. This happens because of how these employees’ stock compensation is structured and because tech workers have more tools at their disposal to ease their tax burden, experts and financial advisors told CNBC.

As companies remain private longer and reach sky-high valuations, financial institutions increasingly serve equity-rich and cash-poor startup employees with tax strategies traditionally only available to founders.

For example, employees at some startups can get a tax break by donating private pre-IPO shares to a donor-advised fund, according to Richard Lowry of asset manager Cresset. Until a decade ago, such donations were generally limited to the ultra-wealthy, he said, because few charities were equipped to accept or manage such assets.

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

There is also a timing consideration regarding SpaceX’s unexpected decline.

Tax revenue from an IPO comes largely from two sources: employees’ ordinary income taxes on restricted stock units, or RSUs, when they vest, and capital gains taxes paid when shareholders sell shares that appreciate in value.

SpaceX uses a unique stock compensation structure that may have carried forward tax revenue from transferring employee shares. In most private companies, RSUs vest after two conditions are met: continued employment with the company and a liquidity event such as an initial public offering or acquisition. This dual-trigger RSU structure leads to a burst of taxable income on IPO day.

But many SpaceX employees have been paying income taxes on their RSUs for years because the stock transfer was solely employment-related and not a liquidity event.

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

“Revenue totals will depend more on financial decisions made by employees and investors who held pre-IPO SpaceX shares and stock options,” LAO said in a statement. he wrote. “Compared to past IPOs, tax revenues from SpaceX’s IPO are likely to be less immediate and more unpredictable.”

LAO, which advises state lawmakers on budget and fiscal policy, has not released tax revenue estimates for the IPOs of SpaceX, Anthropic or OpenAI. However, in LAO’s statement to CNBC, there was cautious optimism that the rollouts would fill the province’s coffers.

“Major tech IPOs in the past have generated significant income tax revenue for the state, and these upcoming IPOs certainly have the potential to do the same,” the statement says.

The California Department of Finance also has not released revenue estimates for IPOs, citing the risk that companies will often delay their IPOs if the market declines. OpenAI and Anthropic, which have filed confidential S-1s in recent weeks, may do the same.

The Department has reason to err on the side of caution, as market fluctuations have previously weakened revenue forecasts. Facebook was forced to revise its revenue forecast from its IPO to $1.3 billion from $1.9 billion following the decline in the social media giant’s shares.

The department’s budget report noted another factor that could limit the positive outcomes from IPOs: the increasing trend of private companies allowing employees to sell shares before going public, reducing the accumulation of stock taxed in the IPO.

Employees at SpaceX, Anthropic, and OpenAI had ample opportunity to get some tips off the table well before the IPO. In October, OpenAI completed a secondary stock sale totaling $6.6 billion, in which current and former employees could sell their shares. With a valuation of $500 billion. CNBC previously reported that OpenAI plans to facilitate a tender offer worth $852 billion at a post-money valuation.

As exit timelines have lengthened, tender offers have gained popularity as a way to reward employees and investors, according to Hamza Shad, director of insights at startup capital management firm Carta.

Gains from those sales are still taxable, but selling earlier brings tax revenue forward and makes it less predictable for regulators, he said.

“In the past, when pre-IPO liquidity wasn’t as common, tax revenue would come in all at once during the IPO and beyond,” Shad said. “But now it’s up to each company whether they want to make tender offers, how big they want them to be, how often they want to make them.”

Still, tender offers come with many conditions, such as a percentage cap on how much stock employees will be paid. can sell. Highly lucrative tender offers and secondary sales are largely limited to “the best of the best startups,” according to Michael Ewens, a professor of finance at Columbia Business School.

Will Gornall, a finance professor at the University of British Columbia, said what eats up potential tax revenue is employees choosing not to sell at all and taking out loans instead.

Shareholders save money by borrowing instead of selling their shares and paying interest instead of capital gains tax. This so-called “buy, borrow, die” strategy is used by Elon Musk, SpaceX founder and the world’s first trillionaire, who took out loans against Tesla shares worth billions of dollars. This strategy also has the advantage of allowing employees to maintain their investments and benefit from future stock valuations.

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 has become extremely aggressive.

“It really comes down to when the shares are vested. The taxable event is the transfer of the shares, and if you’re a California resident there’s not much you can do about that,” he said. “I think California is looking forward to a really big infusion of funds.”

Of course, IPOs are one-time revenue raises, and there is a potential downside to hefty billings. Ewens told CNBC that he’s concerned that a large tax burden will drive these newly wealthy and often entrepreneurial workers away from the state.

“This is not a point where California should lower its taxes right now, but I think it should keep in mind that taxes have longer-term implications for people’s entrepreneurial decision-making, and that’s a big driver of wealth in the state,” he said.