America’s economy continues to sputter. But stocks are picking up steam and flirting with four-year highs. We’re even seeing new “dot-coms” hitting the market. Last May, the social networking site LinkedIn went public at $45 per share, then leaped to $94.25 in its first day of trading. Internet coupon vendor Groupon opened in November at $20 per share, then jumped 31% on its first day of trading. And earlier this month, Facebook filed registration papers with the Securities and Exchange Commission for what may be the hottest IPO since Google.
Companies typically go public to raise money to expand. But Facebook doesn’t really need cash from an IPO. The company made nearly $4 billion in advertising revenue in 2011. So why go public?
Well, companies also go public to let founders and early investors cash out. Mark Zuckerberg, Facebook’s 27-year-old founder, is already a “paper” billionaire, ranked #14 on the Forbes 400list of richest Americans. (Not many entreprenuers find themselves richer than Scrooge McDuck while still at an age that they watch Scrooge McDuck.) But Facebook’s IPO will give Zuckerberg and fellow early investors liquidity, converting paper wealth into cash for the houses, charitable gifts, and other spending that new dot-com millionaires historically indulge in.
The IPO will also stick Zuckerberg with a historically large tax bill. (You knew that was coming, right?) In fact, one of the big reasons the company is going public in the first place is give Zuckerberg a way to pay taxes when he exercises options to buy even more stock.
Here’s how it works. For tax purposes, the value of most stock options is treated as compensation and fixed the day you exercise them — whether you actually sell them or not. Let’s say you pay $5 to exercise a share of your employer’s stock, on a day when that stock is worth $25. Your company gets a deduction for that $20 per share, even though there’s no cash outlay. That’s great for the company. But at the same time, you’ll owe immediate tax on $20 of income, even if you hold the stock in hope of future appreciation. (If the stock tanks before you actually sell, you still owe tax on that gain.) That may not be so great for you!
Zuckerberg currently owns 414 million shares of Facebook. He also has options to buy another 120 million shares for — get this — just six cents each. Zuckerberg has announced plans to exercise those options and sell enough shares to cover his taxes. We don’t know yet what Facebook shares will trade for. However, private-market trades have valued shares at $40 each. If Zuckerberg exercises all 120 million options when shares are valued at that price, his taxable gain will be nearly $5 billion. He’ll owe 35% to the IRS, plus 10.3% to the state of California, for a total tax bill of over $2 billion. That’s right, billion with a “b.” Can you imagine signing a return with a billion-dollar tax bill? How about signing a check for that much — payable to the IRS!
The important thing to realize here is that Zuckerberg’s tax bill came as no surprise. It’s actually the result of careful planning. Remember, Zuckerberg’s pain is Facebook’s gain. The strategy will probably give Facebook enough deductions to wipe out the entire tax on its 2011 profit, plus refunds from 2009 and 2010, plus even more to carry forward.
Think about that the next time you click the “Like” button on your computer. And remember, we’re here to bring the same sort of smart tax planning to your business.