When Kay Luo joined LinkedIn in 2006, she received a grant of shares with a value of 12 cents each. The company went public in 2011 at $45 a share. By the end of the first day of trading, the price had doubled, and she began the process of selling her stock.
“It was more money than I’ve ever known,” said Luo, who is in her 40s and has retired from the tech industry. “I felt very unsophisticated to manage the wealth. I thought the right thing to do was hire a fancy accountant.”
Her new accountant helped with common techniques to minimize her tax on the windfall, like trusts, gifts and philanthropy. But she said he missed what has become one of the great windfalls in Silicon Valley and other tech hubs: a provision in the tax code that allows employees at small companies to receive tens of millions of dollars in stock gains tax-free.
Luo said she was shocked that her accountant had failed to tell her about this: “It was hundreds of thousands of dollars we overpaid,” she said.
The tax code provision addresses what’s called qualified small-business stock. It says that people who are invested in a company valued under $50 million are eligible to exclude from their taxes $10 million or 10 times their investment, whichever is higher. It can be used by employees at startups who are given stock as part of their compensation plans.
“This is just an incredible way to exclude a large amount of income,” said Raymond L. Thornson, managing director at the accounting firm Andersen Tax in San Francisco. “What makes this unique is most of the opportunities to save on taxes are to give money away or deduct your mortgage.”
There are a few restrictions to the election, in addition to the size of the company when an employee receives shares. Workers must hold the stock for at least five years. And the stock must be in a business that makes something, including tech companies. That, in theory, excludes law offices, accounting practices, financial service firms and other service providers.
The tax-free boon from the qualified business stock is acting as a recruiting tool for some companies. And that’s because when it works out, as it did for Luo’s LinkedIn colleague Danis Dayanov, it really works out.
In his case, the tax savings was so significant that he was not sure it was real. Dayanov, an engineer who emigrated from Russia to work in Silicon Valley, said he discovered the benefit not through his accountant but by playing around on TurboTax. The program asked him questions that led him to believe that the stock he received when he joined the company in 2003 would qualify.
“Because the stock price was so high, I wasn’t sure it would work,” he said.
What matters is not the current stock price but the value of the company when an employee joined. Dayanov started at LinkedIn when the company was still valued below $50 million.
But an accountant told him TurboTax was wrong and so he paid a higher tax than he should have for two years. It was then that he emailed an early director at LinkedIn, who confirmed that his shares qualified for the tax break.
He amended his return and received a refund, but was audited in the process. After a year and a half, he said, the audit was closed and his refund was upheld.
Making sure the company qualifies for this exemption is worth the headache. With the capital gains rate at 20% and a net investment income tax of 3.8% on top of that, a few lucky employees are looking at saving an extra $2.4 million if they reach the $10 million limit.
The option to claim the tax break for qualified small-business stock has been around since the 1990s but was little used before because capital gains rates were lower, corporate taxes were higher and the percentage that could be excluded was capped, Thornson said. But both the capital gains rate and the exclusion amount went up two decades later, and the strategy became more attractive, he said.
It’s so appealing that savvy lawyers and accountants have thought their way around restrictions that exclude companies that provide services. In their view, a financial technology company that, say, created an online banking service is not a financial services company; it is a company that created a new technology.
For that matter, Uber and Lyft are not car services; they’re companies that created something that did not exist before, said Christopher A. Karachale, partner at the law firm Hanson Bridgett.
“I could see the IRS coming back and saying Uber is just a car service,” Karachale said. “My argument would be that Uber has created this better technology to make this service more efficiently. The value is not the service but the actual app.”
Owners of the shares actually have to truly own them, with all the risk and reward that entails.
“You can’t mess with them,” said Peter Kong, managing director and private wealth adviser at Merrill Private Wealth Management. “You can’t hedge them. You can’t short them. And if you meet all those tests, we’re going to say you don’t have to pay tax on the first $10 million or 10 times your basis.”
Those who don’t follow the letter of the law risk an audit.
Many of the biggest qualified small-business stock elections are being reviewed by the IRS. Before 2010, the election eliminated the tax on only half of the stock. (There was a short period when it was 75%.) But at the end of 2010, the amount went up to 100% for federal taxes.
For many Silicon Valley workers, that started the five-year clock on holding shares. The first people getting the 100% election were able to take advantage of the tax break when they filed their returns in 2016. Generally, it takes the IRS three years to audit returns. So accountants and lawyers expect rulings on the provision to be forthcoming.
Yet when tax provisions are vague, advisers often see an opportunity to push the limits. One way is to split up the benefit among multiple people through trusts.
Take a worker who was given stock at a very low price and it appreciated far beyond the $10 million limit. One option is to create irrevocable trusts that could each have $10 million of the qualified stock in them.
“If an individual taxpayer sells his shares, once he goes past $10 million, the benefit ends,” said Toby Johnston, partner in charge in the Silicon Valley office at Moss Adams, an accounting firm that serves many technology workers. “But if the taxpayer transfers shares to an irrevocable trust, that trust is a different owner and could get the tax benefit.”
Trusts also serve as a great estate-planning tool for successful venture capitalists who may not need the windfall right away. Kong said clients might have to use up some of their gift tax exemption in creating trusts for children and grandchildren, but in the end, they’ll save more in taxes and allow the money in those trusts to grow for the beneficiary.