Saturday, February 4, 2012

Options and Taxes: Is a "Facebook" tax next?

Facebook is in the news and I will do my usual pre-IPO valuation and posting in a few days on the company but I want to focus in on an interesting story in this morning's New York Times about option exercise and taxation (at both the individual and corporate levels).

The story itself focuses on two tax issues. The first is that Mark Zuckerberg is planning to exercise about $ 5 billion of options ahead of the offering, resulting in a tax bill of roughly $ 2 billion for him, about $1.5 billion in federal taxes and $ 500 million in California taxes.  The second is that Facebook will be claiming a tax deduction of roughly the same value, which will shelter them from taxes this year and allow them to claim tax refunds of about $ 500 million from prior years. All of this has some in Congress in full "indignation" mode, with Senator Carl Levin saying "“When profitable corporations can use the stock option tax deduction to pay zero corporate income taxes for years on end, average taxpayers are forced to pick up the tax burden,” he said. “It isn’t right, and we can’t afford it.” Before we embark on another tax policy change predicated on a sample of one (Facebook), it is worth examining the broader question of how employee options get taxed, especially at the corporate level.

At the moment, if you are a company that grants options to its employees, the accounting laws require you to value those options as options (rather than at exercise value) and expense them when you grant them (though you can amortize these expenses over a period of time). Thus, what you see reported as operating or net income for a company today is after employee options have been expensed. This, of course, is a sharp reversal of accounting policy prior to 2006, when firms had to show only the exercise value of the options at the time of the grant. Since at the time of the grant, employee options were usually at the money (strike price = stock price), this effectively meant that option grants had no effect on earnings when they were granted. However, if and when the options were exercised, companies were required to show the difference between the stock price and the strike price as an expense. 

To illustrate the difference, assume that you grant 100 million options with a strike price of $10, when the stock price is also $ 10, in 2008. Let's also assume that the options get exercised 2 years later when the stock price is $ 40. With pre-2006 accounting, you would not have shown an option expense in 2008 but you would have shown an expense of $ 3 billion [$40 - $10) (100)] in 2010. In the post-2006 time period, the company would have had to show an option expense in 2008, with the expense computed by valuing the options at the time. (For instance, an at-the-money option with five years to expiration on a stock with a price of $ 10 and a standard deviation of 40% would have a value of $3.36. Carrying this through, the company would have to record an expense of $336 million in 2008 and revisit this expense in subsequent years, as stock prices go up or down.  If you want to, you can try your hand at valuing options with the attached spreadsheet).
[Update: I have been taken to task by the accountants among my readers for being simplistic (and wrong) on the accounting rules, since they are far more complex than what I have described in this example. I confess to the crime but I feel no remorse. I think that I am being truer to the underlying accounting principle of matching expenses up to revenues than the current accounting rules claim to be. My point is that accounting has moved grudgingly to accept the fact that options have to be expensed when they are granted and not when they are exercised, though the accounting obsessions with smoothing and back filling finds their way into the rules. In fact, more on that in my next post]

So, what does this have to do with today's story? While the accounting treatment of options changed in 2006, the tax treatment did not. In effect, the tax authorities still use the pre-2006 convention, not allowing companies to expense options when they are granted but only when they are exercised. This creates a disconnect between accounting earnings and tax earnings, which can make valuation more difficult. But is it a loophole? Seems like it, if you only consider Facebook, which will save a billion dollars in taxes because its options will be exercised at a time when its stock price is sky high. But let's add to this sample of one. Take a company like Cisco, which has granted hundreds of millions of options over the last decade. Since the stock has stagnated over the period, many of these options are now under water and will either end up un-exercised or exercised for far less than the value at the time of the grant. If Cisco had been able to deduct these options at the time they were granted (at option value), they would have saved hundreds of millions of dollars, which they may now will lose forever, if these options remain under water. In the aggregate, with the current tax treatment of options, the government collects less in taxes from Facebook and more in taxes from Cisco.  

Do I think that the tax rules on options should be changed? Perhaps, but it is not because the tax law is unfair or because I think it creates a loophole. As I see it, here are the three choices:
  1. Continue with the existing policy of taxing options when they are exercised. The net effect is that the most successful companies (at least in terms of creating market value) will get bigger tax deductions from option expensing than the least successful companies.
  2. Change tax law to match accounting law and allow companies to expense options in the year that they grant them. It will smooth out tax collections, level the playing field across companies and create more consistency. But here is the follow up question that gives me a little pause:  Should employees who receive the options then have to show them as income in the year that they receive them? If you are being consistent, the answer is yes, but where will they come up with the cash to pay the taxes? After all, employee options are not liquid and the employee while wealthy (in terms of options) may be cash poor.
  3. If you follow Senator Levin's logic that this is a loophole, and you try to craft legislation, I am not sure where it leads you. Should we ban the expensing of options by companies? I would accept that, if you stop taxing employees who receive these options. (If that had been in place this year, Facebook would have to pay about a billion more in taxes but the government would be collecting two billions less in taxes from Zuckerberg...)
As someone interested in valuation, I have wrestled with options and their effect on value for a while. I think that options are mishandled in many valuations, with flawed arguments (Options are non cash expenses...) and perilous short cuts (treasury stock and fully diluted value approaches) overwhelming common sense. In fact, I wrote a paper on the topic that you can download by clicking here


Anonymous said...

Very confusing article. One glaring problem is that you fail to distinguish the accounting and tax treatments for the two primary types of options .... ISOs and NQSOs.

Anonymous said...

An interesting topic but the description of the accounting impact is either incorrect or confusing.
From the Famous French Accountant.

Anonymous said...

so the current tax treatment makes good times better and bad times worse for betas are higher and idiosyncratic returns are pulled from a more volatile distribution.

However, it seems like companies would like to pay out more options under a countercyclical tax policy, possibly increasing the company's risk.

These forces seem to work in opposite directions- a pro-cyclical tax treatment of options could be offset by less use of options, making the net effect on firm risk uncertain...

Aswath Damodaran said...

You are right. The accounting treatment is more complex than what I have described and I largely chose not to go down that path, because a discussion of FASB 123 or its international analog would have sucked the energy out of this discussion, which is really about the tax treatment. However, my point is that the accounting treatment of options now reflects the expensing when granted convention, rather than expensing when exercised.
As for the accounting treatment making earnings more volatile and betas higher, accounting rules cannot make firms safer or riskier. They can either reflect the true riskiness or not. Now, they do, whereas prior to 2006, they did not.

Anonymous said...

No need for a big accounting discussion - you just got the older treatment wrong. There were 2 parts to your post:
1. Accounting at the grant: no expense recorded (because of options granted at the money). This was correct.
2. Accounting at exercise: you claimed the firm recognized an expense. They didn't. They never recognized any expense at the grant date, during the vesting period, or at exercise.

It's now fixed, and the expense shows up properly in the period in which the employees earn that compensation (during the vesting period).

Aswath Damodaran said...

While it is true that they did not have to record an explicit expense, they had to show the effect on their book value of equity. Thus, it had the same impact (though it was clearly not transparent) as recording an expense, reporting a loss and reducing your book value of equity. In fact, that was the other problem I had with pre-2006 accounting; the way in which firms reported the effects of exercise varied widely and you had to be a detective to find out what happened.

Anonymous said...

Isn't Levin completely wrong about the government not getting their little mitts on the tax income? Yes, Facebook gets the deduction, but Zuckerberg IS paying the taxes on those options. The Fed gov gets paid either way - in fact, at a higher tax rate as well.

I don't understand what Levin is whining about. Does he want to make Facebook AND Zuck pay taxes on the same options?

TQS said...

The current tax treatment of options is no more a loophole than the current tax treatment of salaries and wages. In both cases, the company has an expense that reduces taxable income, while the employee has income that is taxable.

It is only the magnitude of this sample of one (Facebook and Zuckerburg) that Senator Levin (and others) finds appalling. But his opposition to this state of affairs only demonstrates his ignorance. By his logic, all employee pay expenses, including wages for the rank and file, deducted by corporations are a "loophole" and should be eliminated.

Either Levin is an uninformed idiot (entirely possible) or he is being purposely divisive and populist to score political points. I'm not sure which is worse.

If he wanted to attack a real tax loophole, he should go after the tax treatment of health insurance benefits. In the case of health insurance, the company deducts the expense, but the value of the benefit is not taxable to the employee. Now that is a real loophole! The proper reform would be to make the value of health insurance provided by companies taxable to the employee. When do you think we can expect the good Senator to take up this cause?

Valuee Investor Team. said...

I agree with TQS here , and I just had one more thing to add. Because taxes are recognized when options are granted Facebook/ Zuckerburg will end up paying more taxes , while on the other side where Cisco granted options which would never be exercised Govt would not get their hands on any money. Which also means probably that Cisco might have taken higher tax deductions in earlier years which it would have to reverse ( Need to check that out ), and overstated earnings.

Accounting guy 1 said...

I'm the Anonymous @2/5 7:16.

First, I apologize for bogging down your very good blog (seriously!) on accounting issues. But I think this is an important topic and you're still giving a bad impression of the former rules.

The former rules never showed any compensation ever. Not at grant date, not during the service period, and not at exercise. So it's not a matter of smoothing or timing issues. It's a matter of the expense never being recognized in any period in any form.

Saying that the effect showed up in book value is true, but isn't helpful. That's because Book Value is the aggregate of Retained Earnings (equity generated by firm performance) and Contributed Capital (equity generated by shareholder contributions). The old rules overstate performance-related equity value (by not ever including the value in compensation expense) and understated contribution-related equity value (what the employees contributed in return for getting those options). Thus, if you're measuring the performance of the firm based on changes in total book value, you run into a Beardstown Ladies type problem that conflates shareholder contribution with firm performance.

Worth noting is that the same is still true for convertible debt. GAAP understates the financing cost of issuing convertible debt because it doesn't recognize the expected loss in value upon conversion.

Aswath Damodaran said...

Accounting guy,
You are absolutely right and I did not mean to blow over your comments. In fact, I think that you are making a case that the accounting treatment of options prior to 2006 was not only inconsistent but also opaque, where investors really did not get an explicit bill for all of these options that were handed out to management. This, in turn, allowed boards to abandon their fiduciary responsibilities and be profligate with options and tech investors paid the price eventually.

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farm land investment said...

Even apart from the accounting treatment of options, the fact remains that Facebook will be a terrible investment post-IPO, especially at 100 billion valuation. As a Brit living in the States, I've never quite understood the fascination with Facebook. I also think that all of the value has pretty much already been sucked out of Facebook as a privately held company, as there does not seem to be much more upside with a 100 billion valuation. Compare this to when Google went public in 2004, where the upside was tremendous.

Swami said...

Excellent blog for even an non-management person like me.

What would be your unbiased rationale on Zuckeberg exercising his options?

a)Increase the expenses, resulting in lesser corporate tax but wouldnt that result in lesser profit, lesser profit sharing with employees and stock holders (if they choose to offer dividends)? OR
b)Help US/California economy by cutting a 2Bil tax cheque OR
c)Expects facebook to tank (not exactly but somewhat like groupon) and wants to cash out before FB2K.

Aswath Damodaran said...

Maybe, he is building a $ 2 billion home...

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It seems very unusual for a company to continue to go about issuing large amounts of additional shares of stock once the company has gone public.

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