Tax windfalls in California IPOs: Factors that complicate the equation

A version of this article first appeared in CNBC’s Inside Wealth newsletter with Robert Frank, a weekly guide for the high-net-worth investor and consumer. subscription To receive future issues, directly to your inbox.

Very popular SpaceX The IPO and potential upcoming public offerings of OpenAI and Anthropic could create a tax windfall for the state of California. However, the revenue raise may be less than previous technology IPOs — at least relative to company valuations — given the specific nature and tax treatment of technology compensation today.

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

The explosion of technological wealth has sparked comparison to the 2012 IPO of Menlo Park-based Facebook, which generated $1.3 billion in taxes for the Golden State, according to California Department of Finance estimates. Facebook’s value at the time was only $104 billion, which indicates this In theory, the new crop of super IPOs could generate billions more.

But the revenue impact may be less, Because of how these employees’ stock compensation is structured and because today’s technology employees have more tools at their disposal to ease the tax burden, experts and financial advisors told CNBC.

As companies stay private longer and reach higher valuations, financial institutions have increasingly patronized wealthy, cash-strapped startup employees through tax strategies that were traditionally available only to founders.

For example, employees at some startups can get a tax deduction by donating private equity before an IPO to a donor-advised fund, according to Richard Lurie of wealth management firm Cresset. Such donations were generally limited to the wealthy a decade ago, he said, as few charitable organizations were equipped to accept or manage those assets.

“Historically, the only people who had shares in a private company and were certainly in a position to give them away were millionaire or billionaire founders who already had their own controlled structures, like a private foundation, where they could decide what they would accept,” said Lurie, managing director and head of tax strategy at Cresit. “Now there’s a cottage industry around letting people profit from this.”

There’s also a timing consideration regarding SpaceX’s windfall.

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

SpaceX uses a unique stock payout structure that may have resulted in increased tax revenues when employee stock vested. In most private companies, RSUs vest after two conditions are met: continued employment with the company and a liquidity event such as an IPO or acquisition. The dual-trigger RSU structure results in a boom in taxable income on the day of the IPO.

However, many SpaceX employees have been paying income taxes on their RSUs for years, as stock vesting was only tied to employment, not a liquidity event.

This stock-payment structure has made it difficult to estimate tax revenues associated with SpaceX’s IPO, according to the California Legislative Analyst’s Office.

“Total revenues will depend more heavily on financial decisions made by employees and investors who own SpaceX stock and stock options prior to the IPO,” LAO wrote in a statement. “Relative to previous IPOs, the tax proceeds from a SpaceX IPO are likely to be less immediate and unpredictable.”

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

“Previous major technology IPOs have generated significant state income tax revenues, and these upcoming IPOs certainly have the potential to do the same,” the statement read.

The California Department of Finance also has not published IPO revenue estimates, citing the risk that companies often delay IPOs in the event of a market downturn. OpenAI and Anthropic, which have filed confidential S-1 filings in recent weeks, could do the same.

The ministry has reasons to be conservative because market volatility has undermined its revenue forecasts before. It was forced to revise its revenue estimates from Facebook’s initial public offering from $1.9 billion to $1.3 billion after the social media giant’s shares declined.

The department’s budget report pointed to another factor that could limit the upside of IPOs: the growing trend of private companies allowing employees to sell shares before they go public, reducing the backlog of taxable shares upon IPO.

The folks at SpaceX, Anthropic, and OpenAI had plenty of opportunity to take some chips off the table long before the IPO. In October, OpenAI completed a secondary stock sale worth a total of $6.6 billion, where current and former employees can sell their shares. With 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 increased in popularity as a way to reward employees and investors as the exit timeline grows longer, according to Hamza Shad, director of insights at equity management startup Carta.

Gains from those sales are still taxable, but an early sale pulls that tax revenue forward and makes it less predictable for regulators, he said.

“In the past, when early liquidity before a public announcement was not prevalent, tax revenues would come in all at once at and after the IPO,” Schad said. “But now it’s up to each company whether they want to do bidding or not, how big they want it, and how often they want it.”

However, tender offers come with a lot of conditions, such as a maximum percentage of the number of employees Can be sold. Highly lucrative tender offers and secondary sales are largely limited to “the best startups,” according to Michael Ewens, a professor of finance at Columbia Business School.

What’s most likely to impact potential tax revenues is that employees choose not to sell at all but take out loans instead, said Will Gornall, an assistant professor of finance at the University of British Columbia.

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

While 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 Wellens, a longtime tax and accounting analyst, who added that the agency is too aggressive.

“It really comes down to when the shares are vested. The taxable event is the vesting 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 at a really big infusion of money.”

Of course, IPOs are a one-time revenue increment, and there is a potential downside to the squeeze of huge bills. Owens told CNBC he fears the high tax burden could push these newly wealthy employees and often entrepreneurs away from the state.

“This is not a point where California should cut its taxes now, but I think it has to keep in mind that taxes have long-term consequences on entrepreneurial decision-making, and that’s a big driver of wealth in the state,” he said.