Against a backdrop of heightened regulatory scrutiny and ongoing geopolitical uncertainty, some companies are looking at alternative markets, which has led to a growing number of companies seeking to list in Hong Kong.
US tax residents remain subject to US federal income tax on worldwide income regardless of residence, and US citizens and US domiciliaries remain subject to US gift and estate tax on transfers of worldwide assets. Accordingly, founders and key employees should carefully evaluate potential US tax implications and available planning options well in advance of a potential IPO.
Following an IPO, the company’s share price may appreciate significantly, which can result in a substantial increase in the net worth of founders and key employees. From a US income tax perspective, no US federal income tax is due until the founder disposes of his or her shares in the future. However, from a US federal gift and estate tax perspective, this appreciation can increase a founder’s tax exposure.
Under the One Big Beautiful Bill Act, the enhanced federal unified gift and estate tax exemption was scheduled to sunset at the end of 2025, reverting to pre-2018 levels. However, it was extended and exemptions are permanently set at US$15 million per individual beginning in 2026, with ongoing annual inflation. The exemption amounts remain subject to future legislative changes, and a reduction in available gift and estate tax exemptions could result in a significantly higher estate tax liability in the absence of advance planning. There are some planning techniques to mitigate such exposure designed to ‘freeze’ the current value of their equity interests while allowing future appreciation to accrue outside their taxable estate. Commonly used techniques include grantor retained annuity trusts (GRATs) and sales to intentionally defective grantor trusts (IDGTs).
Grantor retained annuity trust (“GRAT“)
A GRAT is a trust created by the founder for a fixed term. The founder is the sole beneficiary of the trust during the term and will receive an annuity payment each year, the total present value of which will equal the current value of the stock transferred to the trust. Because the present value of the annuity payments equals the current value of the stock transferred, the founder is deemed to have made a current gift of nil value (usually called a zero-out GRAT). If the stock price skyrockets (as it usually does after an IPO), a significant portion of the stock will remain in the trust after the annuity payments. Generally, the founder would also create a family trust, which will be the beneficiary of the GRAT after the expiration of the term. This planning is blessed by the Internal Revenue Code. However, it should be noted that, if the founder passes away during the term of the GRAT, this planning technique would fail and the entire value of the stock would be included in the founder’s estate. In addition, proposals have been made to remove the statutory blessing for the zero-out GRAT.
Sale to an intentionally defective grantor trust (“IDGT“)
A grantor trust is an irrevocable trust that is disregarded for US income tax purposes. In other words, trust assets within a grantor trust are considered to be owned by the grantor (generally the person who created and funded the trust) directly for US income tax purposes. However, a grantor trust can still serve as an effective estate tax blocker as long as the grantor does not have certain powers. A grantor trust can be beneficial in the sense that grantor can make gift tax-free gifts by paying income tax on the appreciation of the trust property. In addition, transactions between the grantor and the trust are disregarded for US income tax purposes, allowing the grantor to sell stock to the trust tax free.
Through this planning technique, the founder will create a trust that is a grantor trust for US income tax but not for US estate tax purposes. The founder will then sell the interest in the company to the trust for an interest-bearing note prior to the IPO. Since the trust is a grantor trust for US federal income tax purposes, the sale would not trigger a gain in the hands of the founder. To the extent that the growth of the assets outgrow the interest rate (which is certainly the case after an IPO and also in light of the current low interest environment), the growth is forever excluded from the founder’s estate.
Given the potential for significant value appreciation following an IPO and the continuing exposure of US founders to US income, gift, and estate tax considerations, early and careful planning is essential. While techniques such as GRATs and IDGTs can be effective in mitigating transfer tax exposure, their suitability depends on a founder’s individual circumstances. Founders and key employees contemplating a Hong Kong listing should therefore seek tailored advice well in advance of an IPO to ensure that any planning is implemented appropriately and aligns with their broader succession and wealth planning goals.This article provides general information only and is not tax or legal advice. Please consult your own tax, legal and accounting advisors before engaging in any transaction.
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For further information, please contact:
Laurence Ho, Partner, Withersworldwide
laurence.ho@withersworldwide.com
