Facebook Founder, Mark Zuckerberg, Expected to Realize $6 Billion in Gross Income On Exercise of Nonqualified Stock Options in Facebook's Initial IPO
Under Section 83, the transfer of property in connection with the performance of services, results in compensation to the service provider in the year in which the property received is non-forfeitable or transferable, and, if neither, if a timely election is made under Section 83(b). Where the “property” transferred consists of options of the employer’s stock, the options are currently includible in gross income as long as they have a “readily ascertainable fair market value” at the time of grant. But see §83(e)(3). The regulations, under Treas. Reg. §1.83-7(b)(2), provide a definition of “readily ascertainable value” if the subject options are actively traded on an established market. In the event that the options are not actively traded on an established market, an option still has a readily ascertainable fair market value where: (i) the option is transferable and is immediately excercisable in full; (ii) the option’s value is not significantly affected by any restriction on the option or the stock to be acquired on exercise, other than a lien or other condition to secure payment of the purchase price; and (iii) the fair market value of the “option privilege” can be measured with reasonable accuracy. See Cramer v. Comm’r, 64 F.3d 1406(9th Cir. 1995); Pagel, Inc. v. Comm’r, 91 T.C. 200 (1988), aff’d, 905 F.2d 1190 (8th Cir. 1990). In many instances the grant of a “nonqualified stock option” will not have a readily ascertainable fair market value. In such case the income tax event remains “open” until the option is exercised, even if the option obtains a readily ascertainable fair market value post-issuance. Comm’r v. LoBue, 351 U.S. 243 (1956). Thus, on exercise, the employee or service provider realizes compensation income to the extent that the value of the shares obtained through the exercise of the option on date of receipt exceeds the amount paid on the exercise. Of course, were the option holder to dispose of the options prior to exercise in a taxable transaction with an unrelated person, the income would be realized at such time. Treas. Reg. §1.83-7(a). Under Section 83(h), an employer is entitled to a deduction under Section 162 for amounts employees or service providers are required to include on grant or exercise of a stock option or other income triggering events. See Rev. Rul. 2003-98, 2003-34 IRB 379.
Now, on to Mr. Zuckerberg, who is expected to become a multi-billionaire shortly as a consequence of the IPO if one considers publicly traded shares to have greater value for achieving economic star status than mere ownership of a company of the same earnings capacity whose equity is not publicly traded. It is reported from the Form S-1 (registration statement) filed by the Company that Zuckerberg will exercise nonstatutory options to acquire 120 million shares of Facebook’s class B (voting) stock. It is presumed that the options, all of which have vested, were treated by the 2004 Harvard University graduate as “open” under Treas. Reg. §1.83-7 at time of grant. The options will expire in 2015.
What is presently uncertain will be the initial IPO price. Let’s assume a value of approximately $100 billion, yes, $100 billion. This results in a per share value for class B shares of approximately $50 per share. The exercise or strike price under the options is quite low, 6 cents per share. So, simple arithmetic would say that if Mr. Zuckerberg exercises options sufficient to realize $6 billion in value, in which he would have a strike price of $7.2 million, the federal income tax on the gain on exercise would exceed $2 billion. Undoubtedly, he would have to immediately dispose of some shares to pay this enormous tax liability although he is barred by certain securities laws from short-selling his shares. Perhaps a derivative “short position” or hedge or a prepaid variable forward contract, as some have suggested, would provide him with liquidity to pay taxes without running afoul of SEC rules. He might be wise to exercise much of his options now since despite the immediate tax cost, he can benefit from upside appreciation at capital gains rates then were he to wait and exercise a substantial portion later. Anyway, he can afford to bring in the “best” advisors to sort that out for him no doubt.
The Company may expect to be able to report a deduction under Section 83(h) for the amount of income realized by Zuckerberg as well as other executives exercising their NQSOs upon the issuance of the IPO. The registration statement mentions that such deductions could generate a tax refund of up to $500 million. Still, withholding would be required, perhaps as early as the day after exercise, which may be achieved in the form of a so-called “cashless exercise” but perhaps that would generate a problem under Section 402(a) of the Sarbanes-Oxley Act provisions as an improper extension of credit. A suggestion was made in the tax press that perhaps the market-maker (underwriter) could advance the withholding amount to the company before the market sale. More legal advisors necessary. As to the current deductibility of the compensation income, Treas. Reg. §1.83-6(a)(4) provides that no deduction is permitted under Section 83(h) to the extent that the expenditures (for receiving the services rendered) have to be capitalized. See Treas. Reg. §1.263A-1. There are also potential issues under Section 162(m) which applies compensation paid to highly compensated executives of public companies.
Congress has entered into the Facebook IPO news so to speak. On February 7th, Senator Carl Levin (D-Mich), introduced the Cut Unjustified Tax Loopholes Act (S.2075) to limit the corporate deductibility of nonstatutory stock options to $1M and also expand the definition under Section 162(m) of “applicable employee remuneration” .
Another reform being kicked about is a proposed mark-to-market taxation system for publicly traded securities, including derivatives, held by the wealthiest and highest earning 1/10 of 1% of individuals. Under the proposal, all public companies, all private companies with $50 million or more of net assets, and all individuals and married couples with $1.6 million of adjusted gross income or $5 million of publicly traded property would be required to mark to market their publicly traded property, derivatives of publicly traded property, and some publicly traded debt and other liabilities. Mark-to-market gains of corporations would be taxed at the regular corporate rates and mark-to-market losses of corporations would be deductible against ordinary income or capital gains. For individuals, the tax rate on gains would be at long term capital gains rate and interest or other ordinary income at 35%. Individuals who are securities dealers or receive allocations of gains for performing investment services, i.e., carried interests, would be taxed at ordinary rates. All other taxpayers would remain on the realization system. This proposal has been coined the “Zuckerberg tax”. In this election year partisan bickering, perhaps these proposals are just "political amunition" and have little chance of being enacted into law.
