How ASC 740 Affects Stock-Based Compensation

How does stock-based compensation affect the ASC 740 provision for tax?

An excess benefit, or windfall benefit, is the amount by which the realized tax benefit associated with an award exceeds the tax benefit associated with the GAAP compensation expense. Excess benefits are recorded as permanent items.

Accounting by award type

The tax accounting for share-based payments differs depending on the ultimate tax consequence of the reward to the company. Awards such as non-qualified stock options (NQSOs) and restricted stock units (RSUs) that ordinarily result in deductions to the company are accounted for as temporary items. Conversely, incentive stock options (ISOs), which provide favorable tax treatment to employees and no deduction to the employer, are treated as permanent items.

Regardless of the award type, excess deductions are recorded as discrete items.

Nonqualified stock options (NQSOs)

In a nonqualified stock option, the company grants an employee the opportunity to purchase a certain number of shares of stock, at the exercise price, after a vesting date. NQSOs are typically subject to a condition of continued employment.

The company calculates the intrinsic value of the options on the grant date using an option-pricing model and records the value as compensation expense over the vesting period with an offsetting credit to APIC.

In anticipation of future deduction, the company recognizes a deferred tax asset related to the compensation expense.

Upon exercise, the company receives a tax deduction equal to the difference between the fair value of the exercised awards and the exercised price of the awards of the exercise date.

The deferred tax asset associated with the exercised option is reversed. Any excess benefit or shortfall is recorded as a discrete benefit or cost in the period in which the NQSO is exercised.

Restricted stock units (RSUs)

In an RSU, the company awards shares of stock to the employee at a future date if the employee satisfies specific vesting requirements, such as continued employment or achievement of performance goals.

For GAAP, the company records the value of the award as of the grant date as compensation expense over the vesting period with an offsetting credit to APIC. The company also recognizes a deferred tax asset related to the compensation expense in anticipation of the future deduction.

Upon vest, the company receives a tax deduction equal to the fair value of the awards.

The company reverses the deferred tax asset associated with the restricted shares upon vest. It records any excess benefit or shortfall as a discrete benefit or cost in the period in which the RSU is exercised.

Incentive stock options (ISOs)

In an ISO, the company grants an employee the option to purchase a certain number of shares of stock, at the exercise price, after a vesting date. ISOs are typically subject to a condition of continued employment. An option must meet certain statutory requirements to be considered an ISO and qualify for preferential treatment.

For GAAP, the company calculates the intrinsic value of the options on the grant date using an option pricing model. It records the value as compensation expense over the vesting period with an offsetting credit to APIC.

Since ISOs do not result in deductions, the company does not record a deferred tax asset. In other words, it treats the compensation expense as a permanent item.

If the employee complies with the requisite holding periods, the company receives no deduction upon exercise.

If the employee does not meet the requisite holding period for preferential treatment (a disqualifying disposition), the company receives a tax deduction equal to the difference between the fair value of the exercised awards and the exercise price of the awards on the exercise date.

The company records any excess benefit or shortfall as a discrete benefit or cost in the period in which the employee exercises the ISO.

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What other tax provision considerations relate to stock-based compensation?

If awards expire un-exercised, the accounting depends on whether the expired awards have been vested. If an unvested award expires, the company reverses the associated compensation cost and writes off the related deferred tax asset as a permanent item to income tax expense. The compensation cost is not reversed for vested awards, but the deferred tax asset is written off to income tax expense.

Valuation allowances

Regardless of subsequent fluctuations in the value of the underlying stock, no subsequent adjustments are made to the total compensation expense associated with a particular award. Furthermore, the existence of underwater options (i.e., options where the exercise price exceeds the fair value) is not negative evidence in considering the need for a valuation allowance. However, if the deferred tax asset is material to the financial statements, it should be disclosed.

Interim reporting

Though the excess benefits are reported as permanent items, they will not be included in calculating the annual effective tax rate. Since excess benefits will be treated as discrete items, as a general rule, this differentiates the treatment of excess benefits from virtually all other permanent items that would typically be reflected in a company’s return for the year. As such, the company should segregate them from the other permanent items as a process matter.