Facebook’s 99%: Later employees may pay almost double the tax rate that early employees will

Even Facebook isn’t immune to the “Warren Buffett” problem. The widely-respected billionaire investor has famously said that he pays a lower rate on his taxable income than his secretary. The picture may not look that different at Facebook, once all the taxes are accounted for in the company’s widely-anticipated initial public offering.

Most Facebook employees who joined the company after 2007 will see almost half of their stakes in the company disappear through taxes following the IPO. That’s about twice the tax rate their much richer co-workers, who joined the company earlier, may end up paying on their holdings in Facebook.

While The New York Times and The Financial Times both ran stories over the weekend pointing out that chief executive Mark Zuckerberg will pay between $1.5 and $2 billion in taxes, they’re missing a more interesting story. Zuckerberg will be paying taxes on $5 billion in gains from exercising options. He won’t be paying taxes on his current 28.2% stake in the company until he sells his shares — if he ever does. When he sells, he will pay taxes at something closer to the long-term capital gains rate (likely in the 20 to 25 percent range when you add in state and other miscellaneous taxes for Social Security and Medicare). Add the fact that he’s cutting his annual salary to $1 next year, and that means virtually all of his income should fall under the capital gains rate going forward.

The story is different for most of Facebook’s 3,200 employees. They will see 45 percent of their stakes in the company withheld to pay taxes six months after the IPO, according to the filing.

That’s because most later employees have restricted stock units, not actual shares that they’ve held for more than a year. Those restricted stock units will convert into shares six months after the IPO. At that time, the value of these shares will be taxed at the ordinary income rate — not the much lower long-term capital gains rate. That’s even if they were earned three or four years ago. The relevant part of Facebook’s filing is excerpted below if you want to read it yourself. We’ve also confirmed this interpretation with multiple attorneys, sources who arrange private sales of Facebook shares and founders or executives who have considered adopting RSUs as well.

This is the Silicon Valley version of the Warren Buffett problem — a debate about tax fairness that is embroiling the 2012 presidential race.

“You have employees who have contributed to a company’s success in a similar way. Yet some are taxed on their reward at 15 percent while others are taxed at 35 percent. It is unfair,” said John B. Duncan, who was a corporate attorney for Google after serving as general counsel for Slide. He has structured restricted stock agreements for two companies and is working on a third. “It’s not necessarily restricted stock units, but it’s still the symptom of an unbalanced tax system.”

Duncan adds that Facebook actually gets more of a tax deduction the more its employees earn under ordinary income. But the company gets no such deduction for what its employees take home under capital gains taxes.

“Most Silicon Valley companies have no taxable income so they don’t care, but these late-stage companies may realize a significant benefit off of the pain suffered by their late employees,” Duncan said.

On top of that, if Facebook isn’t careful about how it dumps all of these employee shares on the market to cover taxes six months after the IPO, the stock might decline and the company may have to sell more to cover the taxes. The filing says the company has reserved 378.8 million shares subject to outstanding restricted stock units, including ones that have yet to vest.