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.

Most of these later employees — including the 2,000 or so that were hired in the last two years — are not the graffiti artists with $200 million of stock The New York Times likes to write about. If you look at Quora’s boards around late 2009 when the company had about 1,200 employees, you’ll see that Facebook was offering around 10 to 15,000 RSUs for entry-level engineering talent. That’s about $400,000 to $600,000 worth of stock at the $40 price Facebook shares went for in a private auction last week. [Update: A helpful reader reminds me that there was a 5-to-1 stock split back in 2010, so this actually represents $2 to $3 million as last week’s share price.] Still, if Facebook went public in the middle of this year, close to half of that would still have to be vested and then almost half of what’s remaining would go toward taxes, leaving them with around $687,500 to $1 million. The other thing to take into account is that there are big equity drop-offs between employees who join the company at different times — a standard practice to reward the earliest employees who take the most risk. So the number of restricted stock units Facebook offers has also declined over the past two years as secondary markets have priced in the value of the shares.

Restricted stock units also behave differently in one other important way: they cannot be traded. So only early employees and investors who hold real shares have been able to participate in the secondary markets that have cropped up over the last few years. Facebook also instituted an insider trading policy in 2010 that banned current employees from selling shares.

The rise of restricted stock units

While nobody’s feeling sorry for Facebook employees, this is an issue that affects many late-stage or recently IPO-ed companies in the technology industry. There are thousands of employees who hold restricted stock units in companies like Groupon and Zynga.

Restricted stock units became popular over the last few years as more Silicon Valley technology companies chose to delay their initial public offerings. To do that, they needed to get around a Great Depression-era Securities and Exchange Commission rule that was originally designed to protect people from making bad investments in privately-held companies they couldn’t get accurate information about. The 1934 act that established the SEC said that companies with more than 500 shareholders needed to start divulging details about their financial performance.

But most late-stage companies don’t want to share such sensitive information if they remain private. So to keep the official shareholder count low while still allowing employees to enjoy upside, companies like Facebook began issuing restricted stock units. The downside is that they’re taxed like ordinary income.

Weighing restricted stock units against options

Facebook didn’t intentionally stick its later employees with these higher rates. One of the main reasons the company is even going for an IPO is to fulfill a pledge to employees, Zuckerberg said in his letter to shareholders.

“We’re going public for our employees and our investors,” he wrote in the company’s IPO filing. “We made a commitment to them when we gave them equity that we’d work hard to make it worth a lot and make it liquid, and this IPO is fulfilling our commitment.”

Zuckerberg just wanted a way build a business for the long-term without the distraction of public ownership. The tax issue is a side effect. In fact, if Facebook had relied more on options instead of restricted stock units, a similarly regressive tax scenario might have emerged anyway. The downside of options is that employees have to spend money to exercise them. In theory, employees can do this whenever it’s economically convenient. But in practice, later employees often hold off because they can’t afford to exercise them right away. They also might not want to risk tens or hundreds of thousands of dollars until they’re sure the stock is worth a lot more during an event like an acquisition or an IPO. That can stick them with the higher tax bill if they haven’t held the shares long enough to qualify for the capital gains rate.

Options have also fallen slightly out of favor over the last 10 years as accounting law tightened around how to value shares in privately-held companies. For companies with strong valuations, the strike price on options can end up being quite high, diminishing their upside to employees. Ultimately, it’s difficult to say whether Facebook’s employees would have done better financially if they were issued options or restricted stock units — all taxes considered.

What this means is that it’s hard to avoid ending up with a regressive tax situation on equity-based compensation in late-stage companies. It would be hard to change it too, given the complicated tangle of laws around incentivized options, non-qualified stock options, stock grants and restricted stock units.

Nobody would ever propose taxing founders more, either. They provide so much of the value that makes Silicon Valley tick. Facebook employees are lucky to have joined the one big winner of the last several years out of thousands of failed startups. And yet, they will probably end up paying a higher tax rate on their much smaller portions of equity than the company’s founders, early investors and early employees will.

“You can’t possibly come up with a better example than Zuckerberg. It’s $28 billion and he will probably get the absolute best tax treatment out of anyone in his company,” said Antone Johnson, who was eHarmony’s vice president of legal affairs before starting his own law firm serving early-stage companies like Gogobot on their legal needs.

After this most recent class of companies — Groupon, Zynga and Facebook — which all used RSUs, we’re starting to see some companies push back. Mobile payments company Square doesn’t plan to offer restricted stock units and instead will go with standard options, according to sources familiar with the matter.

If other companies in the $1 billion valuation-club follow suit, we might see a resurgence of Silicon Valley’s once-favored form of compensation.

Here’s the excerpt from Facebook’s filing (some of the bolding is mine):

We anticipate that we will expend substantial funds in connection with the tax liabilities that arise upon the initial settlement of RSUs following our initial public offering and the manner in which we fund that expenditure may have an adverse effect.

We anticipate that we will expend substantial funds to satisfy tax withholding and remittance obligations on a date approximately six months following our initial public offering, when we will settle a portion of our RSUs granted prior to January 1, 2011 (Pre-2011 RSUs). On the settlement date, we plan to withhold and remit income taxes at applicable minimum statutory rates based on the then-current value of the underlying shares. We currently expect that the average of these withholding tax rates will be approximately 45%. If the price of our common stock at the time of settlement were equal to the midpoint of the price range on the cover page of this prospectus, we estimate that this tax obligation would be approximately $ billion in the aggregate. The amount of this obligation could be higher or lower, depending on the price of our shares on the RSU settlement date. To settle these RSUs, assuming a 45% tax withholding rate, we anticipate that we will net settle the awards by delivering approximately shares of Class B common stock to RSU holders and simultaneously withholding approximately shares of Class B common stock. In connection with this net settlement we will withhold and remit the tax liabilities on behalf of the RSU holders in cash to the applicable tax authorities.

To fund the withholding and remittance obligation, we expect to sell equity securities near the settlement date in an amount that is substantially equivalent to the number of shares of common stock that we withhold in connection with the initial settlement of the Pre-2011 RSUs, such that the newly issued shares should not be dilutive. However, in the event that we issue equity securities, we cannot assure you that we will be able to successfully match the proceeds to the amount of this tax liability. In addition, any such equity financing could result in a decline in our stock price. If we elect not to fully fund our withholding and remittance obligations through the issuance of equity or we are unable to complete such an offering due to market conditions or otherwise, we may choose to borrow funds from our credit facility, use a substantial portion of our existing cash, or rely upon a combination of these alternatives. In the event that we elect to satisfy our withholding and remittance obligations in whole or in part by drawing on our credit facility, our interest expense and principal repayment requirements could increase significantly, which could have an adverse effect on our financial results.