A founder who expects a ~$30 million capital gain could stand to earn about $35 million more over their lifetime if they put their non-QSBS-eligible shares into a Charitable Remainder Trust before selling them.
An Example for a Founder
How the Co-Founder of a Bay Area start-up reduced the taxes on the sale of her start-up
Our example is Sheryl, who lives in the Bay Area and co-founded her start-up in 2018. She and two other friends from college have founded an incredibly fast-growing architectural start-up, focused on architectural services for tiny homes made from environmentally sustainable materials of all types. Unfortunately, Sheryl’s company doesn’t qualify for QSBS but fortunately she will have large capital gain coming, as she plans to cash out a portion of her equity once they’re acquired.
Suppose that her shares are valued at around $3 million today. And although she could never be certain, her best guess is that she’ll likely be able to sell her shares at a significant markup—say, $30 million. (We’ll note here that although Sheryl and her company are pre-IPO, this strategy works just as well with post-IPO equity, so you shouldn’t hesitate to get in touch at any stage of your company’s lifecycle.)
If she just sells her shares, Sheryl will owe the federal government about $7.1 million in taxes on her capital gains, and she’ll owe California another $3.7 million, for a total tax bill of $10.8 million. That number is too big to stomach, so Sheryl would like to do some tax planning, and she’s chosen a Charitable Remainder Trust. How should she think about the details?
There is one key question that Sheryl, like everyone who is thinking about setting up a trust, will have to answer: How much of her shares does she want to put into her trust? The sizing question is a personal one, because putting her money into a trust will affect her immediate liquidity (though not as much as you might expect), and so Sheryl will have to consider whether she wants to hold a bit back to take care of any immediate needs. Let’s say she has enough other savings and ongoing income to cover her expenses, and she decides to put all of her shares into a trust. How will the numbers work out?
Recapping the numbers
Cost Basis: $0
Current Value: $3,000,000
Expected Value at Sale: $30,000,000
Immediate Charitable Deduction
The first benefit Sheryl as founder will receive from putting her shares into a CRT is an immediate tax deduction. There’s some complicated math here, mandated by the IRS, but the bottom-line answer is simple: She’ll get to deduct about 10% of the current value of the shares she puts into the trust. In this case, that’s a $300,000 deduction. Since she lives in a high-tax state, the tax savings are substantial: That $300,000 deduction translates into cash savings of about $108,000 on next year’s taxes.
No Taxes On Sale
So Sheryl starts about $108,000 ahead of the game. The next major (and we mean major) benefit of a CRT is that Sheryl gets to defer all of the taxes—state and federal—she would otherwise have owed on her big gain. So, assuming she decides to sell all of her shares, instead of paying that $10.8 million we calculated above, she’d get to keep that money and invest it.
We’re starting to see the numbers take shape, but there’s one more significant data point we haven’t gotten to yet: How does Sheryl plan to use her money? One of the first questions our (very savvy) users ask us is the following: “These massive absolute gains are great, but will my money be locked up for the entire term of the trust? The answer, emphatically, is “No.” There are various ways to get liquidity out of a CRT, and we discuss them in some depth here. But the simplest answer is that, due to the structure of NIMCRUTs, Sheryl (and you) will have access to a growing share of money every year, starting as soon as she reaches her liquidity event.
Assuming, for the reasons we discussed above, that Sheryl chooses a NIMCRUT, how much money would she have at her disposal every year? The answer is actually pretty simple: Every year after she sells her shares, she’ll be able to cash out a set percentage of the trust’s current value. (For a term trust, it’ll be around 11%; for a lifetime trust, it depends on her age, but it’ll be right around 7%.)
The first thing to note, based on these numbers, is that Sheryl will receive a pretty decent windfall in the year she sells her shares—here, $2 million. That’s nice, and it allows her to buy a second home, take a lengthy vacation and make other personal investments.
Sheryl lives frugally and doesn’t have much need to pull capital out, but by investing in some dividend paying stocks she’ll certainly get some consistent payouts annually. She decides to leave the other assets untouched (effectively not realizing any income) and defers some of those larger withdrawals until later years. Assuming a market growth rate of 7% annually, Sheryl would have $8 million of deferred payouts she could take by year 5.
What would all of these tax savings, investment gains, and withdrawals mean for Sheryl’s bottom line? After, say, 40 years, if Sheryl has her money in a Charitable Remainder Trust, she’ll end up with about $230 million in total post-tax payouts. About $56 million will go to the charity of her choice—that’s the bargain she struck when she chose a Charitable Remainder Trust. (For reference, the numbers for a Lifetime Flip CRUT are lower: She’d end up with about $60 million in her pocket at the end.)
If, instead, Sheryl had kept her money in a regular, taxable investment account, she would have instead ended up with about $195 million.
In other words, even after making what can only be described as a very generous donation to charity, Sheryl still pockets an extra $35 million, all because she put her founder shares into a Charitable Remainder Trust back when they were worth comparative peanuts. Not a bad return on those shares, considering it was once a small architectural business that she started out of her parents basement.
See our next article in our CRT series on how to defer taxes on secondaries with a Charitable Remainder Trust. Access our one-step calculator to evaluate the potential return of investment given your situation, or if you have any questions, chat with our team.
- Startup Exit Strategy to Start Planning
- Stock Option Plans for Founders
- Startup Employees: Defer Taxes On Equity With A CRT
We have built a platform to give everyone access to the tax planning tools of the ultra-rich like Mark Zuckerberg (Facebook founder), Phil Knight (Nike founder) and others. Valur makes it simple and seamless for our customers to utilize the tax advantaged structures that are otherwise expensive and inaccessible to build their wealth more efficiently. From picking the best strategy to taking care of all the setup and ongoing overhead, we make take care of it and make it easy.