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Bernie Sanders Is Insane – Zoom Tax Bill Edition

We have this from Senator Bernie Sanders:

This refers to this report:

The company reports that it made $660 million of pre-tax profits for 2020, an exponential increase from its $16 million in pre-tax profits in 2019. The immediate shift to online activity explains the company’s unprecedented income growth. For many, Zoom has become a ubiquitous daily meeting space, both for work, class instruction, family gatherings and evening happy hours.

But why was the company’s income bonanza not matched by at least a token federal tax bill? The main answer appears to be the company’s lavish use of executive stock options. Zoom’s income tax reconciliation says it reduced its worldwide income taxes by $300 million in 2020 using stock-based compensation.

As an ITEP report explains, companies that compensate their leadership with stock options can write off, for tax purposes, huge expenses that far exceed their actual cost. This is a strategy that has been leveraged effectively by virtually every tech giant in the last decade, from Apple to Facebook to Microsoft. Zoom’s success in using stock options to avoid taxes is neither surprising nor (currently) illegal.

Parts of this are true, parts are not. The detail is as follows:

The Book-Tax Gap for Stock Options
In most cases, reporting corporate compensation is straightforward. A corporation reports employee wages and salaries as an expense on its books and in the financial statements made public for investors. The corporation also can claim compensation costs as a business expense on the tax return it files with the IRS, deducting the expense from its taxable income, just as it deducts other expenses.

The problem is that stock options are valued differently under U.S. accounting rules versus U.S. tax rules. For accounting purposes (and in public disclosures to investors), corporations are required to report the cost of stock options on the date they are granted. Companies calculate the value on the grant date using sophisticated formulas which, in part, attempt to predict the market price of the underlying stock when the options will be exercised, which cannot really be known in advance. The value of the options on the grant date for accounting purposes is, therefore, necessarily an estimate. But U.S. accounting rules require this estimate to be included on the corporate books as a compensation expense.

Tax rules, on the other hand, allow a company to wait until stock options are exercised by the employee and use the actual value on the exercise date to calculate the amount of the company’s tax deduction.

If the actual value of the options on the exercise date matched what the corporation reported on its books as the estimated value on the grant date, this timing difference would not be a problem. But in most cases, the value reported for tax purposes far exceeds the estimated value reported for accounting purposes.

In order to report higher profits to investors, corporations typically minimize the estimated stock option expense on their books. When the stock options are later exercised and produce a final value far above the earlier estimated book expense, corporations are happy to report that higher expense on their tax returns and thereby reduce their tax bills.

For example, assume a corporation enters into a contract to allow its CEO to buy one million shares of the company’s stock at any point in the next 10 years at $10 a share. In theory, if the corporation estimates that its share will be worth exactly $10 during the whole 10 years, then it would estimate that the stock options were worth nothing because they would permit the CEO to buy shares at the same price that everyone else pays. More realistically, because share prices tend to increase over time, the corporation could estimate that its stock price will increase to $25 a share.

That means the stock options would allow the CEO to buy one million shares worth $25 million but pay just $10 million. The corporation could, therefore, estimate that the stock options given to the CEO as compensation have a value of $15 million, because that is the expected benefit to the CEO, the difference between what he is allowed to pay for the shares and what they will be worth on the market.

In most cases, however, the corporation does not stop there. It further reduces the estimated value of the stock options to reflect stock price volatility and other factors. Those types of adjustments could reduce the estimated value of the stock options by as much as a third.[3]

So, in this hypothetical scenario, on the grant date (when the corporation grants the options to its CEO), the corporation could record on its books a total stock option compensation expense of just $10 million ($15 million reduced by a third).

When it comes to taxes, however, the corporation would be required by U.S. tax rules to value the stock option compensation cost in an entirely different way. As explained earlier, the company cannot take a tax deduction until the CEO holding the options exercises the right to buy the stock, which in this example occurs 10 years after the options were first granted. On that exercise date, the CEO pays the company $10 million to obtain the underlying stock and then sells the shares on the market. But instead of the expected profit of $15 million, assume the share price has skyrocketed and the CEO sells the shares for a profit of $50 million. The company would then enjoy a windfall tax benefit–it would be able to deduct $50 million from its taxable income, even though it recorded a compensation expense of only $10 million on its books and even though it did not pay any additional money to its CEO, who sold the stock to third parties in the marketplace.

The bit that’s being missed here. When does the company actually give the stock to the CEO? On the option exercise date. So, what does the stock cost the company on the option exercise date? The market value of the stock on the option exercise date.

So, what is the cost to the company of the options grant? The market value of the stock on the option exercise date. What, therefore, is the righteous tax deduction on the stock option grant? The market price of the stock on the options exercise date.

We could travel down a slightly different road and ask whether such stock awards (whether options or of restricted stock) should be deductible as an expense at all. Which they obviously should be given that they are a standard part of compensation ins many areas of the economy. And compensation of the workers is one of the costs of being in business.

The complaint about options reducing the tax bill is being made up out of whole cloth. Entirely invented that is. It is nonsense, nonsense upon stilts.

The original amount in the books, at the moment of the options grant, is an estimate of what might happen in the future. We don’t know so we’ll have a good ol’ guess. The value in the tax accounts happens after the option is exercised and is the real cost. Therefore that’s the value which is allowable for tax purposes.

There is no tax avoidance here. Not in the slightest.

All that’s left to work out is whether these people are lying or are just too stupid to understand. Sadly we have no short manner of deciding between those two as either explains progressive politics – if not, all too often, both.

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3 years ago

So, as usual, they paid no US tax because they took advantage of an aspect of US tax code—that is, they did what Congress wanted them to do; in this case, share ownership with employees. And, as usual, Sen. Sanders wants to practice demagoguery and smother the facts in pursuit of the next tax increase.

Michael van der Riet
Michael van der Riet
3 years ago

I have a company. I can choose to take out the profits as dividends, in which case the company pays company tax and I pay tax on dividends received. Or I can take out the profits as salary, in which case the company pays nothing and I pay all the tax. I can minimise tax but not avoid it.

Those who exercised their stock options paid tax on value received. No tax was avoided.

3 years ago

They also paid taxes at a higher individual rate than the corporate tax rate.

3 years ago

Or, you have a company. You obligingly open a factory in a city designated an Enterprise Zone and thereby minimize—maybe cancel, for a year—your taxes.

Or, you start a company and run at a loss for a few years. We want companies to be started, so we let you use the negative tax liability to offset liability when you start profiting.

But we never guarantee that Bernie won’t demagogue you.

3 years ago

Paying staff is an operating expense, film at ten.

If taxation was changed the way Sanders is asserting, so business was taxed on income before outgoings, it would bankrupt most of the economy overnight.

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