Twitter’s San Francisco Payroll Tax ‘Deal’ and Why Stock Option Compensation Matters

Last week, San Francisco’s Board of Supervisors voted to approve the Mid-Market Payroll Tax Exclusion, legislation which will give Twitter a tax “break” for moving into San Francisco’s Mid-Market neighborhood, an area of the city with a less than stellar reputation and one which San Francisco hopes to revitalize. 

This legislation, which came after months of discussion between Twitter, San Francisco’s mayor, and the city’s Board of Supervisors,  was a response to Twitter’s announcement that it was evaluating whether to stay (and expand) in San Francisco or relocate outside of the city.  Moving out of San Francisco, Twitter had determined, could save the company a substantial amount especially if the Company were to go public.  Key to Twitter’s decision, was the impact of San Francisco’s Payroll Expense Tax.  This tax is imposed on all companies with payroll in excess of $250,000, and is calculated at 1.5% of a company’s payroll expense, which, in addition to salaries, wages and similar forms of compensation, includes the compensation element from stock option transactions.  Incidentally, the Payroll Expense Tax, which was originally enacted in the 1970’s, was modified in 2008 to include gains on stock option exercises by non-employees.   This was a response to what had become a common practice (especially by high-tech start-ups) of awarding stock options to consultants, investment bankers, and other non-employees, either as payment for services or to “sweeten” their portion of the deal by giving these non-employees a piece of equity.  And although an entire discussion on stock options, and other forms of equity compensation is a great topic for a future post (and one I plan to cover), for today I’ll give a high-level summary of how “compensation” from stock options transactions is triggered and why the exemption was so important to Twitter. 

There are two types of stock options, Incentive Stock Options (ISO’s), and Non-qualified Stock Options (NQSO’s).  One reason the distinction is important is for determining whether and when exercising an option creates compensation.  For NQSO’s (generally awarded to rank-and-file employees and non-employees) compensation is triggered on the date an option is exercised and is calculated as the difference between the market value of the stock on the date of exercise and the “strike” price (the price the employee must pay to exercise as determined by the option grant).  IRS rules require that this “bargain element” be reported as W-2 compensation for employees or on Form 1099 for non-employees.  ISO’s, which receive beneficial treatment but must meet stricter IRS rules in order to retain their ISO treatment, do not generally trigger compensation when they are exercised.  Compensation is triggered only if there is a “disqualifying disposition” of the stock acquired through the ISO exercise, which occurs when the stock is sold or disposed of within 1 year from the date of exercise or 2 years from the date of grant.  When a “disqualifying disposition” of an ISO share occurs, the “bargain element” is treated as compensation. 

Now, it’s pretty common knowledge that Twitter plans to go public.  Once this happens, the amount of compensation from NQSO exercises and ISO disqualifying dispositions will likely be HUGE!  Understandably, Twitter had much to gain from the passage of the Mid-Market Payroll Tax Exclusion.  So what exactly, was included in the “Twitter deal”?  Will Twitter be totally exempt from paying the city’s Payroll Expense Tax.  First of all, before benefitting from the exemption, Twitter must relocate to a zone in the Central Market Street and Tenderloin Area (see Twitter’s blogpost announcing their 2012 move).  Secondly, the exclusion will only apply for a six year period and will only exclude “new payroll”.  That is, during the six year period that the exclusion remains in effect, Twitter will still pay a tax based on it’s base year payroll expense.

Sylvia’s Summation:  There you have it, the “Twitter tax break”.  But this exclusion isn’t just for Twitter, it’s available to any company that relocates to the Mid-Market area.  Already there’s been talk that Zynga and Yelp, two more pre-IPO companies, are interested in getting the same tax break. And, while the media’s focus has been on yet another corporate taxpayer getting an underserved tax break, tax “deals” occur all over the country all the time, aren’t just for big or well-known companies, and often include “clawback” provisions. 

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