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Preparing For An IPO: Tax Deferral Strategies

IPOs are exciting for pretty much everyone involved, from the founders and original investors to retail investors looking to jump on board today. But an IPO is an especially thrilling time for the company’s employees, no matter when they joined the company — windfalls can do that.

If you’ve made it this far, most of the hard work is behind you and now it’s time for your reward, but there are a few common pain points, and they can be significant. You found this article, so you’ve probably spent some time searching the web for solutions to those issues, and you’ve likely read countless articles on how to “prepare for an IPO.” Typical topics range from the mundane like “Prepare for change!” to the informational “Understand how many options/shares you own,” “When can I sell?” and “what is lock-up” to, maybe most consequential of all, “Are my shares eligible for the Qualified Small Business Stock Exemption (QSBS)?”

We’ll let you find those answers elsewhere. We’ll focus instead on our bread and butter: the key tactical approaches you can take to maximize the hard-earned gains coming your way and, in particular, leveraging tax deferral structures with Charitable Trusts.

Planning For Your Situation – How Realized vs. Unrealized Gains Impacts Your Decision

An IPO is an exciting win — seeing your hard work pay off and for the potential financial windfall. At the same time, though, you want to reduce your up-front IPO taxes. And who wouldn’t? You’re at the finish line and want to keep as much of your hard-earned gains as possible, and rightfully so.

We can help. Whether you’re still holding your shares (so your gains are “unrealized”) or you’ve already sold (and “realized” those gains), there’s a tax strategy available:

  • Charitable Remainder Trusts — Work best for appreciated assets with unrealized gains, meaning that you have the opportunity to place your options/shares in a trust “prior” to selling.
  • Charitable Lead Trusts — Work best for appreciated assets with already realized gains, meaning you’ve exercised your options and sold your shares, and you’re now trying to reduce your tax bill after the fact.

Unrealized Gains – Using a Charitable Remainder Trust to Defer IPO Taxes

It pays to plan ahead. If you have unrealized gains at or after your IPO, it’s possible to delay or eliminate your expected tax obligation and realize significant returns with a Charitable Remainder Trust (CRT). A CRT allows you (the holder of the shares) to gift vested and exercised shares to a trust and pay no taxes when you sell. (If that seems too good to be true, we suggest that you check out our foundational post on how Charitable Remainder Trusts work).

charitable remainder trust
The flow of assets in a Charitable Remainder Trust

Assumptions for this example:

  • Options granted Feb 2015 and exercised Mar 2019 — 250,000 options, strike price of $0.25 ($62,500)
  • IPO in Jan 2021 — $12 per share
  • California Tax Rates — Approximately 35% (for long term capital gains)

If you sell your shares w/o a trust:

  • You sell your 250,000 shares @ $12 per share (250,000 * 12) = $3,000,000
  • Your pre-tax profit is $2,937,500 ($3,000,000 – $62,500)
  • You owe $1,028,125 in taxes ($2,937,500 * 35%)
  • Your profit is $1,909,375

If you sell your shares w/ a Charitable Remainder Trust:

  • You gift the shares to a Charitable Remainder Trust, where you and the charity of your choice are named as a beneficiary, before the shares are sold
  • The trust sells 250,000 shares @ $12 per share (250,000 * 12) = $3,000,000
  • Because the trust is considered tax exempt, you avoid paying taxes on the sale. Instead, you, as the trust’s beneficiary, will receive annual distributions from the trust, and that’s when you’ll pay taxes (still at the same, lower capital gains rate you would have outside of the trust)

Summary of Benefits:

  • Massive gains — You could earn an additional $11.5MM over your life (that’s 62% more), assuming you set up a lifetime Charitable Remainder Trust
  • Immediate charitable deduction — equal to 10% of the amount contributed to the trust — in this scenario, $300,000 (which can be spread out over up to 5 years)
  • Tax deferral — you’re able to reinvest the $1,028,125 of tax savings and grow those assets tax free
  • Tax smoothing — by taking what would have been a single year of high taxable income and spreading it out over multiple years, you in turn reduce your effective tax rate

The upshot:

You’ll be able to avoid taxes on the sale of the asset as long as you set up the trust and transfer the assets before you sell, giving you more assets to invest and grow! This can happen before or after the company has completed its IPO!

Realized Gains – Using a Charitable Lead Trust to Offset IPO Taxes

So you’ve already sold your shares? First and foremost, congrats are in order! You’ve likely had a major windfall and now are taking the steps to figure out how to reduce your tax exposure. The additional good news is that it’s not too late. With a Charitable Lead Trust (CLT), you still have the opportunity to reduce that tax bill and realize significant additional returns. A Charitable Lead Trust allows you to gift any asset to the trust, send a small donation to a charity every year, and receive a massive up-front charitable tax deduction. (If you’re not familiar with CLTs, take a look at our foundational post on how Charitable Lead Trusts work.)

Charitable Lead Annuity Trust

Assumptions for this example:

  • Options granted Feb 2015 and exercised upon IPO — 250,000 options, strike price of $1.00 per share
  • IPO in Jan 2021 — $12 per share
  • California Tax Rates — Approximately 45% (ordinary income rate, which applies to exercise-and-sell transactions)

If you sell your shares w/o a trust:

  • You purchase 250,000 shares @ $1 per share or $250,000
  • The value of the shares is $3,000,000 according to the IPO price (250,000 * 12)
  • You’re making $2,750,000 in profit upon exercise ($3,000,000 – $250,000)
  • Your tax liability is $1,237,500
  • Your after tax income is $1,512,500

If you sell your shares and set up a Charitable Lead Trust:

  • You’ve already exercised your options and sold (realizing those gains at a personal level), whether that happened the same day or over a period of time
  • Now you would set up a Charitable Lead Trust, which would give you an up-front charitable deduction, effectively reducing your taxable income for the year.

Summary of Benefits:

  • Massive gains — You could earn an additional $2.6MM over 30 years (that’s 44% more), assuming you set up a 30 year Charitable Lead Trust
  • Immediate charitable deduction — When you gift assets to the trust (any asset, but usually the cash proceeds from your share sale), you get an immediate charitable deduction this year, typically equal to up to 50% of your taxable income. For example, if you gifted $1,500,000 of your cash proceeds, you could reduce your income by $1,500,000, up to 50%. If you make $250,000 per year in salary and have a large capital gain of $2,750,000, you could use that whole deduction this year; if your income is lower, you can use up the remaining deduction next year.) Ultimately this reduces your tax liability by $1,500,000 (your deduction) * 45% (the applicable tax rate), to create $675,000 in tax savings
  • Shifting ordinary income to long-term gains — With a CLAT, you’re able to lower your tax rate by shifting what would be ordinary income this year to long-term capital gains in future years, and those gains are typically taxed at more favorable rates

This strategy tends to work best for individuals who are not concerned about liquidity. This is because, unlike the Charitable Remainder Trust, the Charitable Lead Trust cannot make regular distributions to the individual setting up the trust. Instead, the person setting up the trust receives the total amount in the trust at the end of the term (which usually runs for between 20 and 30 years). So this tends to feel more like an especially well funded retirement account that has real tax benefits, kind of like an IRA, but with significant charitable giving built in.

The upshot:

You can set up a Charitable Lead Trust at any point during the year when you realize your big gain, and the structure will reduce your taxable income in that year. It’s important to make sure you’ve done this in the year you’re experiencing the gain, to make sure you can apply the charitable deduction to that income spike.

Next Steps

Setting up a Charitable Trust will allow you to defer your taxes and maximize your gains from an IPO. You’ve already picked a winner. Now it’s time to protect and grow those gains!

Read our next post on how to use a Charitable Remainder Trust to sell real estate tax free, evaluate the potential return of investment given your situation with our tax planning calculator, or just schedule a call with our team.

About Valur

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.