Facebook’s amazing disappearing tax trick

A funny thing happened during Facebook’s IPO.

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A company that looked like a model corporate citizen, paying high tax rates for its pre-IPO years of 2010 and 2011, suddenly turned into one of those giant corporations that pay no tax at all.

Writing about Facebook’s S-1 a year ago, Benchmark Capital’s Bill Gurley wrote, “Warren Buffet’s secretary would be happy. Facebook’s tax rate is already north of 40 percent. Other multinational companies typically have found a way to reduce this. Facebook is paying full-boat.”

There are some ambiguities to computing the effective tax rate for a corporation, so let’s put it in terms of actual dollars. In the S-1 filing, Facebook reported that it was setting aside $695 million for taxes in 2011 and $402 million for taxes in 2010.

How quickly things have changed. In Facebook’s most recent 10-K annual filing, the company revealed that it’s receiving tax refunds of $429 million for the 2012 fiscal year.

But it doesn’t stop there: The company is receiving an additional $451 million credit for “carrybacks” on the taxes it paid for 2010 and 2011, which means it’s getting a retroactive tax benefit against the taxes it paid in those years.

And Facebook will be carrying forward an additional $2.17 billion in tax credits for use in future years.

The upshot: Despite generating $1.1 billion in profits in 2012, the company is not paying any federal or state taxes this year, according to Citizens for Tax Justice, and it has cut its tax bill for the past two years by about 40 percent — retroactively.

“They probably won’t be paying taxes for several years to come,” Robert McIntyre, the director of CTJ, told me.

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The CTJ is a nonprofit advocacy group, which clearly has an agenda in favor of tax fairness, by which it means getting corporations (and perhaps wealthy people) to pay more taxes.

Based on the experts I talked with, corporate tax is a complex issue, so this isn’t exactly a black-and-white issue. There are a lot of ways to slice up a financial report, and the categories used for a 10K don’t correspond with those used for federal taxes, so confusion abounds. CTJ is not alleging that Facebook is doing anything illegal — far from it.

“It’s legal as hell,” McIntyre said.

The question is whether this kind of tax dodge is fair, or ethical, especially in a country that’s struggling to come up with the money to pay for basic things like education.

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You can read the CTJ’s report on Facebook’s taxes here (PDF file).

So how did Facebook manage it? Simple: By issuing restricted stock units (RSU) instead of incentive stock options (ISOs).

With ISOs, which were more common in the past, employees don’t pay any taxes when they exercise the options (buying the stock at the option price). Instead, they pay long-term capital gains taxes when they finally sell the stock, assuming they’ve held it long enough. That’s nice for the employee, because the capital gains tax rate in the U.S. maxes out at 15 percent, compared with a top tax rate of 35 percent for normal income in 2012 and 36.9 percent in 2013.

RSUs and nonqualified stock options, which have been the predominant type of option for the past 10 or 15 years, put the tax burden on the employee receiving them. Any increase in value from the option price counts toward the employee’s income for that year — and will be taxed as income, not capital gains.

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However, the nonqualified route enables the company granting the options to take a tax deduction equal to the amount of additional income that the employee must declare.

In other words, Facebook isn’t exactly cheating the government out of $429 million in taxes for 2012; it’s just transferring that tax burden to its employees (now presumably much wealthier thanks to all that Facebook stock they own).

A Facebook spokesperson made the same point in an email to me today: “Billions of dollars went to the U.S. treasury and to the California state treasury, as well it should have. It’s fairly typical for a company in the period after an IPO to have most of its taxes collected this way, while not having a large corporate tax burden. … It’s a mistake to look only at the corporate tax revenue while ignoring the billions in taxes paid from the initial shareholders.”

This is one reason Facebook founder Mark Zuckerberg sold 30.2 billion shares on IPO day, netting him an estimated $1 billion. Most of that money, Facebook’s S-1 said, would be going to pay his tax bill — taxes Zuck would have incurred as he came into ownership of his Facebook stock.

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On the other hand, Facebook got a huge deduction for granting those stock options — a deduction that cost them absolutely nothing. It’s a common move in the tech industry, but one that McIntyre, and others, feel is unfair.

Many Facebook employees are probably facing a similar situation as Zuck did, albeit on a smaller scale. If they want to exercise their options and turn them into Facebook stock, they’ll have to sell some of that stock in order to pay for the taxes they’re about to owe. (And by doing so, they’ll be helping contribute to the company’s tax deductions.)

I suspect, however, that plenty of tax lawyers out there could help them reduce their tax bill.

Perhaps Facebook’s corporate finance department could make an introduction, as they’ve clearly mastered the art.

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Correction 3:30pm Pacific: Facebook issued its employees restricted stock units, not nonqualified stock options, as I wrote earlier. The tax implications are the same, however — both count towards the employees’ income, not capital gains, and are deductible by the corporation issuing them.

Top image via Francis Luu/Facebook