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There Are Plenty of Good Reasons to Hate Facebook, But Tax Breaks Are Not Among Them

When you write about tax law, you interact with a lot of commenters, most of them of the angry variety. Of course, most people are of the angry variety, so it adds up. But I’ll say this – when it comes to tax law, at least the anger is often justified. It can be very frustrating to stare at your depleted paycheck every week and wonder where all of your hard-earned money is going.

In fact, the only thing more infuriating than having no idea how your tax dollars are being used is finding out exactly how they’re being used. 

On Tuesday, Senator Tom Coburn (R-OK), released his annual “Wastebook,” a 177-page report detailing outflows by the government that were, shall we say…less than prudent.

Included in this year’s report are examples of spending that Mike Tyson would find extravagant and frivolous.  See if you can guess which one I made up!

  • $125,000 to build a 3-D printer to make pizzas for NASA.
  • $8,000 to hang drapes in front of nude statues in the Great Hall of the Department of Justice.
  • $566,000 paid by the U.S. Postal Service to a “futurist,” Faith Popcorn, to try and envision a viable future for the post office.
  • $15,000 to collect thousands of gallons of human urine and test it as a hay field fertilizer.
  • $18,000 apiece to “pillownauts” — people whom NASA recruited to lie on a bed for two straight months.

Guess what? I didn’t make any of them up! To be fair, however, the second one was done way back in 2002, when crazy person former Attorney General John Ashcroft didn’t feel comfortable being photographed in front of art deco boobies.

Also included in Coburn’s report was this little nugget, which as a tax guy, naturally caught my eye (footnotes removed):

Despite bringing in more than $1 billion in U.S. pretax profits last year, the social-media giant Facebook reported a combined $429 million refund from its federal and state tax filings.

By providing stock options as a major form of their compensation, to date, Facebook has claimed $3.2 billion in federal and state stock option deductions, $1.03 billion of which was used to offset their total U.S. pretax profit of $1.1 billion in 2012, and $429 million was refunded from its 2010 and 2011 tax bills.

The remaining $2.17 billion in stock option tax deductions can now be carried forward by the company and used to offset future tax liabilities. This rollover, in addition to currently outstanding employee stock options, may once again make this year’s tax bill disappear.

If Facebook has the same U.S. pretax profit in 2013 as last year ($1.1 billion), the company will be able to zero out their tax bill for the next year.

First things first, I get it. I understand that it makes for an interesting headline when a billion-dollar enterprise pays no federal taxes, and in fact gets a large refund. But using the Facebook refund as an example of the utilization of a corporate loophole reflects a gross inability on the part of Senator Coburn to understand how the tax law actually works when it comes to stock options. Facebook isn’t avoiding corporate taxes through the use of some fancy, perverted-sounding tax shelter like a Double Irish with a Dutch Sandwich; rather, the company is simply reducing its tax liability by paying compensation –- compensation that the recipients are paying tax on, a fact that Coburn fails to understand or acknowledge.

And because chances are good that a large number of current GC readers will grow into future Congressmen and women, I want to prepare you so that when you reach a position of power, you’re not guilty of the same ignorance. So here goes…

When a corporation wants to compensate its employees, it typically uses cash. But it doesn’t have to. In fact, the corporation may prefer to pay the employees in its own stock.

During Facebook’s formative years, this was a common practice. To compensate everyone from Mark Zuckerberg to the guy who painted the office, Facebook issued shares of restricted stock.

Restricted stock is more desirable in the eyes of an employer because it not only rewards employees for past services, it also provides incentive for employees to continue working hard. This is because when restricted stock is issued, the employee does not own the stock outright until some future bogey is hit, whether it’s years of service or the reaching of certain financial goals. As you can see, restricted stock provides employers with the opportunity to dangle a carrot for the unwashed masses to pursue.

When restricted stock is issued, the recipient is typically not required to pay anything for the shares. But that’s where the good news ends. The stock typically can’t be transferred, and there is a continued risk that the employee will have to forfeit the stock until some predetermined event occurs, at which point the restricted stock “vests.” In the case of Facebook, the vesting of most shares of restricted stock was tied to the public offering.

From an income tax perspective, the granting of restricted stock is governed by Section 83. This provision provides that when a taxpayer receives property in exchange for past, present or future services, the recipient must recognize compensation income to the extent the fair market value of the property exceeds any amount paid for the property by the recipient.

Section 83 also acts as a deferral provision, however; the idea being that a recipient of property shouldn’t pay tax on the value of the property until he or she truly owns it. Within the meaning of Section 83, this is defined as the first date on which the property is either: A) freely transferable or B) no longer subject to a substantial risk of forfeiture.

Because restricted stock is typically not transferable and is subject to a substantial risk of forfeiture, Section 83 will not tax the grant of such stock (unless a Section 83(b) election is made, but that’s a topic for another day). When the stock eventually vests, however, Section 83 will rear its head once again, and tax the employee on the fair market value of the (now un)restricted stock, with the income inclusion reported as compensation income to the employee.

How about an example?

On January 1, 2011, X Co. grants to employee A 1,000 shares of X Co. stock with a fair market value of $5,000. The stock is restricted; as a result, A cannot own the stock until a triggering event occurs, in this case, the employee must continue to be employed six months after the public offering of X Co. stock.

In January 2014, X Co. goes public, and six months later, the fair market value of the stock is $20,000. At that time, the restrictions on the stock lapse, and A must recognize $20,000 of compensation income related to the restricted stock.

After the Facebook IPO, hundreds of millions of shares of restricted stock suddenly became unrestricted. As a result, at that time anyone who had previously received restricted stock was now taxed on the fair market value of the stock on the date it became unrestricted. Because the value of the Facebook stock was so high at that time, the combined income inclusion was huge.

To illustrate, simultaneous with the IPO, Zuckerberg became entitled to 60 million shares that were worth approximately $35 per share. While Zuckerberg did have an exercise price for the shares, it was an immaterial 60 cents per share. Do the math, and upon receipt of the now unrestricted shares, Zuckerberg had taxable compensation income of approximately $2.1 billion.

So what’s this have to do with Coburn’s outrage? Section 83(h) provides the rather logical rule that when a recipient of restricted stock recognizes compensation income, the corporation issuing the stock is entitled to a corresponding compensation tax deduction equal to the amount included in the recipient’s income. So when Zuckerberg got his shares and picked up $2.1 billion of income, Facebook got a $2.1 billion tax deduction.

Add in all the other people who simultaneous vested in their Facebook shares after the IPO, and you get the $3.2 billion stock-based compensation deduction Coburn refers to in his report. As a result, despite earning a pre-tax profit of $1.062 billion in 2012, courtesy of its stock-based compensation deduction, the company reported a huge net loss for tax purposes; large enough to generate big ol’ refunds and with enough left over to carry into 2013, where it will likely once again wipe out all of the corporate income.

But what Coburn’s missing is that EVERY DOLLAR of that $3.2 billion deduction was included in the taxable income of the collective recipients of the stock.  So the government isn’t losing any money on the stock-based compensation play, particularly when you factor that the stock-based compensation is subject to payroll taxes.

So while Coburn is right to point a finger at many of the government’s spending practices — which appear to be the fiscal equivalent of lighting a pile of cash on fire – his anger with Facebook is misplaced. The company’s “loophole” was a zero-sum proposition from a tax revenue perspective, something the Senator should have understood before publishing his report.