Today's Times includes an article that describes how Facebook will recognize a huge tax benefit when Mark Zuckerberg exercises some options later this year in advance of the company's IPO. When the options are exercised, the company gets a deduction equal to the spread between the fair market value of the stock received by Zuckerberg and the low exercise price he pays. The value of this deduction in the form of tax reduction is roughly equal to 35 percent (the corporate tax rate) of this spread. There has been some recent uproar over this result because the company gets the huge deduction without laying out any cash. But what this uproar seems to neglect is that Zuckerberg pays ordinary income tax on the same spread at the same time, plus employment taxes, resulting in a 37.9 percent tax liability. So, the option exercise is a net winner for the government. (This is not to say that the current taxation of options is perfect; option grants are tax-advantaged, but the analysis is much more nuanced and the advantage much smaller than the uproar has suggested.)
On the other hand, when Zuckerberg sells his founders' stock (the stock he received very early on), he will recognize capital gains (taxable at 15%) and the company will get no deductions at all. This prospect has also created some uproar, as much of the gains can be attributed to Zuckerberg's labor. But, on a net basis, Zuckerberg's receiving founders' stock instead of more options will have made the government lots of money because Zuckerberg will pay a bunch of tax and the company will not get any tax benefit.
The problem with the uproar in both cases is that it focuses only on one side of the transaction. But, that's wrong when the transaction has a tax impact on both sides of the transaction. Viewed from the company's perspective, options look like a huge tax windfall relative to founders' stock; viewed from the founder's perspective, founders' stock looks like a huge windfall relative to options. What should be clear (I hope) is that they can't both be huge windfalls.
Brant Hellwig and I have a piece coming out in the Iowa Law Review that compares the tax consequences of issuing founders' options versus founders' stock. In some cases (like Facebook), options are better; in other cases where the company's loss utilization is much slower, founders' stock is better. In either case, the story is a lot more complicated than it appears if you look only at one side of the transaction.
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