California IPO Tax Windfall: Factors Complicating the Equation

A version of this article first appeared in CNBC's Inside Wealth newsletter with Robert Frank, a weekly guide for high-net-worth investors and consumers. Register to receive future issues, directly to your inbox.

The box office success SpaceX The initial public offering and possible future public offerings of OpenAI and Anthropic could generate a tax windfall for the state of California. However, the revenue growth may be lower than previous tech IPOs – at least relative to company valuations – given the specific nature and tax treatment of current tech compensation.

Following its initial public offering 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 Anthropic and OpenAI are also expected to go public later this year at valuations that could approach $1 trillion.

The explosion of technological wealth has generated comparisons to Menlo Park-based Facebook's 2012 initial public offering, which generated $1.3 billion in taxes for the Golden State, according to California Department of Finance estimates. Facebook's valuation at the time was just $104 billion, suggesting In theory, the new generation of super IPOs could generate billions more.

But the impact on income may be mitigated, because of how these employees' stock compensation was structured and because tech employees today have more tools at their disposal 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 capital-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 pre-IPO private stock to a donor-advised fund, according to Richard Lowry of wealth manager Cresset. He said such donations were generally limited to the ultra-wealthy just a decade ago, as few charitable organizations were equipped to accept or manage such assets.

“Historically, the only people who had equity in a private company and were certainly in a position to give it away were 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 is now a cottage industry that allows people to take advantage of this.”

There is also a timing consideration in SpaceX's windfall.

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

SpaceX uses a unique stock payment structure that may have boosted tax revenue from employee stock acquisitions. In most private companies, RSUs vest after two conditions are met: continued employment at the company and a liquidity event such as an initial public offering or acquisition. This double-triggered RSU structure leads to a boom in taxable income on IPO day.

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

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

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

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

“Previous large tech IPOs have generated significant income tax revenue for the state and these upcoming IPOs certainly have the potential to do the same,” the statement read.

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

The Department has reason to be conservative, as market swings have undermined its revenue forecasts in the past. It had to revise its Facebook IPO revenue estimate from $1.9 billion to $1.3 billion after the social media giant's stock fell.

The department's budget report noted another factor that could limit the benefits of IPOs: the growing trend of private companies to allow employees to sell shares before going public, reducing the stock buildup burdened by IPOs.

Employees at SpaceX, Anthropic and OpenAI have had ample opportunities to take some chips off the table 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. with a valuation of 500 billion dollars. CNBC previously reported that OpenAI plans to facilitate a takeover bid with a post-money valuation of $852 billion.

Takeover bids have gained popularity as a way to reward employees and investors as the timeline for exit has lengthened, according to Hamza Shad, insight manager at startup capital management firm Carta.

Profits on these sales are still subject to tax, but selling earlier boosts that tax revenue and makes it less predictable for regulators, he said.

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

Still, public offerings come with many conditions, such as a percentage limit on the amount of equity employees can can sell. And the wildly lucrative public offerings 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 is most likely to affect potential tax revenue is if employees choose not to sell anything and instead take out loans, said Will Gornall, an associate professor of finance at the University of British Columbia.

By borrowing against their shares instead of selling them, shareholders save money by paying interest instead of capital gains taxes. This so-called “buy, borrow, die” strategy is employed by SpaceX founder and the world's first billionaire, Elon Musk, who has taken out loans against billions of dollars in Tesla stock. 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, so have the California Franchise Tax Board's audit methods, according to Robert Willens, a longtime tax and accounting analyst, who added that the agency is notoriously aggressive.

“It really comes down to 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 that,” he said. “I think California is expecting a big injection of funds.”

Of course, IPOs involve a one-time increase in revenue, and launching high bills has a potential downside. Ewens told CNBC he worries that a large tax burden could drive these newly wealthy and often entrepreneurial employees out of the state.

“That's not the point that California should cut its taxes now, but I think you have to keep in mind that taxes have long-term consequences for people's business decision-making, and that's a big wealth generator in the state,” he said.