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10.7 Employer's income tax deductions for stock-based awards
Publication date: 30 Nov 2022
us Stock-based compensation guide
The following section summarizes some of the key corporate income tax considerations related to stock-based compensation under US federal income tax laws and regulations. It is intended to provide helpful context for considering plan design from the employer perspective. However, it is not intended to be and should not be considered comprehensive authoritative guidance for any specific employer or employee tax consequences.
Most areas of the income tax laws and regulations can be overwhelmingly complex and rule-driven. It should therefore come as no surprise that an employer's reporting of income tax deductions for stock-based compensation is a complicated matter. This section reviews the income tax rules for employers that companies commonly need to address when they design or modify their stock-based compensation plans. The following guidance should be considered a summary, not an all-inclusive description. Because the rules that govern employers' reporting of income tax deductions continue to evolve, companies should monitor the legislation and IRS regulations for new developments.
See TX 17 for a discussion of the financial accounting implications of income taxes associated with stock-based compensation.
10.7.1 Employer’s income tax rules for stock-based awards
As discussed in the preceding section of this chapter regarding employee's taxable income, IRC Section 83 provides guidance on the taxation of stock-based compensation to the employee. IRC Section 83 also specifies how an employer should deduct stock-based compensation on its tax return. IRC Section 83(h) provides that upon the transfer of property in connection with the performance of services, the "person for whom services were performed" (i.e., the employer) may claim a corporate tax deduction under IRC Section 162. The amount of the employer's tax deduction should equal the amount that was included in the gross income of the person who performed the services (this includes both employees and nonemployee service providers). If the employer timely reports the income on the employee's Form W-2 or on Form 1099 for independent contractors, (1) the person is deemed to have included the compensation in gross income and (2) the company may deduct the compensation on its tax return.
The employer's compensation deduction is generally allowed in the taxable year during which (or with which) the employee's taxable year ends. In other words, the employee's tax year is considered first, and the deduction may be delayed if the employer and employee use different taxable years. Consider the following examples:
- If the employer and employee are both calendar-year-end taxpayers, the timing of the employer's deduction will generally correspond with the timing of the employee's recognition of income for the compensation.
- If the employer's tax year ends on August 30, any compensation paid to the employee after December 31 and before September 1 may cause a one-year delay in the reporting of the employer's tax deduction.
Treasury Regulation Section 1.83-6(a)(3) makes a significant exception to this timing rule. The exception permits the employer to take a deduction in accordance with its method of accounting (cash or accrual) if the property is substantially vested upon transfer. Typically, most non-qualified stock-based compensation awards, other than restricted stock, will qualify for this exception and the deduction will be taken when the employee recognizes income.
Companies that do not have a calendar year-end should familiarize themselves with this regulation because the timing of recognizing the employer's tax deduction will impact the recognition of the tax impacts of the awards in the financial statements.
Companies will recognize windfall tax benefits when the uncertainty about the amount of the deduction is resolved, which is typically when an award is exercised or expired, in the case of share options, or vests, in the case of nonvested stock awards, subject to normal income tax valuation allowance considerations. For example, assume an employer's fiscal and tax years end on June 30. If a taxable exercise of a non-qualified stock option occurs on May 1, 20X6 (during the company's fiscal year ended June 30, 20X6), the employee will reflect the compensation income in their tax return for the year ending December 31, 20X6. Any compensation earned by the employee between January 1 and June 30 may not be deductible by the employer until its following fiscal year. Therefore, the company may not be able to reflect a tax deduction until its June 30, 20X7 tax return, as that is the company's tax year that includes the year-end date of the employee's 20X6 tax year.
10.7.2 Tax deductions for various types of stock awards
The following section discusses the timing of deductions by employers for restricted stock, restricted stock units, and stock options.
10.7.2.1 Restricted stock award tax deductions
The timing of the deduction for restricted stock awards will typically correspond with the employee's recognition of income under IRC Section 83(a). Because restricted stock shares are not fully vested upon transfer, the employer's deduction is subject to the general timing rule under Treasury Regulation Section 1.83-6(a)(1). Thus, the employer's deduction is taken in its tax year in which the employee's tax year ends. This guidance assumes that the compensation will have been included, or deemed to have been included, in the employee's gross income due to the employer's timely reporting.
If the employee makes an IRC Section 83(b) election (which accelerates the employee's income recognition), the employer is allowed to take the tax deduction in the year that the employee reports the compensation in gross income. If the amount of compensation that the employee recognized is not properly reported for tax purposes on the employee's Form W-2 (or the independent contractor's Form 1099-MISC), the employer will not be able to claim its deduction unless it can prove that the employee properly recognized the amount as compensation.
10.7.2.2 Restricted stock unit tax deductions
Similar to restricted stock awards, the timing of the deduction for RSUs will correspond with the employee's recognition of income upon vesting. However, because most RSU shares are fully vested upon transfer, the employer's tax deduction is generally taken under the special timing rule under Treasury Regulation Section 1.83-6(a)(3). Therefore, to the extent that the RSU income is timely reported by the company on the employee's Form W-2 (or the independent contractor's Form 1099-MISC), the employer may take a deduction in accordance with its method of accounting in the year the vested shares are transferred. Because an RSU is a promise to deliver shares to the employee in the future and does not represent an actual property interest, it is not until the shares are both vested and transferred (as sometimes the share transfer is delayed) that the employee will have taxable compensation and the employer is eligible to claim a tax deduction.
10.7.2.3 Nonqualified stock option tax deductions
Nonqualified stock options are not treated as property on the grant date for purposes of IRC Section 83, unless the option is in the uncommon position of having a readily ascertainable fair market value at that time. The grant of a nonqualified stock option to an employee is generally not reported on the employee's tax return. Instead, the compensation event occurs when the options are exercised and the underlying stock is delivered, at which time the employee is taxed. If the employee receives vested shares upon exercising the option, the employer is entitled to a tax deduction at the time of exercise. The timing of the deduction will be determined under Treasury Regulation Section 1.83-6(a)(3), which permits the employer to take a deduction in accordance with its method of tax accounting. If, however, the shares delivered upon exercise are not substantially vested and if the employee does not make an 83(b) election, the employee's taxation is delayed under IRC Section 83(a), and the employer would take its deduction under the general rule of Treasury Regulation Section 1.83-6(a)(1).
10.7.2.4 Statutory stock option tax deductions
If the employer has granted statutory stock options (i.e., ISOs or ESPPs), it will receive a tax deduction only upon a disqualifying disposition. If there is a disqualifying disposition, the employer will be entitled to a tax deduction if (1) the employee recognizes ordinary income at the time of sale and (2) the employer reports the income. An employer that otherwise satisfies the requirements of IRC Section 6041 will be regarded as having fulfilled those requirements in a timely manner.
Many companies allow employees to transfer their shares to personal brokerage accounts. When that occurs, companies may lose the ability to track disqualifying dispositions and corporate tax deductions may be lost. Companies that continue to grant ISOs might consider requiring that shares be held with a specified broker during the holding period, requesting annual self-reporting by employees, or legending the stock (which is a restriction that prevents the shares from being sold or transferred until approved by the company) to prevent sales without notification to the company.
10.7.3 Nonqualified stock options—employer payroll taxes
Under ASC 718-10-25-22, a liability for the employer’s portion of payroll taxes on employee stock compensation should be recognized on the date of the event triggering the obligation to pay the tax to the taxing authority. For a nonqualified stock option, payroll taxes generally will be triggered and recorded on the exercise date. Even though the employer’s payroll taxes are directly related to the appreciation of stock options, those taxes are part of the entity’s operating expenses and should be reflected as such in its income statement.
PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
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