By James Kwak
Some people have been claiming that Marc Zuckerberg is subject to a high tax rate, with Robert Frank even claiming,
“Mr. Zuckerberg’s tax bill will also provide an important counter-point to the notion that the rich pay lower tax rates than the rest of America. That may be true for professional investors and private-equity chiefs, but not for dot-commers and many entrepreneurs.”
I’m surprised that Robert Frank, whose column “looks at the culture and economy of the wealthy,” made this mistake, assuming it’s an honest mistake. He’s right about the specific transaction. Zuckerberg is exercising 120 million options with a strike price of 6 cents. Those are non-qualified options (not ISOs, for which the tax treatment is different), so the paper gain is taxable as ordinary income (35 percent) at the moment of exercise.
But Zuckerberg also owns more than 400 million shares free and clear already. Those are probably shares that he bought for a token amount on the day that Facebook incorporated. Zuckerberg’s primary contribution to Facebook has been labor, not capital: the man had an idea, and he worked at it for years. But as a company founder, most of his compensation has taken the form of capital gains (appreciation of his founder stock). If he ever sells that stock, he will pay tax at the capital gains rate, which is currently 15 percent, not 35 percent.
In short, the only reason Zuckerberg is paying 35 percent on his option exercise is that he got more options in 2005, after getting founder stock worth $20 billion today. If he hadn’t gotten those options, he would be paying tax at a 15 percent rate. So yes, Mark Zuckerberg does pay taxes at a lower rate than most Americans.*
In the Times, David Miller tells the real story. It’s likely that Zuckerberg will never sell any of his stock; even if he does sell, we can be sure he’ll only sell a tiny fraction of it. (If he does sell, he will be sure to sell some of the 120 million shares from his option exercise, since those will have a cost basis equal to the market value on the date of exercise. Since that would net him several billion dollars, it’s hard to imagine why he would ever sell any of his founder stock.)
Instead, other people will inherit it, and no one will ever pay tax on the appreciation during his lifetime. Or he’ll donate it to charity, and no one will ever pay tax on any appreciation, ever. (But he’ll be able to take a tax deduction for the full value of the stock on the date of donation, even though he won’t have paid tax on that stock.)
Miller suggests that we switch to mark-to-market taxation, so we pay tax on the appreciation of our assets each year. There are various technical problems with mark-to-market taxation, but he gets around them by limiting his proposal to the super-rich and to publicly traded securities, which would be easy to liquidate in order to pay the new annual tax. It sounds like a good idea to me. Another possibility would be to eliminate step-up of basis at death, which allows the very wealthy to escape tax by passing assets on to their heirs.
Sure, Mark Zuckerberg is warmer and more cuddly than Mitt Romney or John Paulson. But let’s not make him out to be a martyr to the Internal Revenue Code. All rich Americans get gifts from the tax code.
* And speaking as another entrepreneur, albeit a much less successful one, I can say that we do just fine by the current tax code.