The mystery of stock-based compensation.
Amazon’s founder is America’s richest person, but the company paid no corporate income tax last year. How can that be?
For starters, Jeff Bezos is rich because of the value of Amazon stock, but for years, Wall Street loved the company even though it was a curiously unprofitable retail and technology giant. But more recently, Amazon has emerged recently as a consistently profitable firm, reporting nearly $11 billion in earnings last year. Yet during this surge into profitability — the company’s earnings doubled between 2017 and 2018 — Amazon’s tax bill has actually gone down. The company paid $0 in corporate income tax last year, according to an analysis from the Institute on Taxation and Economic Policy, an astonishing figure that generated dozens of news stories last week.
A big part of the story here is the tax treatment of stock-based compensation for executives, which has the slightly odd feature that the more successful your company becomes, the lower your tax bill becomes.
Amazon, in other words, didn’t manage to avoid paying any corporate income tax in 2018 despite the huge surge in profits but largely because of it. If this seems like a policy failure, though, the real problem is probably not Amazon’s light tax bill but the extent to which a policy initiative from the early 1990s that was meant to constrain CEO pay has totally backfired.
Amazon’s three tricks for reducing its taxes
An interesting thing to note here is that Amazon isn’t lowering its tax bill through classic technology company shenanigans like stashing profits in offshore subsidiaries or declaring itself to be a foreign company. Amazon’s sales are mostly in the United States, and its No. 2 market is Germany, which is also a relatively high tax jurisdiction.
Amazon isn’t cheating anyone here; it just legitimately owes no taxes.
- Some of that is because Amazon is able to avail itself of the research and development tax credit, a not-very-controversial policy that encourages profitable companies to plow earnings into R&D. Congress routinely extends this on a bipartisan basis, with the thinking that research into innovation is good, and Amazon is obviously a company that does a fair amount of R&D.
- The second reason is that the Trump tax bill included a temporary provision allowing companies to take a 100 percent tax deduction for investment in equipment. This is a controversial idea, but it has some support across party lines — Obama White House economist Jason Furman likes it, for example. More broadly, when Democrats complain that companies are plowing too much of their profits into share buybacks rather than investing, they are in effect saying they wished more companies acted like Amazon — which does not do any share buybacks and does invest a lot — and this provision of the Trump tax bill encourages companies to do this.
- Last and most significant to understanding the change in 2018 is the fact that companies can deduct the cost of stock-based compensation from their taxable earnings even though it doesn’t actually cost companies any money to hand out shares of their own stock to employees. What’s more, the way this cost is estimated is that the more your share price rises, the bigger the deduction for handing out shares. So precisely because Amazon’s profits surged, the price of the company’s shares went up a lot and the value of these deductions surged as well.
That may sound a little unconventional — in general, the idea is that more successful firms should pay higher taxes, not lower — but there’s a pretty good accounting reason for it. At the same time, the entire tendency of companies to offer executives stock-based compensation packages is essentially a giant loophole in a decades-old tax provision that was supposed to deter lavish executive compensation.
Stock-based compensation, explained
Normally, while companies pay sales taxes to state and local governments, the federal government taxes them on their profits. Revenue that is paid out to employees as salaries and benefits is not profits, and thus doesn’t get taxed. But section 162(m) created an exception to that rule — any salary of over $1 million paid to top executives would not be deductible for tax purposes. The idea was to deter lavish executive compensation packages. Except there was an exception to the exception — compensation that took the form of stock options or stock grants would still be deductible. So in a practical sense, what the 1993 change did was incentivize companies to use a lot of stock-based compensation for their executives.
But here’s a critical thing.
While a company of course could provide stock-based compensation by taking money out of the bank, using it to buy shares on the open market (this would be one of the dreaded share buybacks) and then giving those shares to executives, in practice, that’s not how it works. Amazon, or any other company, can just issue more shares of Amazon stock anytime it wants to. This costs Amazon shareholders in the sense that creating new shares tends to devalue the existing ones, but it doesn’t involve any direct financial cost to the company per se.
Here’s what’s even weirder. When a company’s share price goes up a lot, the value of stock-based compensation rises as well. That’s by design. Part of the goal of stock-based compensation is to make sure you are paying executives for performance — or at least guaranteeing that rank-and-file workers will share in the prosperity of the company’s shareholders. But this means that in accounting terms, when a company’s share price goes up a lot — as it might if, say, it successfully doubled profits — the value of the tax deduction for the stock-based compensation also goes up a lot.
That’s exactly what happened with Amazon. Thanks to a good year for the company, its Securities and Exchange Commission form 10(k) shows it recorded about $1 billion in deductions for stock-based compensation — eliminating what would otherwise have been a non-zero tax liability.