Meanwhile, some of Silicon Valley’s richest and best-known companies are avoiding income taxes by taking deductions related to stock options used to compensate executives. Twitter, which went public on Thursday, is one of them.
Last April we detailed how tech companies park cash overseas to avoid taxes, and now a new report from the Center for Tax Justice shows that a dozen emerging tech companies have stockpiled enough unused stock option tax credits to avoid paying income taxes on the next $11.4 billion of U.S income they (collectively) earn.
This means that Uncle Sam will miss out on a combined $4 billion in tax revenue from these 12 companies, which also include Facebook, LinkedIn, and Priceline.
A IPO gift from Uncle Sam
Twitter’s IPO will earn the company about $1.8 billion, by most accounts, putting the total estimated value of the company at about $18.3 billion. Twitter, says the CTJ, is now holding $107 million of unused stock option deductions, which means that it won’t have to pay taxes on the next $107 million of earned profits.
A little present from the IRS to ease Twitter’s transition into “public” life? Maybe. Twitter will now have to start reporting its profits every month, but at least the company won’t have to cough up income taxes on the first $107 million in profits it reports.
Twitter has some experience with tax breaks. It took a substantial payroll tax break from the city of San Francisco to keep its operations based in the downtown area.
Twitter is one of a wave of new tech companies awash in VC cash flocking to set up shop in San Francisco. Their arrival has sent housing prices and general cost-of-living spinning out of control in the City by the Bay. So while the city’s apartment owners, health clubs, Whole Foods Markets, and dog walking services are benefitting from the arrival of the new wealth, Uncle Sam may miss out on his cut.
How the deduction works
Young tech companies often compensate employees by selling them stock options at bargain rates. As the company reaches maturity, employees will “execute,” or sell, the options at a rate far higher than they paid for them. The federal government allows corporations to take a tax deduction for the difference between the value of the stock when granted to the employee, and the price of the stock when the employee finally sells it.
The CTJ argues that the beneficiaries of the deduction haven’t really done anything to deserve it. While it costs a company something to pay employees real money, there isn’t much cost in paying employees on paper.
Says the CTJ’s report, “Unlike the wages earned by most employees, the stock options granted to executives don’t result in a dollar-for-dollar cash outlay by corporations – so the case for allowing companies to deduct stock option ‘expense’ as a cost of doing business is weak.”
Some in Washington agree. Senator John McCain (R-AZ) and Senator Carl Levin (D-MI) said this in a statement Wednesday:
“Nowhere else in the tax code can compensation costs produce a tax deduction several times larger than that same expense shown on its corporate books.
“For example, when Twitter goes public later this week, the company may avail itself of this existing tax loophole. Under this loophole, the company will be able to take an estimated $154 million tax deduction for a stock option compensation expense which its own books show cost Twitter only $7 million.
“Given the deficit and damaging sequester cuts facing this country, this corporate stock option tax deduction is the kind of tax loophole that ought to be closed.”
Facebook was among the first to realise the huge benefits of exploiting the options deductions.
The company created more than 1000 new millionaires (some of them many times over) when it held its IPO in 2012. That wealth was created when employees exercised stock options they took as compensation from Facebook earlier in the company’s life.
So while Facebook reported profits of $1.1 billion during 2012, the $1 billion in option compensation deductions the company had stored up, along with some other deductions, allowed it to pay effectively no income tax at all for the year, and even receive $429 million in refunds.
And, as the CTJ report points out, Facebook still has $2.17 billion in unused tax breaks for offsetting future income. At the 35 percent federal tax rate, this means the company’s next $6.2 billion in U.S. earnings could be tax free.
Amazon won big, too
The CTJ says Amazon has also benefitted hugely from the deduction in past years. Amazon was able to reduce its federal and state income taxes by $750 million between 2010 and 2012.
“The company’s combined federal and state effective tax rate over this period was just 9.4 percent; minus the stock option tax break, the combined tax rate would have been 40.4 percent,” the report says.
The fun continues
CTJ says LinkedIn can use the stock option tax break to eliminate income tax on the next $571 million it earns. This could remove LinkedIn’s taxes for the next 10 years.
The cloud-computing company NetApp holds $484 million in unused deductions for stock options. At its current profit levels, the company could pay no income taxes for more than two years.
The travel website Priceline discloses having $900 million of unused stock option deductions, meaning that the next $900 million the company earns could be tax-free. Since Priceline’s U.S. income averages $119 million a year, the company might end up paying no income taxes for the next nine years.
Other companies profiled in the CTJ report include 3D Systems, Cirrus Logic, Rackspace Hosting, Salesforce.com, Verisign, WebMD, and Zynga.
Economists fear that if the U.S. does not begin to manage deficits and pay down the debt, its credit rating could tumble, or – God forbid – it could default on its loans. This would be calamitous, on the scale of the Great Depression, or worse.
To control the deficit, the government needs to both control spending and maximize tax revenues. It needs to ensure that everyone, from individuals to large corporations, pays their fair share.
Let the (public and transparent) debate continue over what those “fair shares” really are, but in the financial straits the country is in, there’s just no more time to tolerate loopholes that give relief to those who don’t need it.