The tax accounting for equity compensation is widely recognized as one of the most complicated areas under ASC 718. While the basic concepts related to deferred taxes and the timing and quantity differences between GAAP and the IRS tax code are simple to understand, the application of these concepts across vast amounts of equity award data, granting jurisdictions, equity award types, and corporate circumstances creates significant complexity and audit risk.
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The basic mechanics of tax accounting for equity awards entail setting up a deferred tax asset (DTA) based on the cumulative book expense for awards that are expected to result in future tax deductions, and reversing that DTA when the award is settled for tax purposes. Differences between these two respective measures of value (taken at different points in time) are typically recorded in additional paid-in-capital (APIC).
A few of the more complicated issues discussed therein are summarized below:
Partial Vested Awards
- The tax accounting is relatively straightforward for companies that adopted ASC 718 using the modified retrospective method, since there is no such thing as an “as if” DTA.
- In contrast, modified prospective adopters only recorded DTAs in their financial statements for new stock options issued after the adoption date, options that were granted before the adoption date but modified after the adoption date, and for the unvested portion (at adoption) of previously issued options (often referred to as “straddle options”).
- These straddle options give rise to a partial book DTA and partial unrecorded (“as-if”) DTA. This bifurcation of the total DTA impacts the entire DTA accounting model, especially at settlement when APIC is credited/debited and the hypothetical APIC Pool is rolled forward.
Incentive Stock Options
- A company is not entitled to a tax deduction related to the issuance of ISOs unless the holder disposes of their shares in a disqualifying disposition. This reduction in tax expense is only recorded if and when there is a disqualifying disposition.
- Disqualifying dispositions can create tax windfalls, but only when the tax deduction recognized as a result of the disposition exceeds the cumulative book compensation. ISOs cannot give rise to tax shortfalls since no DTA is ever recorded in the first place.
- On partially vested ISOs at adoption, the tax deduction is allocated between the pre-adoption and post-adoption periods, which is intended to prevent the recording of a tax benefit in the income statement for the portion of an award that never actually gave rise to compensation expense in the income statement.
- Most know the APIC Pool as an off-balance sheet account that tracks realized windfall tax benefits, and which is available to offset tax deficiencies. Tax deficiencies are debited to additional paid-in-capital only to the extent that sufficient credits exist in the APIC Pool.
- Companies were given two methods for calculating the beginning APIC Pool balance as of the adoption of ASC 718: a long method (described in ASC 718 itself) and simplified method (through the release of FASB Staff Position FAS 123R-3). Some companies never went through the initial calculation exercise, and it is not imperative that they do so in the event shortfall situations occur.
- Ongoing tracking of the APIC Pool differs based on whether the long or simplified method was used to calculate the beginning balance. The difference concerns how options that were fully vested prior to adoption are treated, whereby under the simplified method, the entire tax benefit serves to increase the APIC Pool.
- ASC 718 changed prior guidance by creating a realization requirement for all excess benefits before they can be recorded in the financial statements or added to the APIC Pool.
- The realization requirement stipulates that excess tax benefits are only considered “realized” if the associated tax deduction reduces taxes payable. Once this happens, the excess benefits are recorded as a credit to APIC and increase the APIC pool. If the deduction merely increases an NOL carryforward, it has not reduced taxes payable and has not been realized.
- If not realizable, the tax benefit and corresponding credit to APIC and increase in the APIC Pool is “put on hold” until the deduction reduces taxes payable – this creates what some refer to as a “Footnote 82 memo account”
- Two techniques are provided for relieving the Footnote 82 memo account: tax-law ordering method and with-and-without method (aka FAS 109 ordering). Companies must elect an accounting policy and apply it consistently.
ISO $100,000 Limitation
- IRC Section 422(d) places a limit of $100,000 on the amount of ISOs that may first be exercisable in a single calendar year by a single employee. Any options exceeding the $100,000 limit are to be treated as non-qualified stock options (NQSOs).
- Companies must identify those awards (or portions thereof) that exceed the $100,000 threshold and thus require NQSO classification. This reclassification to NQSO status enables a company to realize a deferred tax asset over the requisite service period, as well as to properly claim the tax deduction and adjust additional paid-in-capital and the APIC pool at exercise.
- Multinational companies should only record expected tax benefits (i.e., DTAs on the balance sheet and deferred tax benefits in the income statement) for countries where they can claim a tax deduction on the local return. In those countries, the local tax rate should be used.
- Most overseas tax authorities require companies to bear the cost of the equity compensation in order to claim a tax deduction, typically by reimbursing the parent via a recharge agreement. In most countries, a tax deduction is not permitted on the local return unless there is a recharge agreement in place.
- One important requirement for multinational firms involves instituting billing processes that enable efficient billing of foreign subsidiaries for the cost of equity issued to employees in those subsidiaries.
Cost Sharing Arrangements
- Two affiliated companies often share the cost of granting equity awards to employees of one company (usually the US parent) that is engaged in R&D that will generate revenue in multiple jurisdictions.
- The affiliated company usually operates in a low-tax jurisdiction, and thus reimburses the US parent for a portion of the R&D costs. This enables the affiliate to own the right to profit from the R&D in their local market without having to reimburse the US parent based on future profits. The ultimate goal is a reduction in the worldwide effective tax rate by minimizing US taxable income.
- Two methods are provided for handling cost sharing agreements, the Exercise Date Method and Grant Date Method. In the former case, the affiliate reimburses the parent based on the actual tax deduction, and in the latter case, the affiliate reimburses the parent based on the book expense.