Tax

This article was originally published on July 6, 2023 on TechCrunch.com. Written by Peyton Carr.

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For company founders and shareholders with an exit on the horizon, this isn’t a myth — a move for tax reasons can make a lot of financial sense.

In tech hubs like the Bay Area and New York City, the highest tax brackets are at 14.4% (as of January 1, 2024) and 14.8%, respectively. In contrast, states like Florida and Texas have no state income tax, meaning there’s no capital gains tax at the state level.

Let’s consider the numbers: On a $30 million exit, a founder could save approximately $4.3 million by moving from California to Florida or approximately $4.4 million by moving from New York City to Florida. That’s a lot of incentive to pull up the stakes and head to Miami.

However, many times it’s not that simple. We all know that moving can be a tough decision, especially for those with strong roots in their community. Leaving behind your favorite golf course, local ski mountain, and your friend group can have a serious impact on your quality of life. And it can be heart-wrenching to pull your kids away from the home, friends, and school they know and love.

This is where some people can get into trouble.

What You Need to Know About Moving to Save on Taxes

Paying less in taxes isn’t as simple as packing up, skipping town, and resurfacing with a new address in a tax-friendlier state.

As tempting as it may be, you can’t keep a foothold in Silicon Valley while dipping your toe in the Gulf Coast — and still save on taxes. The kids may be unable to stay in their Manhattan private school while you relocate to Miami.

Living in both states won’t save you here; when it comes to taxes, you must be all-in at your new address, or you’ll likely owe taxes at your old address.  Unfortunately, some may not realize this until after they have spent a lot of time, money, and emotional investment.

Every state has its own rules for determining your residency for tax purposes, and you will not be able to fly under the radar if you’re a high-net-worth individual or top earner. High-tax states like New York or California pay especially close attention to those in the highest tax bracket. If you stop paying taxes at the state level, chances are the state will notice and challenge your new residency claim.

In other words, your move is likely to trigger an audit.

In particular, California’s Franchise Tax Board is known to be vigilant in monitoring individuals who attempt to terminate their California residence, making it all the more crucial to thoroughly plan and document your move.

Additionally, it’s important to consider the complexities of community property laws, which may impact your tax exposure if you have a spouse residing in California, even if you move to a lower-tax state. Proper legal and tax advice is essential to navigate these complexities and ensure a smooth transition.

Many people mistakenly think that splitting time between states and claiming the more favorable tax jurisdiction is easy. But when you have the means to travel and maintain more than one home, this doesn’t mean you get to choose the domicile that works most favorably for you when tax time comes. Simply spending 183 days of the year outside your high-tax state isn’t likely going to shrink your tax obligation.

Even after leaving high-tax states like New York or California, it’s important to be aware of potential tax obligations tied to passive income sources within those states. For example, if you continue to have passive income from partnerships, investment properties, or other sources within New York or California, you’ll need to file a nonresident return and pay taxes on that income in those states.

Additionally, having passive income sources in your former state can increase the likelihood of a residency audit. As a result, it’s important to carefully consider whether retaining those investments producing state-specific income aligns with your overall financial and tax planning goals.

Preparing to Move

If you’re considering a move to a lower-tax state, it’s crucial to plan ahead and be prepared. The more time you give yourself before your company’s exit, the better off you’ll be. We recommend making a clean break from your high-tax state several years in advance to ensure a smooth transition. It’s also wise to assume that you may be subject to a state tax audit, so keep meticulous records and be prepared.

Saying you were away isn’t enough; an audit will look for logs and calendars that track your whereabouts and activities throughout the year. And if you’re thinking of fudging it or estimating where you were and what you were doing at a later date, think again. Technology can track your exact location at practically any given time. For example, credit card purchases and phone records have been the “gotcha” in far too many audits for taxpayers to claim ignorance.

Fortunately, technology can come to the rescue when it comes to keeping track of your whereabouts for tax purposes. There are day-tracking apps that can record and organize your location data, making it easier to prove your residency in the event of an audit. It’s important to note that the burden of proof is on you — the states typically take the position that you were there every day you can’t prove you were somewhere else.

Hence, the value of good contemporaneous record-keeping, with or without an app, is vital. For founders, using these apps can simplify the process and provide peace of mind as they accurately document their residency status.

With the help of your tax advisor, it’s up to you to be familiar with the subjective domicile test for your primary state — the measure of your true, primary residence. Remember, the state will review various items to determine where your “intent” to live is and whether your move is considered permanent or temporary. Some examples that are considered include:

• Where you are registered to vote.
• Where your vehicles are registered.
• Establishment of bank accounts.
• Location of clubs, gyms, and other organizations where you hold membership.
• If you own a home in California or have keys to an apartment in New York.
• Where you spend your weekends and holidays.
• Where your spouse and children live.
• Location of your place of work.
• Where you own a business or most often conduct business.
• Location of your doctors’ offices.

Your actions and how you present yourself should be consistent with a permanent and not a temporary move. Have you told your friends and neighbors that you’re moving? Did you set up a forwarding address at the post office?

Have you taken steps to register to vote or find a new dentist? Not everything is a dealbreaker, but anything that can be considered inconsistent with a permanent move can potentially count against you.

Common Mistakes to Avoid When Moving for Tax Purposes

Even with the best intentions, some founders find themselves in hot water trying to save on state tax by moving. The possibility of a residency audit means you must be diligent about checking off all the right boxes; there are no safe shortcuts or workarounds.

Here are examples of common mistakes to avoid:

• Owning a home in New York or California while renting in Florida.
• Exaggerating travel day estimates, which can be easily discovered via technology and financial records.
• Owning a business in New York or California and living in Florida, claiming to work from home when you’re actually in the office often.
• Suddenly traveling more often just to say you spend more days out of the state without actually moving your home base.
• Claiming you live in Florida when your spouse and children live in New York or California.
• Putting off selling your home in your old state without renting it out.
• Moving too close to selling your company or equity without fully establishing your new residency.

Simply put, moving states to save on taxes is a legitimate strategy, but you must be committed to moving forward and demonstrate that you intend to make it a permanent move to a new domicile.

How Close to a Transaction Can You Move?

There is no cut-and-dried answer to this question. In high-tax states like California and New York, where domicile is being disputed, an important factor will be your intent behind the move and proving that this is a permanent move rather than temporary. For example, you will not have a good case if you move down to Florida from New York a week before your company is sold.

It’s also important to consider certain technical rules when it comes to timing your move relative to a transaction. For instance, if there’s a signed contract to sell your company with no major contingencies left to clear between the signing and closing dates, the effective date for the transaction is likely the signing date, not the closing date — regardless of the time lag between the two dates.

Additionally, some states, such as New York and California, have specific rules regarding stock option exercises. These rules may treat option exercises as being sourced back to the state where you were living when the options were earned. So, if you earned options while living and working in New York, you may still owe New York state tax when you exercise those options, even if you’ve since moved to a lower-tax state like Florida.

Contrarily, If you planned in advance, established a domicile in Florida, moved your company headquarters down to Florida, sold your New York home, bought a new home in Florida, then sold your company two years later, you’d likely have a much better chance at proving your intent.

Long-Term Benefits of Moving to Save on Taxes

Even if you are unable to relocate and time your move before selling your company, it’s important to recognize the significant impact that a long-term move to a tax-exempt state can have on the compounding of your wealth over time.

By residing in a state without income tax and avoiding the tax drag on your investment portfolio, you have the opportunity to maximize your financial growth. Even if you end up paying taxes in your high-tax state due to the timing of your move and company exit, it may still be worthwhile to evaluate whether a future relocation for long-term tax optimization makes sense.

When Moving Is Not an Option

For founders who realize a move is not in the cards, there are some other advanced planning strategies for state tax optimization that I mention here that can include using one or more trusts. Additionally, anyone expecting an exit larger than $10 million should be planning ahead and at least consider the options available for some advanced exit planning.

The Bottom Line

Deciding whether to move to a lower-tax state is a complex decision and should be approached with a strategic mindset. It’s essential to carefully weigh the pros and cons, which can be both quantitative and qualitative, before making a final decision. In some cases, relocating can be a smart move, but it’s crucial to consider all the factors involved.

If you’re already considering a move down the line, syncing it with a potential future exit could be a wise decision. However, it’s important to keep in mind that moving states to save on taxes associated with an exit requires careful planning and preparation well in advance.

The information and opinions provided in this material are for general informational purposes only and should not be considered as tax, financial, investment, or legal advice. The information is not intended to replace professional advice from qualified professionals in your jurisdiction.

Tax laws and regulations are complex and subject to change, and their application can vary widely based on the specific facts and circumstances involved. Any tax information or advice in this article is not intended to be, and should not be, used as a substitute for specific tax advice from a qualified tax professional.

Investment advice in this article is based on the general principles of finance and investing and may not be suitable for all individuals or circumstances. Investments can go up or down in value, and there is always the potential of losing money when you invest. Before making any investment decisions, you should consult with a qualified financial professional who is familiar with your individual financial situation, objectives, and risk tolerance.

This article was originally published on TechCrunch.com on November 18, 2022. Written by Peyton Carr.

When a founder sells their company, valuation gets a lot of attention. But too much emphasis on valuation often leads to too little consideration for what stockholders and stakeholders pay in taxes post-sale. Personal tax planning can ultimately impact the take-home proceeds for a founder as much as exit-level valuation changes can. And with the pullback in both public and private market valuations this year, and fewer exits occurring, optimizing on the personal planning front now can make a meaningful difference in the future.

After an exit, some founders may pay a 0% tax rate while others pay over 50% of their sale proceeds. Some founders can walk away with as much as two times the take-home as other founders at the same sale price—purely due to circumstances and tax planning.

How does this happen? Taxes owed will ultimately depend on the type of equity owned, how long it’s been held, where the shareholder lives, potential tax rate changes in the future, and tax planning strategies. If you’re at least thinking about taxes now, chances are you’re ahead of the game. But determining how much you’ll owe doesn’t come with a simple answer.

In this article, I’ll provide a simplified overview of how founders can think about taxes and an easy way to estimate what they will owe in tax upon selling their company. I’ll also touch on advanced tax planning and optimization strategies, state tax, and future tax risks. Of course, it goes without saying that this is not tax advice. Prior to making any tax decisions, you should consult with your CPA or tax advisor.

How Shareholders Are Taxed

Let’s assume you’re a founder and own equity or options in a typical venture-backed C-Corp. A number of factors will come into play to determine whether you will be taxed at short-term capital gains or ordinary income tax rates versus long-term capital gains or Qualified Small Business Stock (QSBS) rates. It’s essential to understand the differences and the areas for optimization.

Below is a chart summarizing the different types of taxation and when each applies. I further break this down to show the combined “all in” federal + state + city taxation, if applicable. Founders with $10mn+ exits on the horizon should explore some of the  Advanced tax strategies I covered in one of my previous articles since there are opportunities to multiply or “stack” the $10mn QSBS exclusion and to minimize taxation further.

As you can see above, some of the more common levers that influence how much tax a founder owes after an exit will be QSBS, trust creation, the state in which you live, how long you’ve held your shares, and the decision of whether or not to exercise your options. 

Charitable planning is not shown in the chart above but can produce excellent tax outcomes for those with large exits. Typically, when an exit involves an IPO or public stock, the founder can donate a portion of that stock to a foundation or donor-advised fund to get the fair market value deduction of the stock without realizing the gain.

QSBS and Risk to QSBS Tax Rates

When it comes to minimizing capital gains tax, QSBS can be a game changer for those that qualify. In case you’re not already familiar with QSBS, here is an overview, including the qualifications. 

If you qualify for QSBS and meet the holding period requirements by the time you sell in the future, you could be in great shape. QSBS is the most significant personal tax savings lever in most transactions.

Currently, a taxpayer can exclude up to $10mn, or 10x basis, whichever is greater. There are some advanced tax planning opportunities to exclude more than $10mn, depending on your situation.

However, there’s a possibility that the QSBS exclusion could change, and founders should be familiar with the history of QSBS and what could happen in the future. QSBS has only been at the 100% exclusion rate since the end of 2010, which has worked out favorably for many tech founders. However, some current lawmakers are looking to cut the exclusion in half. The first version of the Build Back Better Bill included a reduction from 100% to 50%. The legislation was killed, but looking forward, there is a possibility this could happen. 

So, what would it mean for you if the QSBS exclusion decreases to 75% or 50% in the future? To understand how this would impact a founder upon an exit, look at the graphic below, which shows estimates of the total tax due (federal + state + city) based on the state where you may live after an exit.

Common Questions Regarding Tax on Selling a Company

As you can see in the table, California founders, in particular, stand to face the most significantly pronounced outcomes. Additionally, California recently quietly increased the top marginal income tax rate from 13.3% to 14.4%, starting in 2024. California-domiciled founders and key shareholders throughout the state understandably should be thinking in advance about this.

We often hear questions such as:

• What is the difference in tax if I wait the full five years to get QSBS versus selling now?
• Should I move to another state before my transaction?
• Should I set up a trust before my transaction?
• How can I optimize for tax before my transaction?

The answer to all of the above is: it depends.

You can use the charts in this article to run through various hypothetical situations that might be similar to your own situation.

For example, on one end of the spectrum, a founder in New York City (NYC), Florida (FL), or Texas (TX) that waits to sell until meeting the QSBS qualifications and holding period requirements could see a big after-tax difference. Assuming 100% QSBS exclusion, a founder in NYC who waits would pay essentially 0% in tax. Without waiting, the NY founder would pay 38.6%, and the FL or TX founder would pay 23.8%. So, waiting to sell could be advantageous, considering all else equal.

On the other end of the spectrum, a founder might not see that material of a difference. For example, if the QSBS exclusion is cut in half from 100% to 50%, a California (CA) founder who waits for the five-year mark instead of immediately selling would pay 31.3% instead of 38.2%—probably not worth a multi-year wait since the tax benefit may not be material enough to influence the timing of the transaction. 

However, state relocation may be worth consideration. If the same CA founder in the same scenario (QSBS at 50%) were to relocate permanently to FL and sell after they reached the five-year mark, they would pay 16.9%. That said, we don’t think upending one’s life to another state solely for tax purposes is the best qualitative decision. But, if there was already an intention to move to a state tax-friendly state like FL or TX, as an example, it might be worth accelerating the timeline on the move.

If a CA-based founder doesn’t plan to move to a state tax-friendly state, they do have other options, such as trust creation in some scenarios, although this needs to be carefully thought through and planned in advance. I cover some of those considerations here; however, depending on where the QSBS exclusion is in the future, they may ultimately yield a different set of answers over time. 

The Bottom Line

As a founder, you’ll need to plan for your personal tax situation to optimize the opportunity set that is presented to you. The framework I’ve outlined in this article will help you think strategically about taxes, run through some hypothetical scenarios, both now and in the future, and have a more informed conversation with your tax advisor or CPA.

The information and opinions provided in this material are for general informational purposes only and should not be considered as tax, financial, investment, or legal advice. The information is not intended to replace professional advice from qualified professionals in your jurisdiction.

Tax laws and regulations are complex and subject to change, and their application can vary widely based on the specific facts and circumstances involved. Any tax information or advice in this article is not intended to be, and should not be, used as a substitute for specific tax advice from a qualified tax professional.

Investment advice in this article is based on the general principles of finance and investing and may not be suitable for all individuals or circumstances. Investments can go up or down in value, and there is always the potential of losing money when you invest. Before making any investment decisions, you should consult with a qualified financial professional who is familiar with your individual financial situation, objectives, and risk tolerance.

High earners in California will be in for a surprise come 2024. Governor Gavin Newsom recently signed SB 951 into law, effectively increasing the top marginal income-tax rate to 14.4% for some high-income earners. 

If you didn’t know a tax increase was on the table, you’re not alone. It was part of a bill designed to increase paid family leave. Currently, employees can receive 60% to 70% wage replacement to take up to eight weeks off should they need to care for a new baby or sick family member. Under the new law, starting in 2025, that increases to 70% to 90% – the higher amount being for lower wage earners. 

Paid family leave in California is funded via a 1.1% payroll tax. Previously, earnings over $145,600 were shielded from this tax. But starting in 2024, individuals earning over $1 million per year will see their marginal income-tax rate increase 1.1%, from 13.3% to 14.4%. Those making between $61,214 and $312,686 will see their rate go up to 10.4%. (1)

SB 951 allows for the rate to be adjusted annually based on need, currently authorizing it to go as high as 1.5%. 

Sources: 

1. https://www.wsj.com/articles/gavin-newsoms-stealth-tax-increase-california-marginal-tax-rate-11664921470

The information and opinions provided in this material are for general informational purposes only and should not be considered as tax, financial, investment, or legal advice. The information is not intended to replace professional advice from qualified professionals in your jurisdiction.

Tax laws and regulations are complex and subject to change, and their application can vary widely based on the specific facts and circumstances involved. Any tax information or advice in this article is not intended to be, and should not be, used as a substitute for specific tax advice from a qualified tax professional.

Investment advice in this article is based on the general principles of finance and investing and may not be suitable for all individuals or circumstances. Investments can go up or down in value, and there is always the potential of losing money when you invest. Before making any investment decisions, you should consult with a qualified financial professional who is familiar with your individual financial situation, objectives, and risk tolerance.

This article was originally published on TechCrunch.com on May 13, 2021. Written by Peyton Carr.

As an entrepreneur, you started your business to create value—both in what you deliver to your customers and what you build for yourself. You have a lot going on, but if building personal wealth matters to you, the assets you’re creating deserve your attention.

There are numerous advanced planning strategies available that you can implement to minimize capital gains tax, minimize future estate tax, and increase asset protection from creditors and lawsuits. Capital Gains tax can reduce your gains by up to 35%+, and estate taxes can cost up to 50%+ on assets you leave to your heirs. Careful proactive planning can minimize your exposure and actually save you millions.

Smart founders and early employees should closely examine their equity ownership, even in the early stages of their company’s life cycle. Different strategies should be used at different times and for different reasons. The following are a few key considerations when determining what, if any, advanced strategies you might consider:

1. Your company’s life cycle – early, mid, or late stage.
2. The value of your shares – What are they worth now, what do you expect them to be worth in the future, and when?
3. Your own circumstances and goals – What do you need now, and what will you need in the future?

Some additional items to consider include issues related to Qualified Small Business Stock (QSBS), gift and estate taxes, state and local income taxes, liquidity, asset protection, and whether you and your family will retain control and manage the assets over time.

Here are some advanced planning strategies for your equity to implement at different stages of your company life cycle to reduce tax and optimize wealth for you and your family.

Irrevocable Non-Grantor Trust

QSBS allows you to exclude tax on $10mn of capital gains (tax of up to 35%+) upon an exit/sale. This is a benefit every individual and some trusts have. There is a significant opportunity to multiply the QSBS tax exclusion well beyond $10mn.

The founder can gift QSBS eligible stock to an irrevocable non-grantor trust, let’s say for the benefit of a child, so that the trust will qualify for its own $10mn exclusion. The founder owning the shares would be the grantor in this case. Typically, these trusts are set up for children or unborn children. It is important to note that the founder/grantor will have to gift the shares to accomplish this because gifted shares will retain the QSBS eligibility. If the shares are sold into the trust, the shares lose QSBS status.

In addition to the savings on federal taxes, founders may also save on state taxes. State tax can be avoided if the trust is structured properly and in a tax-exempt state like Delaware or Nevada. Otherwise, even if the trust is subject to state tax, some states, like New York, conform and follow the federal tax treatment of the QSBS rules, while others, like California, do not. For example, if you are a New York State resident, you will also avoid the 8.82% state tax, which amounts to another $2.6mn in tax savings if applied to the example above. This brings the total tax savings to almost $10mn, a material savings in the context of a $40mn gain. Notably, California does not conform, but California residents can still capture the state tax savings if their trust is structured properly, and in a state like Delaware or Nevada.

Currently, each person has a limited lifetime gift tax exemption, and any gifted amount beyond this will generate up to a 40% gift tax that has to be paid. Because of this, there is a tradeoff between gifting the shares early while the company valuation is low and using less of your gift tax exemption vs. gifting the shares later and using more of the lifetime gift exemption. The reason to wait is that it takes time, energy, and money to set up these trusts, so ideally, you are using your lifetime gift exemption and trust creation costs to capture a benefit that will be realized. However, not every company has a successful exit; therefore, it is sometimes better to wait until there is a certain degree of confidence that the benefit will be realized.

Parent-Seeded Trust

One way for the founder to plan for future generations while minimizing estate taxes and high state taxes, such as California or New York, is through a parent-seeded trust. This trust is created by the founder’s parents, with the founder as the beneficiary. Then the founder can sell the shares to this trust. This does not involve the use of any lifetime gift exemption and eliminates any gift tax, but it also disqualifies the ability to claim QSBS. The benefit is that all the future appreciation of the asset is transferred out of the founder’s and the parent’s estate and is not subject to potential estate taxes in the future.

The trust can be located in a tax-exempt state such as Delaware or Nevada to also eliminate home state-level taxes. This can translate up to 10%+ in state-level tax savings. The trustee, an individual selected by the founder, can make distributions to the founder as a beneficiary if desired.

Further, this trust can be used for the benefit of multiple generations. Distributions can be made at the discretion of the trustee, and this skips the estate tax liability as assets are passed from generation to generation.

Grantor Retained Annuity Trust (GRAT)

This strategy enables the founder to minimize their estate tax exposure by transferring wealth outside of their estate, specifically without using any lifetime gift exemption or being subject to gift tax. It’s particularly helpful when an individual has used up all their lifetime gift tax exemption. This is a powerful strategy for very large “unicorn” position sizes to reduce a founder’s future gift/estate tax exposure.

For the GRAT, the founder (grantor) transfers assets into the GRAT and receives back a stream of annuity payments. The IRS 7520 rate, which is currently very low, is a factor in calculating these annuity payments. If the assets transferred into the trust grow faster than the IRS 7520 rate, there will be an excess remainder amount in GRAT after all the annuity payments are paid back to the founder (grantor.) This remainder amount will be excluded from the founder’s estate and can transfer to beneficiaries or remain in the trust estate tax-free. Over time this remainder amount can be multiples of the initial contributed value. If you have company stock that you expect will pop in value, it can be very beneficial to transfer those shares into a GRAT and have the pop in value occur inside the trust. This way you can transfer all the upside gift and estate tax-free out of your estate and to your beneficiaries.

Additionally, because this trust is structured as a grantor trust, the founder can pay the taxes incurred by the trust, making the strategy even more powerful.

One thing to note is that the grantor must survive the GRAT’s term for the strategy to work. If the grantor dies before the end of the term, the strategy unravels and some or all the assets remain in his estate as if the strategy never existed.

Intentionally Defective Grantor Trust (IDGT)

This is similar to the GRAT in that it also enables the Founder to minimize their estate tax exposure by transferring wealth outside of their estate, but has some key differences. The grantor must ‘seed’ the trust by gifting 10% of the asset value intended to be transferred, so this approach requires the use of some lifetime gift exemption or gift tax. The remaining 90% of the value to be transferred is sold to the trust in exchange for a promissory note. This sale is not taxable for income tax or QSBS purposes. The main benefits are that, instead of receiving annuity payments back, which requires larger payments, the grantor transfers assets into the trust and can receive back an interest-only note. The payments received back are far lower because it is interest-only (rather than an annuity).

Another key distinction is that the IDGT strategy has more flexibility than the GRAT and can be generation-skipping.

If the goal is to avoid generation-skipping transfer tax (GSTT) the IDGT also is superior to the GRAT because assets are measured for GSTT purposes when they are contributed to the trust prior to appreciation rather than being measured at the end of the term for a GRAT after the assets have appreciated.

The Bottom Line

Depending on each founder’s situation, we may use some combination of the above strategies or others depending on the circumstances and goals. Every founder, their company life cycle, and their personal situation is different. Many of these strategies are most effective when planning in advance; waiting until after the fact will limit the benefits you can extract. When considering advanced strategies for protecting wealth and minimizing taxes as it relates to your company stock, there’s a lot to take into account—the above is only a summary. We recommend you seek proper counsel and choose wealth transfer and tax savings strategies based on your unique situation and individual appetite for complexity.

The information and opinions provided in this material are for general informational purposes only and should not be considered as tax, financial, investment, or legal advice. The information is not intended to replace professional advice from qualified professionals in your jurisdiction.

Tax laws and regulations are complex and subject to change, and their application can vary widely based on the specific facts and circumstances involved. Any tax information or advice in this article is not intended to be, and should not be, used as a substitute for specific tax advice from a qualified tax professional.

Investment advice in this article is based on the general principles of finance and investing and may not be suitable for all individuals or circumstances. Investments can go up or down in value, and there is always the potential of losing money when you invest. Before making any investment decisions, you should consult with a qualified financial professional who is familiar with your individual financial situation, objectives, and risk tolerance.