TikTok: Risky Tax Advice and Supersize Valuations

Tax expert Ed Slott explains why following some tax advice on TikTok could lead to an IRS audit. Jack Shannon, Morningstar Research Services’ senior manager research analyst, pits the valuation of privately held ByteDance against publicly traded rivals Meta and Snap.

How are Companies like ByteDance Valued?

Why Valuations Matter

ByteDance and Tech’s 2023 Rally

TikTok, Meta, and Snap

TikTok’s Business Risks

The “Unicorn of all Unicorns”

IRS Releases Memo About TikTok Trend

Audit Warning

What the TikTok Trust Promoters Are Getting Wrong

How to Protect Yourself

Read about topics from this episode.

How Mutual Funds Are Valuing TikTok, Twitter, and Other Private Companies https://www.morningstar.com/funds/how-mutual-funds-are-valuing-tiktok-twitter-other-private-companies

The Best and Worst Mutual Fund Bets of the Past 25 Years https://www.morningstar.com/funds/best-worst-mutual-fund-bets-past-25-years

IRS Chief Council Memo https://www.irs.gov/pub/lanoa/am-2023-006-508v.pdf

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Read what our team is writing:

Ivanna Hampton https://www.morningstar.com/authors/2399/ivanna-hampton

Jack Shannon https://www.morningstar.com/authors/2372/jack-shannon

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Ivanna Hampton: Welcome to Investing Insights. I’m your host, Ivanna Hampton. TikTok’s financial community draws millions of people looking for advice. Some mutual fund companies see the social media app itself as an investment opportunity. They’re betting TikTok parent company, ByteDance, could rival other platforms. In this episode, I’ll talk with tax expert Ed Slott about the IRS warning about trusts being promoted on TikTok. Those who follow the advice could get audited! But first, let’s start with whether some mutual fund companies’ valuations of privately held ByteDance match its publicly traded competitors. Here’s my conversation with Morningstar Research Services’ senior manager research analyst Jack Shannon.

Thanks for joining me, Jack.

Jack Shannon: Yeah, happy to be back.

Hampton: So, let's start off with how are privately held companies like ByteDance valued and how does it work?

Shannon: Yeah, so there's actually no rules and no regulations on how a fund company can value a private equity holding. So, it's not up to the portfolio managers, so you're not going to see like the person actually running the fund determining the valuation because that presents some obvious issues and conflicts of interest. Most of these firms have independent teams that assess the valuation of the company and then sort of push that out to any funds within their lineup that hold that private holding. So, in practice, they look for observable prices. So, for private equity, the only real observable prices are financing rounds. So, these companies are usually young companies, they're unprofitable, they're always needing more money because, hey, we have a new product we need to launch or, hey, we need to make this big marketing push because for all of them to get higher valuations, it's all about growth, growth, growth, growth and to get the growth, they need money.

So, for a long time, you'd see sort of ever higher valuations. So, in periods of like low interest rates where the risk appetite is high, investors are beating down the doors of these venture capital private equity companies saying, we want in on this stuff. And so, when that's happening, you get a lot of fundraising activity and when there's a lot of fundraising activity, it's pretty easy to see the market view even though it's only a sort of small subset of players but you get a view of what people think the company's worth. When interest rates are low and fundraising is sort of dying down and you get longer periods between fundraising rounds, then it's sort of an art to determine what do you think this company is worth. And so, they'll use sort of every, typical technique you might value a public company with, DCF, discounted cash flow analysis, they'll look at multiples. But at the end of the day, it is ultimately their call and like I said, there's no regulation on how they can or can't do it. So, balls in their court.

Hampton: So, why do valuations matter and how do they affect individual fund investors?

Shannon: So, they matter because you are paying for it. So, there is the NAV, which is the net asset value. That is the price of a mutual fund or ETF that you pay for or you get when you buy or sell a share. Now, the net asset value is the rolled up asset value of the portfolio and one of those values is that private equity valuation. So, a simple example would be, imagine two identical portfolios. They have nine publicly traded stocks in each, one privately held company as well and they're held at the exact same weights. So, it's identical baskets of securities. Except imagine portfolio B holds that company at a 20% premium to portfolio A, the private company that is. So, if you're an investor looking to buy one of these two baskets of securities, you have to pay more in B because they're saying this company is worth more than fund company A is saying.

Go a step further, assume unrealistically that some time period passes and none of the stocks move, right? 0% gain on all of them. The only difference is that fund company B comes to their senses and says, I think we're a little overzealous with our valuation. We're going to knock it down to what company A is holding it at. Well, if you owned A, which was the one that was not held at a premium, nothing gained, nothing lost, 0%. If you want to sell it today after you bought it, you have a nothing gained, nothing lost. But in B, you paid more up front. So, now when you go to sell it, they've knocked down that private equity valuation. You're now selling at a loss even though the exact same thing, the exact same events occurred within each portfolio. The only difference was that valuation. So, that's a super simplified sort of dumb example, but it gets to the mechanism of why it matters.

Hampton: I don't think it was dumb at all. I think you provided a great example for us to follow along. So, mutual fund companies like Fidelity and T. Rowe Price, they hold ByteDance shares in their funds. Tech got hit hard in 2022 and rallied in 2023. Describe how the firms treated ByteDance valuations during that time.

Shannon: Yes. So, to maybe back up, we should start with where they went into the year valuing ByteDance, which is TikTok. So, three fund companies own it. So, T. Rowe Price, BlackRock, and Fidelity. T. Rowe Price was the first to buy it. They bought it in the Series E round, which valued it at $72 billion. And then BlackRock and Fidelity came in later, Series E1 at a $180 billion valuation. So, by the time BlackRock and Fidelity got in, T. Rowe had already doubled their value in it. But going into 2022, BlackRock was actually holding ByteDance at a 30% premium to what T. Rowe and Fidelity were. So, they were already sort of higher than those two. 2022 comes, we all know what happens, growth stocks get killed. The Russell 1000 growth is down 30%. In that time, though, T. Rowe Price ups their valuation of TikTok 37%-ish. Fidelity ups it 45%. And BlackRock, they dip it maybe 2% or something like that.

So, you get these big relative differences in them. But again, BlackRock was starting from a higher valuation to begin with. So, at the end of 2022, they were sort of close to each other in terms of their absolute valuations. But then 2023 comes around, we have the sort of opposite market environment. Growth stocks take off again, they're up 30% the first six months. So, the question that I always had was, okay, like you wrote it up during a period where the market pulled back, what are you going to do when the market goes up? Are you going to write it up even more? Are you going to take maybe a contrarian approach? And it's sort of a mixed bag. So, T. Rowe didn't touch it that much. Actually, I think they just recently had the disclosed portfolio that upped it a decent amount. But in the first few months, they didn't touch it at all. BlackRock up theirs about 8%. And then Fidelity up theirs 18%. So, again, not as much as the market went up, but over that whole sort of 18-month span, they've certainly written up ByteDance far more than a typical, than the growth index went up. So, they certainly are implicitly saying that sort of the market environment that affected growth stocks in general really didn't affect TikTok on its own.

Hampton: So, TikTok has publicly traded rivals, Meta, Snap. How does ByteDance valuation compare to those companies?

Shannon: Yeah, that's what I have beef with. So, Snapchat and Facebook. So, going from September '21 to September '22, they both got killed. So, Facebook was down like 70%. Snapchat was down like 80%. And it was all on sort of similar themes. There was like macro headwinds where there was like sort of recessionary fears and that, oh, discretionary ad spending is going to get pulled back and these companies make money selling ads. It's a pretty basic business. So, there was fear there. There was fear on the Apple privacy change on their cell phones where users could opt out of sharing data with third-party apps. And so, when your business is selling targeted ads, not having that data, in theory, should probably crimp your revenues. So, they got killed. But in that time, like we said, Fidelity and T. Rowe wrote their stakes up pretty significantly.

So, right now, I think if you have to trace it back to when these companies first bought into ByteDance, Fidelity is holding ByteDance, this is my assumption based on the math of when they bought it and what they've raised it since then, around $400 billion is what the valuation they have for TikTok. T. Rowe is around $300 billion, they're a little less than $300 billion and BlackRock is right around T. Rowe. But within this one company, you have a $100 billion difference in opinion on what this company is worth. $100 billion's a huge company on its own and that's just the gap between these two. So, Snapchat is now like a $15 billion company. Facebook has bounced back since 2022 and I think it's around $750 billion, something like that. So, it dwarfs Snapchat now, but it's still not quite at the Facebook Meta levels.

Hampton: So, TikTok's parent company, ByteDance, could face some business risks. What are they?

Shannon: Yeah, I think the obvious one is regulatory. So, you have people in the United States government, the federal government, very high up people, openly wondering if TikTok should be banned. Now, if TikTok's banned in the United States, the United States is a very, very big market that would create a lot of problems for TikTok. So, you have states banning it off of state-issued devices. Now, that's not a huge piece. It's just a government device. Hey, you can't have TikTok on that. Okay, no big deal. But still, it's a non-zero threat of that happening and we've seen regulatory impacts like wipe out a business before. You can go to China where they basically outlawed those tutoring education stocks. They basically made those companies nonprofits overnight and those companies went to zero just on a whim. You get it in the United States with private equity companies like Juul. Juul is the vaping company that the FDA essentially said you can't sell flavored products and then when that happened, their valuation got basically cut to zero. So, that's the main risk that I see with TikTok.

Hampton: So, we're going to talk about unicorns now. A private startup company gets that name when its value exceeds $1 billion. You've written that ByteDance valuation would suggested it's the, "unicorn of all unicorns". You got to explain that one.

Shannon: Yeah. So, again, these valuations that are sort of implied by these fund companies of $300 billion to $400 billion, that's a massive number for a privately held company. So, unicorn is $1 billion. We're talking 300 to 400 times that. I think the biggest IPO, well, Alibaba went public as the biggest IPO when it debuted and that was like $170 billion. So, we're already talking two to three times higher than that because it's probably going to have to go public at a premium to what it's valued at now. Saudi Aramco went public at a higher valuation, but I don't really consider that. That's not really a true IPO because they were already a cash cow beforehand. So, it's certainly going to be, if it goes public, which we don't really, there don't seem to be any sort of firm plans on that. But if and when it does, it will most likely be the biggest IPO in history, at least amongst this sort of tech crowd.

Hampton: Thank you, Jack, for explaining today why valuations matter.

Shannon: Yep. Thank you.

Hampton: We’ve talked about TikTok’s parent company being in mutual funds. What about people who are trying to find financial advice on the social media platform? Tax expert Ed Slott is bringing attention to a TikTok trend where some professionals are misinterpreting the federal tax code.

Thanks for joining me, Ed.

Ed Slott: Great to be here.

Hampton: So the IRS issued a memo about non-grantor, irrevocable, complex, discretionary, spendthrift trust.

Slott: I have it here in front of me because I could never remember it. This is a marketing thing. Even the Chief Counsel Memorandum, which is pretty serious, mentions on the bottom. These are just advertising and marketing things, names made up. They call it NICDS. And I have to look at it. I don't know how you remembered it, but non-grantor, irrevocable, complex, discretionary, spendthrift trust. So my first comment is if you have to have all those names in there and you need to market this on TikTok and social media and have all these things out there to show why it's legal, it probably doesn't work. And that's what IRS said in this Chief Counsel Memorandum.

Hampton: So the IRS says some attorneys and accountants on TikTok are promoting a way to remove, "certain trust income from current taxation". How so?

Slott: Yeah. And that was a scary part. I'm reading right from the announcement, the pronouncement from their Chief Counsel. Accountants, enrolled agents, and unlicensed tax advisors. So this is the problem. They go on TikTok or social media and they list, in this case, all kinds of section numbers, why it's legal, how you can do it. And what IRS said here is they went bullet by bullet, in their words, rebutting the promoter's misinterpretation. So the bottom line is if trusts made taxes magically disappear, wouldn't we all become a trust? I mean, if everybody could do it, it just doesn't work. But they sell people. And, the dangerous part here is this seems to appeal to high net worth, wealthier people. They have a lot of money. They think, oh, if I put it in trust, I can avoid taxes. I can get creditor protection for my beneficiaries. And IRS said this doesn't work. And it shows how much this has proliferated because it's rare to see IRS come out with such a heavy announcement from their Chief Counsel. It's a Chief Counsel Memorandum.

So obviously it's pervasive enough, at least in IRS's opinion, that they had to issue this announcement to protect people from these promoters and marketers that say you can just move your money into a trust and take a note back and then go around the corner, jump up and down around the block. You get all the candy store benefits of no taxes and no creditors. And it just doesn't work. It's very dangerous. And, in fact, the worst part is at the end, I don't know if you saw to the end of this Chief Counsel memo, at the very end under the IRS's recommendation, they say in each case using this structure, our recommendation is that the trust income tax returns should be examined, in other words audited. And the danger here for people watching this, if you're even considering this, and obviously the IRS is here to protect you from getting into trouble, losing money, having an audit. And the problem with audits on trusts. Trusts by their nature, their very nature are pass-through entities. They hold property for certain beneficiaries and certain future beneficiaries and they pass through income and things like that.

So by their very nature, they have tentacles out everywhere. If one of these things, if you're a wealthy person or you're trying to save taxes like everybody or you have high net worth and you're considering this, consider this warning from the IRS. If these trusts get examined, audited, it's not the trust itself. It will start with the trust, but then it will reach out tentacles to beneficiaries and all related entities and the people behind them. Who knows where it will stop? You could be in court or fighting this with lawyers for years to come. And IRS said this just doesn't work. You just can't magically remove taxable income by using a trust.

Hampton: So the promoters of these trusts, what are they getting wrong? Like they're looking at the tax code. What are they misinterpreting when they're spreading this?

Slott: Well, they're using parts of the tax code. So they go through section by section saying this section says it's okay, and this section says it's okay. So IRS in this Chief Counsel Memorandum rebutted it section by section. Yes, this part's correct, but you didn't mention this other part says it won't work. So they're only giving you half the story to get you excited about putting your money in this thing. And there are just so many bells and whistles and hoops you have to jump through. And like I always say, if they have to spend 30 pages telling you why it will work, it probably won't. If it was totally legit and legal, they could explain it in easily understandable language in one paragraph. And everybody would know about it. If that were true, nobody would ever pay taxes. Oh, I'll just do this. And all of a sudden, I don't have any capital gains and interest and dividends, all tax free. And they even mention the creditor protection for beneficiaries because people are always worried beneficiaries might get themselves into trouble. Maybe they have issues of their own bankruptcy, their own kind of litigation, divorce, whatever. But IRS points out that it's not going to hold up if the beneficiaries have access to the monies, the creditors will get to it.

Hampton: And what should anyone listening to this or watching this ask their financial advisors, lawyers or accountants to make sure that they're following the tax code?

Slott: You know what I always told my clients for years, because this is not the first time. I mean, these things pop up all over the -- they've been popping up for years. I always tell my clients, if you ever get any of these solicitations, always say the magic words I give them. Let me first run this by my accountant. And that usually stops 90% of them. But some of the promoters over the years got smart and headed that off. And they prep the client to say, if you tell me you're going to run it by your accountant, it's not going to work because this is so sophisticated. We figured out something that nobody knows your accountant will disapprove of it, will give it a thumbs down because your accountant just doesn't understand this sophisticated tax scheme we've created. So I've had people come up. And when I said, no, don't go near it. They said, oh, that's they told me, they told me you would say that because you just don't understand it. It's so sophisticated.

Hampton: Well, something to perk your ears up if you hear this is so sophisticated, possibly go another direction. Right.

Slott: Look, isn't it the old -- all it comes down to, if it sounds too good to be true, it is. That's you can take that to the bank with every scheme and scam out there. If it sounds too good to be true in this case, just put tons, thousands, hundreds of thousands, millions into a trust and no tax. It's just too good to be true. But people do fall for it because it sounds good. And the way they present it, I'm simplifying it here for our program here. But the way they do it. Oh, this code section says this and they cite private letter rulings in court cases. It's very official. But if you go to this. If you read this Chief Counsel Memorandum, IRS really point by point. And they say that they say that right in the front for simplicity, this memorandum is rebutting the promoters misinterpretation point by point.

Hampton: All right. Thanks, Ed, for your time today and really explaining, breaking down this warning from the IRS.

Slott: Yeah, it's for your own protection. Be careful. And I'd still say the same thing. Run this first by independent advisors, your accountant, your attorney. The problem is a lot of the people promoting this are accountants and attorneys. But make sure it's not your accountant and attorney.

Hampton: Double check. Thanks, Ed.

Slott: Okay, thanks.

Hampton: Thanks for checking out Investing Insights this week. Thanks to senior video producer, Jake VanKersen, and lead technical producer, Scott Halver. Subscribe to Morningstar’s YouTube channel to see new videos from our team. You can hear market trends and analyst insights from Morningstar on your Alexa devices. Say ‘Play Morningstar’. I’m Ivanna Hampton, a senior multimedia editor at Morningstar. Take care.