As you probably know by now, Facebook is going public (details and legal analysis in Thursday’s post). But, did you know that Mark Zuckerberg, Facebook’s CEO, is anticipated to foot the largest tax bill in US history? $2 billion. Holy cow, right? That sounds like enough money to fix a lot of the US’s economic problems. While his money will no doubt be a boon to the IRS, it appears the $2 billion might be the only tax Zuckerberg pays on his Facebook shares–ever–despite those shares being valued at roughly $28 billion. Based on the value of the shares, $2 billion represents a 7% effective tax rate. That’s half of Republican Presidential candidate Mitt Romney’s 14% effective tax rate that has so many people up in arms.

The reason? Realization. The simple tax principle that a taxpayer need pay taxes only upon income “clearly realized.” Commissioner v. Glenshaw Glass Co. Thus, while the value of Zuckerberg’s property is estimated to be $28 billion, his property is still just that–property, not income. Only upon a sale of his property (which will generate income) will Zuckerberg owe taxes. The problem is, most pundits predict that, after Facebook’s IPO, Zuckerberg will not sell any of his Facebook stock, in order to avoid tax. Steve Jobs and Larry Ellison, both CEOs of prominent tech companies, successfully avoided the need to sell shares after their companies went public. Instead of selling shares, which would have generated taxable income, Jobs and Ellison both borrowed against the value of their shares. This provides the same effect as selling shares–having money to spend–without the taxable “realization” event. How much can the shares be collateralized for? Well, Ellison was able to borrow over $1 billion against his shares, and had enough disposable income to buy one of the most expensive yachts on the planet. It is expected that Zuckerberg will employ a similar strategy in approaching his post-IPO taxes.

An equally advantageous benefit of holding onto the shares is the shareholder’s heirs will receive a “stepped-up” basis upon the shareholder’s death. For example, Steve Jobs’ widow recently inherited $2 billion of Apple stock. Stock that Steve never paid taxes on (because he didn’t sell it). Upon his widow inheriting it, she can sell the stock and need only pay tax on the difference between the $2 billion value at Steve’s death and any subsequent appreciation. Tax-wise, this is great news for her, as Steve most certainly would have had to pay taxes on close to the full $2 billion value if sold. Even though Zuckerberg is young and death seems to be in his distant future, his future heirs have to be happy that they can receive a “stepped-up” basis upon inheritance, and won’t have to take Zuckerberg’s $0.06/share basis.

Recently, Obama proposed a new tax, called the “Buffet Rule.” The Buffet Rule would require millionaires to pay tax at a 30% effective minimum rate. However, the Buffet Rule still relies on realization. That is, in the case of appreciated stock, the 30% effective minimum rate would only apply to those shares which are sold. In the case of Zuckerberg, Jobs, and Ellison, where there are no stock sales, the Buffet Rule would not require any more taxes. An interesting idea, which recognizes this problem, is being kicked around. It is called the “Zuckerberg Tax.” Under the Zuckerberg Tax, taxation for an ultra-wealthy individual, whose wealth is primarily in publicly traded stock, would be based not on realization, but would be based on the value of the stock. This mark-to-market taxation does not increase the tax rate, but instead increases the tax base. While the Zuckerberg Tax is just an idea, it is an interesting one. To be sure, it would allow the IRS to collect much higher taxes from people like Zuckerberg. In this case, instead of paying only $2 billion, Zuckerberg would pay $5.45 billion.

– Andrew Harline

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2 Responses to When $2 Billion is Not Enough…

  1. Christina Santana says:

    Great post Andrew! It may be worrying to some that there is a very real possibility that Zuckerberg will not get taxed while he holds the shares. However, it is also important to remember that there are two very real reasons why – liquidity and fairness. While Zuckerberg will indeed be made a very rich man by Facebook’s IPO, his gains will be solely on paper until there is a realization event. Indeed, while Zuckerberg may be able to raise cash by borrowing against his shares, his ownership of Facebook stock alone will not provide him with the liquidity required to pay taxes due under a mark to market system. Furthermore, mark to market implicates fairness. Because markets are inherently volatile, it is not certain whether Zuckerberg will indeed experience any gain during the time in which he holds the stock. However, under a mark to market system he would be forced to pay taxes on any paper gains observed in a particular year, even if he ultimately sells the stock at a loss.

  2. Samara Pals says:

    Really interesting! I would not necessarily call Zuckerberg paying 2 billion dollars in taxes a problem though. If we really wanted address shortfalls in spending and to broaden the tax base, the true money would be found in small increases on the middle class over large increases on the “1%”. However, if we confiscated the entire income of the top 10% of earners, we would not be able to pay off the national debt or fund the national government, as noted in this article (and this was when the debt was 1/3 the size it is today): http://online.wsj.com/article/SB10001424052748704621304576267113524583554.html

    If the goal isn’t to do something about long term deficits, but merely to take more because he makes more, I am not sure what the principle is that needs more money in taxes from someone who created a service that gives over 800 million people a highly enjoyable tool, time-waster, way to stay in-touch and self-express in exchange for access to their personal information. It just appears to be another way of slowly weakening personal property rights.