California IPO tax windfall: Factors that complicate the equation

A version of this article first appeared in CNBC’s Inside Wealth newsletter by Robert Frank, a weekly guide for high-net-worth investors and consumers. Sign up to receive future editions directly to your inbox.

blockbuster space x OpenAI and Anthropic’s IPOs and possible future public offerings could result in a tax windfall for California. However, given the specialized nature and tax treatment of today’s technology-related fees, the revenue growth may not match past technology-related IPOs, at least relative to company valuations.

Following last week’s IPO, SpaceX is now valued at $2.5 trillion, making many of its employees, who live and work near the company’s Hawthorne, California, offices, billionaires, at least on paper. California-based Anthropic and OpenAI are also scheduled to go public later this year, potentially giving them a valuation approaching $1 trillion.

The explosion in tech assets is being compared to Menlo Park-based Facebook’s 2012 IPO, which brought in $1.3 billion in taxes for the Golden State, according to California Treasury estimates. Facebook’s valuation at the time was just $104 billion, suggesting a new super IPO could theoretically generate billions more.

But the impact on the bottom line could be blunted because of how these employees’ stock compensation is structured and because today’s tech employees have more tools at their disposal to reduce their tax burden, experts and financial advisors told CNBC.

As companies go private longer and valuations become much higher, financial institutions are increasingly leveraging tax strategies traditionally available only to founders to cater to the employees of equity-rich but cash-poor startups.

For example, employees of some startups can receive tax deductions by donating pre-IPO private equity to donor-advised funds, said Richard Rowley of asset manager Cresset. He said such donations were generally limited to the ultra-wealthy as few charities had the capacity to accept or manage such assets.

“Historically, the only people in a position to hold equity in a private company and reliably transfer it were billionaire or billionaire founders who already had their own management structure, like a private foundation, and could decide what they were willing to accept,” said Rowley, managing director and head of tax strategy at Cresset. “There is now a cottage industry around it that people can take advantage of.”

There are also timing considerations for SpaceX’s windfall.

The tax revenue generated by an IPO comes from two main sources. One is the ordinary income tax on an employee’s restricted stock units (RSUs) upon vesting, and the other is the capital gains tax that is paid when the shareholder sells the appreciated stock.

SpaceX has a unique equity pay structure, which may lead to accelerated tax revenue from employee stock vesting. For 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. This dual-trigger RSU structure leads to a spike in taxable income on the day of the IPO.

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

The stock compensation structure makes it difficult to estimate the tax revenue associated with SpaceX’s IPO, according to the California Office of Legislative Analysis.

“Total proceeds will largely depend on financial decisions made by employees and investors who own SpaceX stock and stock options prior to the IPO,” LAO said in a statement. “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 estimates of tax revenue from SpaceX, Anthropic and OpenAI IPOs. That said, LAO’s statement to CNBC was cautiously optimistic that the market debut would increase state coffers.

“Major high-tech IPOs in the past have generated significant income tax revenue for the state, and future IPOs certainly have the potential to do the same,” the statement said.

The California Department of Treasury also does not release IPO revenue projections, citing the risk that market downturns often cause companies to postpone IPOs. OpenAI and Anthropic, which each filed confidential S-1s in recent weeks, could do something similar.

The ministry has reason to be conservative, as market fluctuations have led to lower revenue forecasts in the past. The company had to revise its revenue forecast from Facebook’s IPO from $1.9 billion to $1.3 billion due to the decline in Facebook’s stock price.

The department’s budget report points to another factor that could limit the upside from IPOs: the growing trend of allowing private companies to sell shares to employees before going public, reducing the amount of outstanding shares that are taxed at the time of an IPO.

Employees at SpaceX, Anthropic, and OpenAI had ample opportunity to take some chips off the table well before going public. In October, OpenAI completed a secondary stock sale totaling $6.6 billion, allowing current and former employees to 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.

As exit timelines lengthen, tender offers are becoming more popular as a way to reward employees and investors, said Hamza Shad, insights manager at startup equity management firm Carta.

Gains from those sales will still be taxed, but early sales bring forward tax revenue and make it less predictable for regulators, he said.

“In the past, when early pre-public liquidity wasn’t as prevalent, tax revenues have really come in post-IPO,” Shad said. “But now it is up to each company to decide whether to make a tender offer, how large the tender offer should be, and how often the tender offer should be made.”

Still, tender offers come with a number of conditions, including a cap on the percentage of stock employees can sell. And Michael Ewens, a professor of finance at Columbia Business School, says highly lucrative tender offers and secondary sales are largely reserved for the “best emerging companies.”

Will Goenall, an associate professor of finance at the University of British Columbia, says what’s more likely to eat up potential tax revenue is if employees don’t sell at all and choose to take out loans instead.

Shareholders can save money by taking out a loan instead of selling their shares and paying interest instead of capital gains taxes. This so-called “buy, borrow, die” strategy is used by SpaceX founder and world’s first billionaire Elon Musk, who has secured loans backed by billions of dollars worth of Tesla stock. This strategy also has the benefit of allowing employees to stay invested and benefit from future stock price appreciation.

As financial techniques for avoiding taxes have become more sophisticated, so have the auditing methods used by the California Franchise Tax Board, said Robert Willens, a longtime tax and accounting analyst, adding that the agency is notoriously aggressive.

“At the end of the day, it’s about when you acquire the stock. The taxable event is the vesting of the stock, 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 really nice infusion of capital.”

Of course, an IPO is a one-time revenue boost, and there are potential downsides to high charges. Ewens told CNBC he worries that the high tax burden will drive these newly wealthy and entrepreneurial workers away from the state.

“That doesn’t mean California should lower taxes right now, but I think we need to remember that taxes have a long-term impact on people’s entrepreneurial decisions, which is a big driver of wealth in the state,” he said.