In defense of JPMorgan and Twitter on taxesNovember 15, 2013: 5:00 AM ET
A longtime critic of corporate tax loopholes concedes that JPMorgan and Twitter are not tax dodgers.
FORTUNE -- The odd couple of JPMorgan Chase and Twitter made news Thursday when the bank canceled a planned session on Twitter featuring vice chairman Jimmy Lee, because it attracted a ton of hostile tweets, such as, "When [JPM CEO] Jamie Dimon eats babies are they served rare?"
The bank and the social media company are linked in another way, as well: They're both being accused in Washington of dodging taxes. But in both cases, the companies are getting what I consider a bum rap. And I'm someone who has spent years writing about tax loopholes, hoping to get some of them closed.
Let's start with JPM, which last month wrote $5.15 billion of checks to Fannie Mae and Freddie Mac, the two big government sponsored enterprises, to settle lawsuits the GSEs filed against the bank three years ago in a commercial dispute over mortgage dealings. Those payments -- settlements of civil lawsuits that have nothing to do with alleged criminality -- are classic examples of deductible business expenses.
But there's uproar and screaming in Washington, where legislation has been introduced to stop JPM (JPM) from being able to deduct those payments. Fines and penalties aren't tax-deductible, but JPM isn't being fined or penalized in this case -- all it's done is settle a commercial lawsuit.
What the block-that-deduction crowd hasn't said -- and few people realize -- is that every penny JPM paid Fannie and Freddie will go to us taxpayers. That's because both firms (quite properly in my opinion) are required to remit all their profits to the Treasury to compensate taxpayers for bailing them out five years ago.
Yes, taxpayers would be farther ahead if the Treasury got the $5.15 billion without JPM being able to save 35 cents on the dollar by deducting it. But is that reasonable? Or fair? I think not.
Now to Twitter (TWTR), which Senators Carl Levin (D-Mich.) and John McCain (R-Ariz.) complain is getting a $154 million tax deduction because employees cashed in option profits as part of the company's initial public offering of stock.
Under current tax law, you see, the profit that an employee makes by cashing in a stock option creates an offsetting deduction for the employer. It makes perfect sense to me, because the option profits are employment income to the employees, so logic suggests that's a deductible employment expense to the company.
Levin and McCain's Senate Permanent Subcommittee on Investigations has done God's work exposing things like Apple's (AAPL) obnoxious tax games. But in this case, they're just making noise. They contend that Twitter and other options-granting companies should be allowed to deduct only the value they placed on the options when they granted them. In Twitter's case, $7 million.
In any event, in the case of Twitter's options, as in the case of JPM's Fannie and Freddie payments, taxpayers are coming out way, way ahead.
Let me show you why. Twitter's option-related deduction is worth 35 cents on the dollar, because the top corporate tax rate is 35%. However, the Treasury will collect considerably more from employees than Twitter will save.
Assuming that options-exercisers are top-bracket payers, they will shell out 39.6% income tax on their options profits; 1.45% of Medicare tax; and 0.9% for the Medicare high-earner surcharge. Total: 41.95%. In addition, Twitter will match the 1.45% of Medicare tax. Add it up, and the 35% Twitter deduction is way more than offset by 43.4% of income and Medicare taxes. (I'm not taking state and local taxes into account, or the fact that Twitter's 1.45% Medicare tax is deductible.)
The real loophole, as my Fortune colleague Dan Primack has pointed out, isn't Twitter deducting the profits employees realize from exercising stock options. Rather, it's the tax that venture capitalists won't be asked to pay on their share of their investors' profits in Twitter stock when it's sold.
Under a fair tax setup, the VCs' "carried interest," which I estimate at $1 billion based on Dan's work, would be taxable as ordinary income, resulting in the same 43.4% for the Treasury that Twitter and its employees pay on option profits.
However, because carried interest income is taxed as capital gains, the VCs' rate is only 23.8%: the 20% cap gains rate and the 3.8% surcharge on high earners' investment income.
That difference to the Treasury -- 19.6% on $1 billion, way more than the alleged Twitter loophole -- is the real scandal. But so far, despite years of talking about closing this loophole, it still exists.
If the politicians picking low-hanging PR fruit by attacking JPM and Twitter close the carried interest loophole, I'll salute them. But I'm not holding my breath waiting for this to happen.
Update: This reflects the deletion of a snarky paragraph saying that Levin and McCain oppose letting companies deduct the value of options that expire worthless. In fact, they support letting companies deduct options when granted, regardless of whether they expire worthless. Sorry for the mistake.