Facebook announced last week that it plans to use cash to pay off a $1.9 billion tax bill related to Restricted Stock Units ( R.S.U.s) that Facebook had granted to employees over the years. It's odd timing for a tax bill. Why would Facebook, not the employees, owe tax on compensation income?
The short answer is that Facebook isn't really paying tax. It's just remitting the tax on behalf of the employees.
Restricted Stock Units are a form of equity compensation similar to restricted stock. Instead of giving the employees stock, Facebook made a contractually binding promise to give them shares later, after the I.P.O. Facebook is now “net settling†the R.S.U.s by withholding the amount of tax due at an estimated combined federal and state tax rate of 45 percent. Still, because the Internal Revenue Service doesn't accept payment in stock certificates, Facebook has to come up with almost $2 billion in cash. Paying the I.R.S. in cash, instead of selling new sha res, allows Facebook to reduce the number of fully diluted shares on its financial statements. In turn, this might buck up its sagging stock price, much like a stock buy-back would.
The colossal tax bill can be traced back to Mark Zuckerberg's desire to keep Facebook from becoming a public company. If Facebook had issued traditional restricted stock, the employees' tax bill would have been smaller, and it would have been paid a long time ago. But Facebook would have been forced to go public earlier.
Restricted stock became popular in Silicon Valley after an accounting change in 2004 required companies to treat stock options as a compensation expense. To keep accounting income looking healthy, some companies began issuing restricted stock, which minimizes share dilution and spreads the compensation expense over the vesting period of the stock. Restricted stock gives employees the economic incentives of a stockholder, but employees cannot sell the stock until the y meet years of service requirements or performance hurdles.
Restricted stock also gives employees a great tax advantage. When employees receive restricted stock, they may choose to take the current value of the stock into income by making a special “section 83(b)†tax election. Accelerating ordinary income with an 83(b) election can be risky, as there is no guarantee that the stock will appreciate in value, and it is generally preferable to defer paying taxes as long as possible. Indeed, public company executives often do not make the election. But for employees of start-ups, the election is routine for one simple reason: any appreciation in the stock is taxed at the lower long-term capital gains rate of 15 percent.
To illustrate, suppose Max, a hotshot software engineer, received 100,000 restricted shares of Facebook stock at $1 per share in 2007. Thinking ahead, he made an 83(b) election and recognized $100,000 of taxable income immediately. Accelerating taxable income is usually a bad idea, but this is the exception to the rule. When Max sells those shares at $20 a share in 2012, the appreciation would be taxed at the long-term capital gains rate of 15 percent. He would walk away with $1.67 million ($2 million minus $45,000 tax paid in 2008 and $285,000 tax paid in 2012).
The problem with restricted stock was that Facebook wanted to delay becoming a public company. Under the securities rules in force at the time, if Facebook had 500 or more shareholders, including all those software engineers, it would been forced to comply with the Securities and Exchange Commission's disclosure requirements for public companies even before it conducted an I.P.O.
Facebook instead issued R.S.U.s, which give employees the economics of an equity interest in the company without the actual shares. The R.S.U.s contained both a vesting restriction and a liquidity restriction, meaning that the actual shares would not be issued unti l a liquidity event occurred, like an I.P.O. or getting acquired by a public company. An S.E.C, No-Action letter allowed Facebook to issue R.S.U.s without counting the recipients as shareholders for purposes of the 500 shareholder rule.
The R.S.U. plan was a clever workaround of the securities laws, but it left the Facebook employees with a tax problem. Because the R.S.U.s are not “property†for tax purposes-merely a promise to pay shares later-the employees could not make an 83(b) election to get capital gains treatment on any appreciation. So Max, our hypothetical software engineer, will actually receive $1.1 million-$2 million less $900,000 in taxes-or about half a million less than if he had received restricted stock and made the 83(b) election.
This adverse tax treatment might create a sense of inequity among Facebook employees. Founders pay tax at capital gains rates, while employees, subject to the same market risk on their equity compensation, pay tax at ordinary income rates. On the other hand, it's possible that savvy software engineers negotiate pay on an after-tax basis; perhaps Facebook had to grant more R.S.U.s to reflect the greater tax hit to the employees.
Indeed, Facebook probably should have granted more R.S.U.s, as it gets the benefit of a much larger tax deduction than if it had issued restricted stock. Facebook will take a tax deduction equal to the amount that the employees take into income-in this case, almost $2 billion. At Facebook's 35 percent tax rate, that deduction is worth about $700 million.
R.S.U.s don't create a serious tax policy problem. Facebook gets a large deduction, but employees pay higher taxes. For the I.R.S., it's a wash, just as it would be with restricted stock.
The interesting question is whether R.S.U.s confuse investors. Because the R.S.U.s create an issuance of shares only after a liquidity event - in this case, six months after the I.P.O. - Facebook will suddenly recognize a huge share-based compensation expense on their income statement.
This strikes me as an odd result from an accounting perspective; it's as if Facebook were paying compensation for all their employees' work now, as opposed to spreading the expense over time. Facebook's best hope is that as a one-time expense, investors will shrug off the R.S.U.s and focus on how the actual business is doing. Facebook's chief financial officer has enough to worry about.
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For further reading on the tax and accounting treatment of stock-based compensation, see David Walker and Victor Fleischer, “Book/Tax Conformity and Equity Compensation,†62 Tax Law Review 399 (2009); Michael S. Knoll, “The Section 83(b) Election for Restricted Stock: A Joint Tax Perspective,†59 SMU Law Review 721 (2006).
“For further reading on changes to the 500 shareholder limit, see Michael D. Guttentag, “Patching a Hole in the JOBS Act: How an d Why to Rewrite the Rules that Require Firms to Make Periodic Disclosures“, Indiana Law Journal (forthcoming); Donald C. Langevoort & Robert Thompson, †‘Publicness' in Contemporary Securities Regulation after the JOBS Act,†Georgetown Law Journal (forthcoming).
Victor Fleischer is a professor at the University of Colorado Law School, where he teaches partnership tax, tax policy and deals. His research focuses on how tax affects the structuring of venture capital, private equity, and corporate transactions.
