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Are Facebook’s $3.2 billion in tax deductions a real business expense?

With Facebook stock selling at $28.32 a share as of the most recent market close, about $10 below its IPO price last year, its earliest public investors are still sitting on a losing proposition. The earliest private investors, on the other hand, are doing fairly well. An analysis last week of Facebook’s most recent SEC filing by Citizens from Tax Justice showed the IPO allowed the company to collect corporate income-tax deductions worth just over $1 billion last year and another $2.17 billion over the next 15 years, and earn a net income-tax refund of $429 million for 2012.

Facebook can claim these deductions because of how it uses stock to pay its employees. When companies pay executives in stock options, they record the options’ present value on the books. Later, when employees exercise the option to buy the stock, it has often increased in value. The employees record this difference as income, and the company gets to deduct it from its tax bill as a labor cost. Deducting employee stock options and carrying forward the tax savings is used by blue-chip companies from GE to Goldman Sachs to avoid tax obligations, and options are favored as compensation by high-risk tech start-ups to attract talent.

Facebook, for example, issued 187 million stock options to its management team before its IPO, mostly to founder and CEO Mark Zuckerberg, and also issued “restricted stock units” (RSUs) to many of its employees. (An RSU is like a stock option, but whereas an option gives an employee the right to buy shares at a certain price after a certain date, an RSU converts automatically into shares on that date; the two are taxed differently.) Both of these were exercised in 2012, as the company went public.  All this created $1.03 billion in US tax benefits in 2012, compared to the $441 million the company set aside to pay its global tax bill last year.

The argument for the tax break is that companies are paying their employees more when stock options increase in value, and that since paying employees is a cost of doing business, this should be deductible like any other expense. But it’s not clear that makes sense, especially to the corporate watchdogs at CTJ. The company isn’t actually increasing real expenses, after all; it’s not paying its employees more cash. (Conversely, it won’t save money if the stock’s price falls below that of the options when they’re exercised.) Similarly, RSUs aren’t based on price, but are simply awarded at an agreed-upon time, without a change in the company’s expenses.

Facebook wouldn’t comment on the record, but its defenders note that the company paid significant amounts of money—just not corporate income tax—to the US government last year, particularly when the RSUs vested as part of the IPO. However, that’s a side-issue. That cash was raised by withholding stock from employeesit’s their money, not the company’s, that’s being taxed. Facebook has undoubtedly created revenue for the US government by paying its employees, but that’s a separate question from its corporate obligations.

Since 2004, companies have been required to deduct the difference between the option price and the stock price from the earnings they report to investors. However, companies consistently report higher profits to investors than to the IRS, underestimating stock increases. US Senator Carl Levin is pushing legislation that would force companies to use the same estimates for their books and tax reporting, in an effort to avoid some $12 to $60 billion excess deductions taken by US corporations every year.

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