Facebook employees face $4 billion tax bite

@CNNMoneyTech May 9, 2012: 5:39 AM ET
Facebook employees with rich equity stakes will face multi-million-dollar tax bills after Facebook's IPO -- even if they don't sell a single share.

Facebook employees with rich equity stakes will face multi-million-dollar tax bills after Facebook's IPO -- even if they don't sell a single share.

NEW YORK (CNNMoney) -- Facebook founder Mark Zuckerberg won't be the only one collecting billions from Facebook's initial public offering: Uncle Sam and the state of California are also poised to cash in big.

Tax collectors will be taking a giant bite out of the paper millions that thousands of Facebook employees will soon gain. The average tax hit: $1.1 million per employee.

That's a very rough estimate, based on Facebook's roster of just over 3,500 employees and its recent disclosure that it plans to set aside an eye-popping $4 billion to cover tax bills this year. For many employees, taxes will consume around 45% of their sudden wealth, Facebook said in its latest regulatory filing.

It's a tax whack that experts say is unprecedented in both its timing and its scale.

"It's virtually unheard of to have all these taxes due all at once," says Sam Hamadeh, an attorney and the founder of private company research firm PrivCo.

Tech companies, even those not yet public, traditionally reward their employees with stock grants or options that vest over time. That means that employees come into their wealth gradually, on a staggered schedule.

But Facebook pioneered a new form of employee equity using "restricted stock units" (RSUs) that don't turn into actual stock until there's a "liquidity event" -- in this case, the company's IPO.

Facebook's goal was to stay below a legal limit on how many shareholders a company can have before it's required to publicly report its financial results. The tactic worked.

The SEC gave its blessing to Facebook's approach, which was then copied by two other buzzy startups, Zynga (ZNGA) and Twitter. The maneuver helped Facebook postpone its IPO date until now. Twitter has yet to file for an IPO. (Zynga went public in December.)

But the new stock units have created an unusual side effect: Thousands of current and former Facebook employees will have their shares vest in a tight window, about five to six months after Facebook's IPO. In that one-month span, Facebook plans to issue around 277 million shares to settle its RSU obligations.

If Facebook's shares at that point are trading around $35 -- the high point of its proposed IPO price range -- that stock bonanza would be worth around $9.7 billion.

Facebook's earliest employees will get the biggest equity payoff. A typical package for a software engineer joining the company in late 2009 included around 10,000 RSUs, according to a discussion thread on Silicon Valley chatter nexus Quora. Thanks to a 5-for-1 stock split in late 2010, that engineer would now be holding a marker for 50,000 shares, worth $1.8 million at the high end of Facebook's range.

Here's the kicker: The IRS taxes RSUs as ordinary income on their full market value when they vest. The logic is, "Hey, the company's giving you valuable stock. That's part of your regular compensation and you should pay taxes on it when you get the shares, not when you sell them."

That means that Facebook employees will owe federal and state taxes this year on their full windfall, even if they choose to hang on to most of their shares.

"With stock options, there's a lot of planning you can do around taxes -- exercise some, hold some, spread out the timing," says Ray Thornson, a San Francisco-based managing director of tax firm WTAS. "With RSUs, there's absolutely nothing that you can do about it."

Like most companies that issue RSUs, Facebook is handling the tax logistics for its employees. It plans to withhold a big chunk of its employees' shares -- 122 million -- and sell them on the open market to cover the tax hit.

So if a Facebook employee is set to receive 10,000 shares and falls into the 45% tax bracket (including both state and federal charges), the employee will actually receive 5,500 shares and Facebook will sell off the other 4,500.

Facebook's latest estimate on its employees' total tax liability is $4 billion, but that figure will easily rise if Facebook's shares price in the mid-$30 range or higher.

Cash-starved California, which has a top personal income tax rate of 10.3%, will get a dramatic lift when Facebook employees come into their equity. A preliminary analysis by California's Legislative Analyst's Office estimated the state's Facebook-related personal income tax revenue for the upcoming fiscal year (which begins July 1) at $1.5 billion -- almost 3% of California's total personal income tax haul for the year.

Forking over nearly half of your paper gains to pay taxes -- even if you don't sell a single one of your remaining shares -- can be painful, but most Silicon Valley employees who hold RSUs consult with advisors about them in advance and aren't surprised by the process when they vest, says Thornson, who counts several Facebook employees among his clients.

It's an issue for a growing number of tech workers. Restricted stock is replacing stock options as the industry's equity currency of choice, according to several Bay Area financial planners. For startups trying to stay private, the flexibility to use them to delay an IPO makes them especially attractive.

"We're dealing with them with several Twitter people," says Stan Pollock, a San Francisco accountant. "They're becoming way more common." To top of page

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