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17.3 Income tax accounting for nonqualified stock options
Publication date: 31 Dec 2022
us Income taxes guide
An entity that grants a nonqualified stock option to an employee generally is entitled to a tax deduction equal to the intrinsic value of the option on the exercise date. Entities generally expense stock options for book purposes before a tax deduction arises, thus creating a temporary difference, and the initial recognition of a deferred tax asset under ASC 740.
The amount of the deferred tax asset will almost always differ from the amount of the entity’s realized tax benefit. This is because the deferred tax asset is based on the compensation cost the entity recorded for book purposes, which is determined based on fair value on the grant date. The ultimate tax deduction is based on intrinsic value on the exercise date for a stock option .
Figure TX 17-1 summarizes the key accounting events (from the grant date to the settlement date) that relate to a typical equity-classified, nonqualified stock option that generates an employer’s tax deduction upon the option’s exercise.
Figure TX 17-1
Key income tax accounting events for an equity-classified, nonqualified stock-based compensation award
Key income tax accounting events for an equity-classified, nonqualified stock-based compensation award
When |
Step |
On the option’s grant date
|
Measure the option’s fair value.
|
Over the option’s requisite service period
|
Recognize compensation cost (adjusted for actual or estimated forfeitures) and the deferred tax asset.
Adjust the deferred tax asset to reflect a change in an entity’s applicable tax rate and employee relocations to jurisdictions with different tax rates; do not adjust deferred tax assets to reflect increases or decreases in the entity’s stock price.
|
On the option’s settlement date (e.g., exercise or post-vesting cancellation)
|
Compare the tax deduction (typically the intrinsic value of the option on the exercise date) with the cumulative book compensation cost. To the extent that the tax deduction exceeds the cumulative book compensation cost, the result is an excess tax benefit. Conversely, when the tax deduction is less than the cumulative book compensation cost, a tax deficiency occurs. Any excess tax benefit or tax deficiency is reflected in the income statement. The deferred tax asset is reversed upon settlement as a deferred tax expense which is offset by the current tax benefit from the deduction of the cumulative book compensation cost.
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17.3.1 Accounting for options that are forfeited or expired
For a variety of reasons, employees might never exercise their stock options (e.g., the stock option is under water during its contractual term, or the employee might forfeit the option). When a stock-based compensation award is forfeited or expires unexercised, the accounting depends on whether the employee had completed the award’s requisite service period at the time of settlement. If an award is forfeited before the requisite service period has been completed, the related book compensation cost is reversed and the deferred tax asset is reversed to income tax expense.
If an award expires after the requisite service period has been completed, the related book compensation cost is not reversed. However, the employer will no longer receive a tax deduction for the option and, therefore, there is no longer a temporary difference. Because there is no longer a temporary difference, the related deferred tax asset should be reversed to income tax expense.
Completion of the requisite service period often, but not always, coincides with the “legal vesting date.” An award is legally vested when an employee’s right to receive or retain the award is no longer contingent on satisfying the vesting condition.
Entities can make a company-wide accounting policy election to either estimate forfeitures each period or to account for forfeitures as they occur. However, there are certain circumstances, such as at the time of a modification or issuance of a replacement award in a business combination, when it is necessary to estimate forfeitures.
An entity that has a number of awards and has elected to apply a forfeiture estimate would record compensation cost only for the number of awards it expects to vest. Accordingly, a deferred tax asset is only recorded for the awards the entity expects to vest. If actual forfeitures caused the entity to change its original forfeiture assumptions, then an adjustment to previously recognized compensation cost and the related deferred tax asset should be recorded.
Example TX 17-1 is an illustration of the income tax accounting for a grant of an equity-classified, nonqualified stock option.
EXAMPLE TX 17-1
Income tax accounting for nonqualified stock options
Income tax accounting for nonqualified stock options
On both January 1, 20X1, and January 1, 20X4, USA Corp granted 10 million equity-classified, nonqualified stock options. Refer to the table below for grant-date details and terms. No additional awards are granted in 20X1, 20X2, and 20X3. The stock price is $50 on January 1, 20X4, when all 8 million vested options are exercised from the January 1, 20X1 grants. Upon exercise, the intrinsic value of each option is $20 (i.e., the shares have a quoted market price ($50) that exceeds the options’ exercise price ($30) by $20).
On January 1, 20X5, the stock price decreases to $45, and the options from the January 1, 20X4 issuance remain underwater until they expire on December 31, 20X8.
Date |
Grants |
Exercise Price |
Stock Price |
Grant-date fair value |
Terms / additional facts |
|---|---|---|---|---|---|
January 1, 20X1 |
10 million equity classified, nonqualified stock options |
$30 |
$30 |
$15 |
-8 million options are expected to (and do) vest.
-Award specifies three-year cliff vesting.
|
January 1, 20X4 |
$50 |
All 8 million vested options are exercised from the January 1, 20X1 issuance.
|
|||
January 1, 20X4 |
10 million equity-classified, nonqualified stock options |
$50 |
$50 |
$25 |
-8 million options are expected to (and do) vest.
-Award specifies three-year cliff vesting |
January 1, 20X5 |
$45 |
The applicable tax rate for all periods is 25%.
USA Corp recognizes compensation cost on a straight-line attribution basis. USA Corp has an accounting policy to estimate forfeitures.
All options have a contractual term of five years.
How should USA Corp compute the compensation cost, deferred tax asset, and tax benefits ultimately realized for options granted on January 1, 20X1 and 20X4?
Analysis
20X1 Awards |
20X4 Awards |
|
Compensation cost |
8 million options × $15 = $120 million = $40 million per year over three years
|
8 million options × $25 = $200 million = $66.6 million per year over three years
|
Deferred tax asset |
$40 million × 25% = $10 million deferred tax benefit each year, accumulating to a deferred tax asset of $30 million.
|
$66.6 million × 25% = $16.7 million deferred tax benefit each year, accumulating to a deferred tax asset of $50 million.
|
Tax benefit realized |
Total tax deduction of $160 million (8 million options times intrinsic value of $20 per option) yields realized tax benefit of $40 million.
Deferred tax asset of $30 million existing on December 31, 20X3 is realized.
Excess tax benefit of $10 million ($40 million total benefit less $30 million deferred tax asset) would be credited to income tax expense.
|
No tax benefit would be realized as the employees never exercise the options.
Deferred tax asset of $50 million existing on December 31, 20X6 (end of vesting period) will remain until the options expire.
When the options expire in 20X8 the entity will write off the $50 million deferred tax asset.
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