Key Takeaway: If you’ve exercised (or plan to exercise) options in advance of (or after) an IPO, you could be on the hook for a massive tax bill. We can help you minimize or even eliminate that bill with a Charitable Lead Annuity Trust.
We love writing about tax mitigation, mostly because of the affirmation we get every day that our content is resonating with the folks we’re out here to help. It’s especially gratifying when we hear, almost in real time, that one of our posts helped someone solve an immediate problem.
That’s been happening a lot lately: We’ve talked to dozens of startup employees working for companies that have recently had their IPO, and most of them didn’t realize that there was a solution to their (often massive) tax bills sitting right in front of them. Today, we’ll tell you about that solution for a specific (but common) situation.
How to minimize or eliminate option exercise taxes
Sophie joined her company in 2017 and received 20,000 options with a 409a valuation/strike price of about $8. Sophie didn’t exercise right away, partly because she wasn’t certain the company would make it and didn’t want to spend the cash to exercise and pay taxes given that uncertainty.
Since then, the company has taken off, and it recently had its IPO at $120 per share. While this is great for Sophie — she’s up more than $2 million on paper — exercising her shares will leave her in a bit of a tax pickle. When she exercises her shares, she will be receiving “income” in the form of her common stock. This means she will have to pay ordinary income tax rates (around 45%) on the $112 difference between her strike price ($8) and the current stock price ($120).
Exercising her options, in other words, means a hefty tax bill of about $1M — (45% tax rate) * (appreciation of $112 per share) * (20,000 shares). Not an easy pill to swallow, but what can she do, right?
As it turns out, Valur can help Sophie reduce or even eliminate her immediate tax bill with a Charitable Lead Annuity Trust, or CLAT.
A quick refresher on CLATs
- You gift assets or cash to the trust and get a charitable deduction up to the entire value you donated (enabling you to write off all or nearly all of your taxes).
- You can seed the trust with nearly any asset — public equities, real estate, crypto, or even cash — and reinvest the gains in other assets throughout the term of the trust.
- Every year, the trust donates a predetermined amount to a recognized charity, such as the American Cancer Society, or your own Donor Advised Fund (DAF). You are liable for the taxes on the income generated inside the trust (though we do our best to minimize this tax exposure).
- At the end of the trust’s term (a predetermined number of years), the trust gives its largest donation to charity and you or your beneficiary receive the majority of the trust assets.
- Celebrate — You successfully deferred your taxes and were able to reinvest what would be taxes to keep those assets compounding and working for you!
A CLAT for unexercised (or recently exercised) options
A CLAT is a trust that allows you to take a massive tax deduction today — up to 100% of your windfall income, thereby reducing that tax bill to $0 — in exchange for future charitable donations.
How did this work for Sophie? She sold her stock — now worth $2.4 million — and put all of the cash proceeds into a CLAT in the same year she exercised her options. We helped her design a donation schedule that would get her the maximum tax deduction — $2.4 million! — spread over the next three years. So instead of owing taxes on $2.4 million of income, she owed…wait for it…$0.
Sophie will end up paying taxes eventually, and she’ll be making a sizable donation to her chosen charity in 25 years. But the benefits of saving that $1 million this year are striking: By reinvesting that money instead of sending it to the government, Sophie could realize an additional $2 million of gains using a CLAT than she would have if she had just sucked it up and paid her tax bill this year. And that’s even after she gets to use $2.9 million to achieve her own philanthropic goals.
How much should you put in a CLAT?
It’s worth noting that Sophie chose the maximal CLAT strategy: She put all of her gains into the trust in order to zero out her tax bill this year. But CLATs aren’t one size fits all, and you may decide that you can stomach a smaller tax bill now to retain some additional flexibility. The bottom line is that this strategy can reduce your tax bill today, and it’s up to you by how much.
Timing is key
CLATs work best if you move your cash or other assets into the trust in the same year you realize your big income event. We’re here to help you understand your options, and, using our streamlined trust planning tools, there’s still time to get you to the finish line by the end of the year.
Funding a CLAT
A common question from clients is what assets should you fund a CLAT with. In order of fit:
- Cash – This is the best asset with which to fund a CLAT because the government allows you to write off a higher amount of your income with cash charitable contributions than any other asset class (100% in 2021), and we can work with you to invest in assets well suited for a CLAT that minimize your tax exposure
- Public Securities – Ideally you want to fund a CLAT with assets that can be readily sold to ensure that you can pay the required charitable contributions
- Cryptocurrency – Often we speak with customers who are consistently exchanging tokens or selling their tokens to buy something with more upside. This creates a tax liability and you could use your crypto to fund the CLAT if needed
- Private Securities – As the CLAT is required to make a charitable contribution annually, holding only illiquid assets can force the trust to sell assets at below-market prices
- Tax Deferral With A Charitable Lead Trust
- CLAT: A Comprehensive Guide
- CRUT vs. CLAT: A Charitable Trust For Every Situation
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.