On Wednesday, Facebook filed S-1 documents in advance of its initial public offering, in which the web giant seeks to raise a cool $5 billion. And while the bulk of the 300 pages serve primarily to sicken readers with the realization that hundreds of 20-somethings will become overnight millionaires simply for designing a place for people to share baby pictures and take joy in how much weight their exes have gained, there are some interesting tax tidbits to be gleaned from the filing:
- Despite recognizing $1.7 billion in pre-tax book income in 2011, Facebook anticipates that it will generate a net operating loss (NOL) in 2012. How is that possible? Through its employees’ exercise of nonqualified stock options, that’s how.
After the IPO, hundreds of millions of shares of NQ options previously granted to employees are expected to be exercised. As a reminder, these forms of compensation are generally not taxable under I.R.C. § 83 until exercise, provided that the stock is freely transferable and not subject to a substantial risk of forfeiture at that time. If these requirements are met, upon exercise the employee must recognize income equal to the excess of the FMV of the stock over the exercise price, with the employer getting a corresponding deduction.
Assuming Facebook stock reaches a price of $40 per share on the open market, the corporate deduction related to the exercise of employee options will be in the billions; large enough not only to enough to wipe out the comany’s 2012 taxable income, but also –according to the prospectus — to generate an NOL that will be carried back to generate $500 million in tax refunds.
- Because the income recognized by employees upon the exercise of NQ options is taxed as compensation, Facebook is anticipating using a good portion of the $5 billion in proceeds raised from the IPO to pay its required tax withholding obligations.
- In addition to its public offering, the prospectus indicates that CEO and Founder Mark Zuckerberg will also sell a significant amount of his common stock to the public. Why would he do it? To pay a tax bill.
In the most startling information contained in the S-1 comes the news that Zuckerberg will be exercising options to purchase 120 million shares of Facebook stock after the IPO. These shares have an exercise price of 6 cents per share, so if the stock price reaches $40 per share as anticipated, Zuckerberg stands to make $4.8 billion in compensation upon exercise. That’s right…billion. The tax bill on that $4.8 billion — between federal and California — could reach nearly $2.0 billion, so Zuckerberg will have to sell additional shares to generate some cash. Needless to say, collecting state income tax of this magnitude from Zuckerberg and other Facebook employees could provide a temporary reprieve to the long-struggling California economy.
- This could be Zuckerberg’s last tax bill for a while, however. The prospectus indicates that while he was paid $500,000 in 2011 for his work as CEO (he also received a $220,000 bonus and $783,000 related to his personal use of the company jet), Zuckerberg’s base salary beginning in 2012 will be reduced to one dollar. Facebook also announced in its filing that it has no intention to pay dividends on its stock anytime soon. Take these two items in tandem, and Zuckerberg’s adjusted gross income could be extremely small in the coming years. Then throw in the fact that Zuckerberg has long stated his desire to donate much of his fortune to charity, and he may well end up generating a net operating loss in 2013 and beyond.
- It appears from the financial data contained within the prospectus that Facebook was generating federal NOLs until 2007 or 2008. In 2009, there was a decrease to the valuation allowance reserved against Facebook’s deferred tax assets (DTA) of $76 million. In all likelihood, the bulk of this DTA related to a large NOL carryforward that the company determined in 2009 would be fully utilized in the future against taxable income, so a valuation allowance was no longer necessary.
- Interestingly, based on the large current tax provisions booked in 2010 and 2011, one could reasonably conclude that Facebook fully utilized its NOLs in 2009 or 2010. However, the tax footnote also indicates that Facebook has $7 million of federal NOL remaining as of 12.31.2011. How could the company, with $2.8 billion of pre-tax book income 2009 and 2010 not fully utilize its NOL carryforward? One possibility is that the pre-2009 NOLs were subject to limitation under I.R.C. § 382, and thus could not be utilized in full to offset taxable income.
In brief, Section 382 applies an annual limit to the amount of pre-change NOL carryforward that may be utilized after a corporation undergoes an “ownership shift” — essentially a more than 50% change in its stock ownership over a three-year period in terms of value. Perhaps during its start-up phase the need to raise capital from outside sources caused Facebook to undergo such a shift, which limited the amount of its pre-2009 NOL available to offset its 2010 and 2011 taxable income. This could explain why the company would have large current tax provisions in both 2010 and 2011 but yet still have an NOL carryforward as of 12.31.2011.
- Assuming that I’m wrong, however, and Facebook’s $7 million NOL carry is not currently subject to I.R.C. § 382, it shouldn’t be even after the IPO. While the IPO may well trigger an ownership change, the I.R.C. § 382 limit is computed by multiplying the long-term tax-exempt rate in place on the shift date by the value of the company immediately prior to the ownership change. As Facebook’s value is into the billions, any I.R.C. § 382 limitation would be well in excess of the $7 million remaining NOL.
- Facebook incurred $388 million in R&D expenses in 2011. I hope for their sake the I.R.C. § 41 credit gets extended.
- The prospectus alludes to recent overtures made by President Obama to eliminate the current tax deferral that exists for foreign subsidiaries of U.S. corporations operating overseas. Such income is generally not taxable within the U.S. until it is repatriated. In discussing the risks of investing in Facebook stock, the S-1 indicates that a change in tax policy to tax U.S. corporations on income earned by foreign affiliates prior to repatriation could have a substantial adverse effect on the company.
Some interesting non-tax notes:
- Fact: There are $2.7 billion likes and comments posted on Facebook every day. Also Fact: 97% of them serve no purpose other than to make the world a dumber place.
- Facebook made business acquisitions totaling $68 million in 2011, which was deemed “not material to the consolidated financial statements.”
- Facebook generates 12% of its revenue from users who purchase virtual tools for use in certain online games. If you’re one of these people, your loneliness saddens me.
- Facebook gave Mark Zuckerberg’s father $2 million shares of stock for helping keep the company afloat during its infancy. At a total potential value of $80 million, that really makes the $200 beach cruiser I gave my old man on his birthday look like crap. Sorry Dad.
- Apparently, Facebook is not allowed in China or Iran. Then who is the Mahmoud Ahmadinejad that keeps “liking” all of my old lifeguarding pictures?