The savings for the richest American families — who would otherwise face a 23.8 per cent capital gains tax — can quickly swell into the tens of millions.
The manoeuvre, which is legal, is known as “stacking” because the tax breaks are piled on top of one another.
If you walk down University Avenue in Palo Alto, California, every person is involved in tech stacks, said Christopher Karachale, a tax lawyer at the law firm Hanson Bridgett in San Francisco. He said he had helped dozens of families multiply the QSBS tax benefit.
Uber, Lyft, Airbnb and Zoom
Early investors in some of Silicon Valley’s marquee startups — including Uber, Lyft, Airbnb, Zoom, Pinterest and DoorDash — have all replicated this tax exemption by giving shares to friends and family, according to people who worked or were briefed on the tax strategies.
So have partners at top venture capital firms like Andreessen Horowitz, who have figured out ways to claim tens of millions of dollars in tax exemptions for themselves and relatives year after year, according to industry officials and lawyers.
Representatives of those companies declined to comment or did not respond to requests for comment. A Lyft spokesperson said the company’s two co-founders did not take the tax benefit. A Roblox spokesperson declined to comment.
The story of the tax break is in many ways the story of US tax policy writ large. Congress enacts a loophole-laden law whose benefits skew toward the ultrarich. Lobbyists defeat efforts to rein it in. Then creative tax specialists at law, accounting and Wall Street firms transform it into something far more generous than what lawmakers had contemplated.
“QSBS is an example of a provision that is on its face already outrageous,” said Daniel Hemel, a tax law professor at the University of Chicago. “But when you get smart tax lawyers in the room, the provision becomes, in practice, preposterous.”
Manoj Viswanathan, who is a director of the Center on Tax Law at the University of California, Hastings, estimates the tax break will cost the US government at least $US60 billion over the coming decade. But that does not include taxes avoided by stacking, and so the true cost of the tax break is probably many times higher.
The Biden administration has proposed shrinking the QSBS benefit by more than half. But the plan would not restrict wealthy investors from multiplying the tax break.
The likely result, said Paul Lee, chief tax strategist at Northern Trust Wealth Management, would be even more tax avoidance. “You’ll end up having more people doing more planning to multiply the exclusion,” he said.
Disqualifying the ducks
The idea for this tax break came from the venture capital and biotech industries in the early 1990s. Venture capital firms were raking in huge profits from early investments in highflying startups like Gilead Sciences and MedImmune.
That stuck them with hefty capital gains tax bills. The QSBS exemption would shield at least a chunk of their future profits from taxation.
With the economy in a recession, Democrats branded the tax break as a boon to small businesses and an engine of job creation. In Congress, an original backer was Senator Dale Bumpers, and he had the support of the National Venture Capital Association. “This is a modest tax incentive that holds great promise for hundreds of thousands of small firms with good ideas but not enough capital,” he said in early 1993.
Bumpers was friends with his fellow Arkansas Democrat, President Bill Clinton, whose new administration embraced the cause within weeks of taking power.
The exemption became law in August 1993. It allowed investors in eligible companies to avoid half the taxes on up to $US10 million in capital gains (it would later be changed to eliminate all taxes on the $US10 million) or 10 times what the investors paid for their shares.
There were a few restrictions. To be eligible for the tax break, investors had to hold the shares for at least five years. Industries like architecture and accounting were excluded. And, at least in theory, the companies could not be big; they had to have “gross assets” of $US50 million or less at the time of the investments.
That number was not picked at random. At the time, a new professional hockey team, the Mighty Ducks of Anaheim, California, had just been created with a price tag of $US50 million. The team was owned by the Walt Disney Co.
Politicians feared that if Disney stood to benefit from the tax break, it risked a public backlash, according to a congressional aide who worked on the legislation.
The Internal Revenue Service [the US tax office] does not publicly disclose data on how frequently the QSBS tax break is used. But tax lawyers said it was slow to gain popularity. It would be decades before Silicon Valley figured out how to fully exploit it.
A flurry of gifts
A few years after graduating from Stanford University in 1985, Baszucki started a software company, Knowledge Revolution. He sold it in 1998 for $US20 million.
Around 2004, after a brief detour into radio, Baszucki teamed up with a former colleague, Erik Cassel, on a new venture. Mostly using Baszucki’s money, they spent two years writing the computer code that would become an early version of Roblox, which they publicly introduced in 2007.
Roblox was a hub for players to find and play video games featuring virtual pets, murder mysteries and much more. The platform allowed users to create games and receive a portion of whatever revenue the games generated.
About a decade ago, after outside investors had begun kicking in millions of dollars, Baszucki and his wife, Jan Ellison, gave Roblox shares to their four children and other family members, according to people familiar with the matter.
The gifts appeared to be the product of estate planning. If Roblox ever became a Silicon Valley powerhouse, the Baszuckis could avoid hundreds of millions of dollars in future gift and estate taxes because they gave away shares when the company was not worth much.
And because Roblox met the criteria for the small-business tax break, the gift recipients could also become eligible for millions of dollars in profits free of capital gains taxes.
Children for tax avoidance
In the past few years, a procession of blockbuster tech initial public offerings has showered Silicon Valley in more than $US1 trillion of new wealth, according to Jay R. Ritter, a finance professor at the University of Florida. The unprecedented explosion and the corresponding tax bills have made the QSBS tax break more enticing.
Tax experts had discovered a big loophole. While the law said that the benefit was off-limits to people who bought shares from other investors, there was no similar restriction on people who received the shares as gifts.
If investors gave shares to family or friends, they, too, could be eligible for the tax break. And there were no limits on the number of gifts they could make.
Stacking was born — and it became a rite of passage for a select slice of Silicon Valley multimillionaires, according to lawyers, accountants and investors.
As the tax break’s popularity has grown, the strategies for exploiting it have grown more aggressive.
One tax adviser said he was helping a family, whose patriarch founded a publicly traded tech company, avoid any taxes on more than $US150 million in profits by giving shares to more than seven of his children, among other manoeuvres.
Karachale, the San Francisco tax lawyer, said he jokes to clients that they should have more children, so they can avoid more taxes. “It’s so expensive to raise kids in the Bay Area; the only good justification to have another kid is to get another” QSBS exemption, he said.
Investment banks like Goldman Sachs and Morgan Stanley and law firms like McDermott Will & Emery have advised wealthy founders and their families on the strategy, according to bankers, lawyers and others.
Stacking has become so common that it has spawned other nicknames. One is “peanut buttering” — a reference to the ease with which the tax benefit can be spread among the original investor’s relatives.
‘An act of patriotism’
In 2015, Rachel Romer Carlson helped found an online education company, Guild Education, that was eligible for the QSBS tax break.
Guild was recently valued at nearly $US4 billion, and Carlson owns about 15 per cent of the company. She will face an enormous capital gains tax bill if and when she sells her stake. To mitigate that, she said, a tax adviser urged her to distribute her shares into trusts to multiply the exemptions.
“You can then take this an infinite number of times,” she recalled the lawyer saying. The adviser, whom she would not identify, told her that some lawyers will recommend creating 10 or more trusts but that his more conservative advice was to limit the number to five.
Carlson said she rejected the advice because she thought the strategy, while perfectly legal, sounded shady. “I believe paying taxes is an act of patriotism,” she said. (When she sold about $US1 million worth of Guild shares last year, the QSBS exemption saved her roughly $US200,000 in taxes.)
Venture capitalists that invest in startups — the same group that pushed for this tax break in the first place — potentially have the most to gain.
The founder of a successful startup might get this tax-free opportunity once in a lifetime. At large venture capital firms, the opportunity can present itself several times a year.
Partners at venture capital firms often acquire shares in the companies in which their firms invest. For each QSBS-eligible company that a partner has invested in, he can avoid capital gains taxes on at least $ US10 million of profits. If he gives shares to family members, those relatives get the tax break, too.
In a good year, partners at a large firm can collectively rack up more than $US1 billion in tax-free profits, according to former partners at two major venture capital firms.
‘A welcome relief’
As the tax break’s popularity has grown, the strategies for exploiting it have grown more aggressive.
The QSBS tax break is limited to either $US10 million in tax-free capital gains or 10 times the “basis” of the original investment. The tax basis is the cost of an investment — the money you spent or the assets you contributed in exchange for shares. One way to expand the value of the tax break is to find ways to inflate the basis.
The strategy is called “packing.”
Say you invested $US1 million in a QSBS-eligible business called Little Company. Your basis would be $US1 million, which means you would be eligible to avoid taxes on $US10 million of future profits.
But let’s say you want to save more. Here is how you can pump up the basis. Little Company developed software patents, and you put those patents into a new company that you also own. The patents grow to be worth $US5 million. Then you merge the two companies. The basis for your investment in the original Little Company has now soared to $US6 million. That means you are eligible to avoid taxes on 10 times that — $US60 million — even though your out-of-pocket investment remains $US1 million.
One tax lawyer said he recently used such a strategy to help a pair of clients completely avoid taxes on more than $US100 million in capital gains.
Another increasingly common strategy has been to put shares into multiple trusts that benefit the same children.
In August 2018, the Trump administration’s Treasury Department proposed regulations to curb such tax avoidance. The rules included hypothetical examples of abusive transactions in which children were given multiple trusts.
But opposition mounted quickly. The next month, the American College of Trust and Estate Counsel, a trade group of tax lawyers who advise the wealthy, wrote to the IRS that the proposal was “overbroad” and “an impermissible interpretation of the statute.” By the time the US Treasury’s rules were completed in early 2019, the proposed crackdown on trusts had been watered down.
It was, the accounting giant EY declared in an online alert, a “welcome relief.”
A gift from Grandma
Roblox says that more than 47 million people use its platform each day. It has branched out beyond gaming, becoming a venue for virtual concerts by the likes of Lil Nas X.
In early 2020, Andreessen Horowitz and others invested $US150 million in the company, valuing it at about $US4 billion. Shares of tech companies were racing higher, and Roblox planned to go public in late 2020 or early 2021.
The Baszuckis were about to become billionaires.
The family took steps to help insulate their fortune from future federal taxes.
Giving away the shares before the IPO — which was likely to drive the stock’s value higher — would make it easier to avoid federal gift and estate taxes.
Baszucki and Ellison had already given away so many shares that future large gifts would be subject to the 40 per cent gift tax. (A married couple can give about $US23 million over their lifetime without incurring the tax.)
But Baszucki’s mother-in-law, Susan Elmore, had not. In fall 2020, she began giving away Roblox shares to about a dozen relatives, including Baszucki’s four children, according to people familiar with the matter.
Elmore’s nephew, Nolan Griswold, said he was among those to receive shares last fall. Elmore’s shares were eligible for the QSBS exemption; now that exemption was replicated for the recipients of her gifts.
In March 2021, Roblox went public. Its market value hit $US45 billion.
That day, Baszucki’s brother Gregory, whose large Roblox stake made him a billionaire, began selling shares. The resulting capital gains taxes could be defrayed in part by the QSBS exemption.
This article originally appeared in The New York Times.