Latepost Options As Well As Taxes: Is A Facebook Revenue Enhancement Next?

Facebook is inward the tidings too I volition do my commons pre-IPO valuation too posting inward a few days on the fellowship merely I desire to focus inward on an interesting story inward this morning's New York Times almost alternative practise too taxation (at both the private too corporate levels).

The story itself focuses on ii taxation issues. The showtime is that Mark Zuckerberg is planning to practise almost $ 5 billion of options ahead of the offering, resulting inward a taxation nib of roughly $ 2 billion for him, almost $1.5 billion inward federal taxes too $ 500 meg inward California taxes.  The 2nd is that Facebook volition last claiming a taxation deduction of roughly the same value, which volition shelter them from taxes this yr too allow them to claim taxation refunds of almost $ 500 meg from prior years. All of this has unopen to inward Congress inward total "indignation" mode, with Senator Carl Levin maxim "“When profitable corporations tin purpose the stock alternative taxation deduction to pay zero corporate income taxes for years on end, average taxpayers are forced to pick upward the taxation burden,” he said. “It isn’t right, too nosotros can’t afford it.” Before nosotros embark on unopen to other taxation policy modify predicated on a sample of 1 (Facebook), it is worth examining the broader query of how employee options larn taxed, peculiarly at the corporate level.

At the moment, if you lot are a fellowship that grants options to its employees, the accounting laws scream for you lot to value those options equally options (rather than at practise value) too expense them when you lot grant them (though you lot tin amortize these expenses over a menses of time). Thus, what you lot run across reported equally operating or cyberspace income for a fellowship today is after employee options withdraw maintain been expensed. This, of course, is a abrupt reversal of accounting policy prior to 2006, when firms had to demo alone the practise value of the options at the fourth dimension of the grant. Since at the fourth dimension of the grant, employee options were normally at the coin (strike toll = stock price), this effectively meant that alternative grants had no lawsuit on earnings when they were granted. However, if too when the options were exercised, companies were required to demo the difference betwixt the stock toll too the strike toll equally an expense. 

To illustrate the difference, assume that you lot grant 100 meg options with a strike toll of $10, when the stock toll is too $ 10, inward 2008. Let's too assume that the options larn exercised 2 years afterward when the stock toll is $ 40. With pre-2006 accounting, you lot would non withdraw maintain shown an alternative expense inward 2008 merely you lot would withdraw maintain shown an expense of $ 3 billion [$40 - $10) (100)] in 2010. In the post-2006 fourth dimension period, the fellowship would withdraw maintain had to demo an alternative expense inward 2008, with the expense computed past times valuing the options at the time. (For instance, an at-the-money alternative with 5 years to expiration on a stock with a toll of $ 10 too a touchstone divergence of 40% would withdraw maintain a value of $3.36. Carrying this through, the fellowship would withdraw maintain to tape an expense of $336 meg inward 2008 too revisit this expense inward subsequent years, equally stock prices larn upward or down.  If you lot desire to, you lot tin travail your manus at valuing options with the attached spreadsheet).
[Update: I withdraw maintain been taken to chore past times the accountants alongside my readers for beingness simplistic (and wrong) on the accounting rules, since they are far to a greater extent than complex than what I withdraw maintain described inward this example. I confess to the criminal offense merely I experience no remorse. I scream upward that I am beingness truer to the underlying accounting regulation of matching expenses upward to revenues than the electrical current accounting rules claim to be. My scream for is that accounting has moved grudgingly to withdraw maintain the fact that options withdraw maintain to last expensed when they are granted too non when they are exercised, though the accounting obsessions with smoothing too dorsum filling finds their agency into the rules. In fact, to a greater extent than on that inward my side past times side post]

So, what does this withdraw maintain to do with today's story? While the accounting handling of options changed inward 2006, the taxation handling did not. In effect, the taxation authorities even therefore purpose the pre-2006 convention, non allowing companies to expense options when they are granted merely alone when they are exercised. This creates a disconnect betwixt accounting earnings too taxation earnings, which tin brand valuation to a greater extent than difficult. But is it a loophole? Seems similar it, if you lot alone regard Facebook, which volition salve a billion dollars inward taxes because its options volition last exercised at a fourth dimension when its stock toll is heaven high. But let's add together to this sample of one. Take a fellowship similar Cisco, which has granted hundreds of millions of options over the final decade. Since the stock has stagnated over the period, many of these options are right away nether H2O too volition either halt upward un-exercised or exercised for far less than the value at the fourth dimension of the grant. If Cisco had been able to deduct these options at the fourth dimension they were granted (at alternative value), they would withdraw maintain saved hundreds of millions of dollars, which they may right away volition lose forever, if these options stay nether water. In the aggregate, with the electrical current taxation handling of options, the regime collects less inward taxes from Facebook too to a greater extent than inward taxes from Cisco.  

Do I scream upward that the taxation rules on options should last changed? Perhaps, merely it is non because the taxation police delineate is unfair or because I scream upward it creates a loophole. As I run across it, hither are the 3 choices:

1. Continue with the existing policy of taxing options when they are exercised. The cyberspace lawsuit is that the most successful companies (at to the lowest degree inward terms of creating marketplace value) volition larn bigger taxation deductions from alternative expensing than the to the lowest degree successful companies.
2. Change taxation police delineate to agree accounting police delineate too allow companies to expense options inward the yr that they grant them. It volition smoothen out taxation collections, degree the playing champaign across companies too do to a greater extent than consistency. But hither is the follow upward query that gives me a piffling pause:  Should employees who have the options too therefore withdraw maintain to demo them equally income inward the yr that they have them? If you lot are beingness consistent, the answer is yes, merely where volition they come upward up with the cash to pay the taxes? After all, employee options are non liquid too the employee spell wealthy (in terms of options) may last cash poor.
3. If you lot follow Senator Levin's logic that this is a loophole, too you lot travail to arts and crafts legislation, I am non certain where it leads you. Should nosotros ban the expensing of options past times companies? I would withdraw maintain that, if you lot halt taxing employees who have these options. (If that had been inward house this year, Facebook would withdraw maintain to pay almost a billion to a greater extent than inward taxes merely the regime would last collecting ii billions less inward taxes from Zuckerberg...)

As mortal interested inward valuation, I withdraw maintain wrestled with options too their lawsuit on value for a while. I scream upward that options are mishandled inward many valuations, with flawed arguments (Options are non cash expenses...) too perilous curt cuts (treasury stock too fully diluted value approaches) overwhelming mutual sense. In fact, I wrote a newspaper on the topic that you lot tin download past times clicking here. 

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