First-time millionaires often forget their IPO earnings come with significant tax exposure. California also stands to benefit from the coming windfall
SeongJoon Cho / Bloomberg via Getty Images
When OpenAI and Anthropic go public, their employees will face a tax system designed to take its cut before the windfall arrives. Most of those employees have never earned enough to encounter the parts of the tax code that apply to stock compensation, and the surprises start well before anyone sells a share.
The two companies are expected to go public later this year or early next, and the IPOs could create about 12,000 new millionaires. For most, the events will trigger federal and state tax bills — as well as a withholding shortfall — on wealth they may not be able to touch for months.
The federal government taxes stock grants under rules most employees have never encountered. California, where most of these prospective millionaires live, collects its own share, and employers routinely withhold far less than what's owed. All of that leaves employees to make up the difference on their own.
Most tech employees receive stock compensation in one of two forms. The simpler kind is taxed the moment an employee exercises it. The difference between the company's discounted price and the stock's current value is treated as regular wages, and the bill is immediate. Incentive stock options appear to be a better deal. Under normal federal rules, employees owe nothing when they exercise, and the tax is deferred until they sell.
But the deferral triggers a separate problem. The IRS runs a parallel tax system designed to catch income that's invisible under the normal rules. When an employee exercises incentive options, the gain that was deferred under the standard system becomes taxable under the parallel one. The IRS treats the difference between the discounted price and the current value as income in the year of exercise, even if the employee never sold a share and has no cash to pay the bill. For employees who received options years ago when their company was worth a fraction of its current valuation, that gap can be enormous, and the resulting bill can reach six figures.
There is one workaround. Employees who receive stock before it's fully earned can file a special election with the IRS within 30 days, locking in the taxable value at the stock's price on that date. At an early-stage startup, that price can be close to zero, which means all future appreciation is taxed only at sale and at the lower long-term rate. But the 30-day window is absolute. The IRS grants no extensions.
Employers compound the problem by withholding too little. When stock compensation vests, employers typically withhold at a 22% rate, even when the employee's actual rate is 37%. The difference on a large vesting event can run into hundreds of thousands of dollars, and many employees don't discover the shortfall until they file their returns the following spring.
California adds a second tax bill on top of the federal one. The state's top income tax rate is 13.3%, which includes a 1% surcharge on income above $1 million that was originally enacted to fund mental health services. For an employee with $5 million in stock gains, the combined federal and state marginal rate can exceed 50%.
California also breaks from the federal system on investment gains. The federal government taxes long-term stock profits at up to 23.8%, well below the top rate on regular income. California doesn't. The state taxes all stock gains at the same rate as wages, topping out at 13.3%. An employee who held shares for five years and qualifies for the lower federal rate still owes California the full amount.
Many first-time millionaires budget for the federal rate and treat the state bill as an afterthought. In California, the state alone can add more than $650,000 to the total obligation on a $5 million gain.
California's budget depends on exactly this kind of income. In 2012, the wealthiest 1% of the state's tax filers accounted for more than half of all income tax collections, a concentration California's Legislative Analyst's Office traced largely to stock sales. That makes the state's revenue stream acutely sensitive to market conditions. The LAO has estimated that stock price movements drive roughly 55% of the year-to-year variation in what the state collects from investment profits.
The coming wave of IPO millionaires will exercise options and sell stock in a compressed window, pushing a one-time surge of taxable income onto California's rolls. That revenue is welcome when it arrives. But investment income either spikes well above or falls well below its long-run average. It almost never lands near the average, making it impossible to count on from a budgeting perspective.
San Francisco, which doesn't collect income tax, captures the wealth indirectly through property taxes, the city's largest revenue source. The real property transfer tax generates about $456 million annually at its rate-adjusted average, according to the San Francisco Controller's Office, and with home prices climbing faster than anywhere else in the country and luxury transactions multiplying, property tax revenue is also expected to grow.
One provision could reduce the government's take. Federal law allows employees who hold stock in qualifying startups for at least five years to shield up to $15 million in profits from capital gains tax entirely. Whether OpenAI and Anthropic stock qualifies depends on each company's structure at the time shares were issued, a question that turns on corporate details most employees have never examined.
For the employees who don't qualify or didn't plan ahead, the full weight of the federal and state systems applies. The employees will pay more than they expected, and the state's budget is built on the assumption that they will.
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