Tax Accounting Trials & Tribulations: Introduction for Emerging Companies

Elizabeth Dodge, CEP, Vice President, Stock & Option Solutions (US)Andy Ryser, Principal, Ernst & Young (US)

Explain fundamentals of stock-based compensation, including:

• Income taxation

• Income tax accounting (provision)

• Process and administration

Objectives

Common acronyms and terms• Stock options

• Non-qualified stock options (NQSOs)• Incentive stock options (ISOs)• Employee stock purchase plans (ESPPs)

• Stock• Restricted stock / performance shares

• Other equity-based compensation• Restricted stock units (RSU) / performance units

• Other key topics• APIC pool vs. additional paid-in capital (APIC) (actual journal entry)• Earnings per share (EPS)• Cash flow statement• Process & practical administration practices• Million dollar cap – § 162(m)

ASC Topic 718, Compensation ─ Stock Compensation

• ASC 718 (formerly 123(R)) requires companies to account for share-based payments based on fair value

• Fair value is generally amortized as compensation expense over requisite service period

• For all awards that vest (i.e., over period during which employee is required to provide services in exchange for award)

Recording of tax effects

• Under ASC 718, tax effects of stock-based awards recognized for financial reporting purposes only for awards that normally result in a tax deduction

• Examples include:• Non-qualified stock options• Restricted stock / units

• Statutory stock options (ISOs and qualified ESPPs) may not be assumed to yield a tax deduction

• May be a future change in status due to disqualifying disposition

Recording of tax effects cont.• Tax rules only allow a tax deduction when and if there is a taxable event

• Examples include:• Non-qualified stock option exercises• Incentive stock option (ISO) disqualifying disposition• ESPP disqualifying disposition• Restricted stock / performance share vesting • Restricted stock unit / performance unit settlement date

Book-tax differences• Timing of compensation

• Book expense is recorded over service period • Tax deduction is generally allowable upon exercise of option, vesting of

shares or settlement of units• Amount of compensation

• Fair value of option expensed for book purposes• Intrinsic value deducted for tax purposes

Deferred tax considerations• Calculating deferred taxes for deductible awards

• Deductible temporary difference (deferred tax asset - DTA)• Expense multiplied by entity’s statutory tax rate

• Estimated forfeiture rate is included indirectly• Compensation expense reversed for awards that do not vest because

service or performance conditions are not satisfied• Changes in estimated forfeitures are recognized through a cumulative

compensation expense catch-up adjustment in period of change in estimate

• Each grant must be tracked separately• Estimates of forfeitures included indirectly as they affect total recognized

compensation cost• Deductions that may be denied pursuant to IRC Section 162(m) should be

considered• Deferred tax asset may need adjustment to reflect changes in company or

employee tax jurisdiction rates

Valuation allowance on deferred tax assets (DTAs)• Record valuation allowance if it is probable that some portion of DTA will not

be realized• A DTA may no longer be realized if entity does will not have sufficient

income to offset DTA (value of underlying equity may not be considered)• Consider whether future taxable income will be sufficient to realize DTA• Changes in award’s intrinsic value not considered when determining whether

valuation allowance is required• Valuation allowance not recorded solely because of deeply out of money

options in which no tax deduction is expected• Disclosure of potential write-off of deferred tax asset may be required if

options approach contractual expiration

Windfalls / Shortfalls• Excess tax benefit (Windfall)

• Tax deduction when options are exercised• If tax deduction greater than recognized compensation cost:

• Excess tax benefit recorded as increase to APIC• Only if tax deduction results in realized tax benefit (i.e., not in

NOL)• Tax deficiency (Shortfall)

• If tax deduction less than recognized compensation cost:• Deficiency recorded against “APIC pool”

• One pool for all awards (e.g., stock options, restricted stock)• APIC pool based on excess tax benefits under ASC 718

• Plus deemed application of FAS 123 • Any remaining deficiency recognized in income statement• If options expire unexercised, no tax deduction results

• Must reverse DTA as if exercised

Realization of tax benefits• Record excess tax benefit only if realized

• When benefit reduces current taxes payable• If company has net operating loss (NOL) that is increased by deduction,

benefit is not realized and excess tax benefit not recorded in APIC• Such unrealized excess tax benefits should be realized in period in

which these tax benefits reduce income taxes payable, only after all net operating loss carryforwards are fully utilized

General concepts• Translation

• Deferred tax asset (D in example below) (that you booked as expense was recognized) does not equal actual tax deduction (A in example below

• If excess = increase to APIC (but only when tax benefit reduces taxes payable)

• If shortfall/deficiency = • Reduction to APIC pool (if sufficient) or • Potential tax expense (if APIC pool not available to offset)• But not for ISOs / qualified ESPPs

• A (actual) – D (deferred tax asset) = + is Excess / Windfall- is Deficiency / Shortfall

Qualified APIC credit pool• Pool of APIC credits available to offset tax benefit deficiencies:

• Includes excess tax benefits generated from awards subject to ASC 740-718 and predecessor standards FAS 123(R) and FAS 123 (pro forma or income statement recognition)

• Applies to all awards modified, granted or settled after effective date of FAS 123 (15 December 1994)

• Only tax benefits that have been realized (i.e. reduces taxes payable)• Grant by grant accounting must be utilized• APIC pool cannot drop below zero• APIC pool can only absorb write-offs of DTA related to share based

compensation

Non-qualified stock options (NQSOs)• General description - right to purchase employer stock at a specified price for

a specified period of time

• Several key events in life of a NQSO:

• Grant date

• Vesting date

• Exercise date

• Subsequent sale of shares acquired upon exercise

Note: This section will generally also apply to treatment of SARs

NQSOs cont.• Example:

• Date of grant: 12/31/06• Employee is granted 3,000 NQSOs• Market value of stock at date of grant: $10• Option exercise price: $10• Fair value of option at date of grant: $3• Under ASC 718 total book compensation expense $9,000 (3,000 shares x $3 fair

value on date of grant)• Vesting: 100% at end of three years, under ASC 718 $3,000 book compensation

expense per year (2007, 2008, 2009)• Employer tax rate: 35%• Date of exercise: 12/31/11• Market value of stock at exercise date: $15

NQSOs cont.Accounting treatment:

• Book compensation expense recognized over service period based on fair value at grant date

• Employer recognizes compensation expense over 3-year vesting period• $3,000 each year for next 3 years, total of $9,000 (3,000 options X

grant-date fair value of $3 per option)• Adjusted for estimated forfeitures up front with adjustment for awards

that actually vest (forfeiture estimate ignored for purposes of this example)

• Employer recognizes deferred tax asset (“DTA”) of $1,050 per year for next 3 years ($3,000 book compensation expense X 35% tax rate).

• For foreign awards, companies must receive a tax deduction in foreign country in order to set up a DTA (may require chargeback arrangements, etc.)

• Requires country by country review of country rules to assess if deduction available and how to secure such deduction

NQSOs cont.• Treatment on date of exercise

• Accounting treatment:

• Because employer’s tax deduction $15,000 is greater than compensation expense previously recognized ($9,000), employer credits additional paid-in capital (actual journal entry) for excess tax benefit

• With exercise, a right to a current deduction results and Company’s deduction of $15,000 will remove gross deferred tax asset of $9,000 (tax effected $3,150 = 9,000 x 35%)

• Additional credit to APIC calculated: $15,000 tax deduction - $9,000 cumulative book deduction = $6,000 tax > book deduction X 35% tax rate = $2,100 credit to “additional paid in capital – excess tax benefits” account (Due to “windfall” that resulted, increase to tax benefit APIC Pool (memo account) for $2,100 also results)

Incentive stock options (ISOs)• Key difference between ISO and NQSO is tax treatment of two awards

• If certain plan design requirements under Internal Revenue Code (IRC) §§421 and 422 are met, option is considered ISO and Employee recognizes no income upon exercise of ISO

• When shares acquired upon exercise are sold in a “Qualifying Disposition”, Employee recognizes capital gain equal to spread between sale price and option price, which is total cash paid to exercise options

• Sale is a qualifying disposition if employee holds stock for at least 2 years from date of grant and 1 year from date of exercise

• Otherwise, part or all of employee’s income will be considered ordinary income

ISOs cont.• Treatment on date of grant cont.

• Accounting treatment:

• Book compensation expense recognized over service period based on fair value at grant

• Employer recognizes cost over 3-year vesting period

• $3,000 each year for next 3 years, total of $9,000 (3,000 options X grant-date fair value of $3 per option)

ISOs cont.• Treatment on date of grant cont.

• Accounting treatment cont.:

• Employer recognizes a permanent add back $3,000 per year for book compensation expense ($1,050 tax effected = 3,000 x 35%). No deferred tax asset is established

• Compensation cost recognized only for awards that are expected to (and eventually do) vest (N/A in this example)

• Note: Even though a company may have ability to estimate that ISO’s are generally exercised and sold in same day and company will receive such deduction, a DTA may not be recognized over vesting period, due to fact award is not designed to provide a tax deduction

ISOs cont.• Treatment on date of vesting cont.

• Accounting treatment:

• A cumulative permanent difference of $3,150 ($9,000 total book compensation expense x 35% tax rate) resulted (again assuming no forfeitures)

• Treatment when employee sells shares in a Qualifying Disposition

• Employee: Upon sale of underlying shares, recognizes capital gain equal to $20 sale price less $10 option price = $10 x 3,000 shares = $30,000 total capital gain

• Employer: No tax deduction in year of exercise or in year of sale

ISOs cont.• Treatment when employee sells shares in a Disqualifying Disposition (DD)

• Employer: Receives tax deduction of $15,000 in year Disqualifying Disposition results. Employer’s deduction is equal to income recognized by employee.

• Accounting treatment:• Employer’s tax deduction $15,000 is greater than compensation

expense previously recognized ($9,000), employer credits additional paid-in capital for excess tax benefit

• Employer recognizes a permanent deduction $9,000 in quarter (discrete event) Disqualifying Disposition occurs, assuming all shares were exercised

• Credit to APIC calculated : $15,000 tax deduction - $9,000 cumulative book deduction = $6,000 tax > book deduction X 35% tax rate = $2,100 credit to “additional paid in capital – excess tax benefits” account.

• (Due to “windfall” that resulted, increase to tax benefit APIC Pool for $2,100 (memo account) results)

Restricted stock• Shares of stock granted to employee at reduced or no cost, but which are

subject to restrictions on transferability and are subject to a substantial risk of forfeiture

• Provides actual share ownership at time of grant. Shares are in employee’s name (even if not physically transferred to them) and they generally have dividend and voting rights

• Key issue is whether employee makes IRC § 83(b) election

• Employee must file election with IRS within 30 days of grant

• If employee files election, employee recognizes ordinary income equal to grant-date FMV (without election, no income recognized until stock vests)

Restricted stock cont.• Example:

• Date of grant: 31 December 2006• Employee is granted 3,000 shares of Restricted Stock• Market value of stock at date of grant: $10• Market value of stock at date of vesting: $15• Under ASC 718 (old method FAS 123/FIN 44) total book compensation expense

of $30,000 (3,000 shares x $10 market value on date of grant)• Vesting: 100% at end of three years, under ASC 718 $10,000 book compensation

expense per year (2007, 2008, 2009)• Employer tax rate: 35%• Date of sale: 31 December 2011• Market value of stock at date of sale: $20

Restricted stock cont.• Treatment on date of grant cont.

• Accounting treatment:• Compensation expense recognized over service period• Cost based on fair market value of stock measured at grant date• Cost recognized only for awards expected to (and eventually do) vest –

estimate up front and true up along way• DTA recognized based on compensation cost recognized over service

period• If 83(b) election filed, generally recognize deferred tax liability for

$30,000 and each year DTL will decrease as book compensation is recognized

• Under ASC 718, total compensation expense of $30,000 (3,000 shares X $10 market value on date of grant)

• Recognized $10,000 per year (2007, 2008, 2009)• NOTE: Forfeiture estimate ignored for purposes of this example

• Assuming no 83(b) election, total DTA of $10,500 recognized over period (30,000 total book compensation expense x 35% tax rate)

Restricted stock cont.• Treatment on date of vesting cont.

• Accounting treatment• Compensation expense will have already been recognized over service period

based on fair market value of stock measured at grant-date• True up for value of shares that actually vest (both a compensation cost and a

deferred tax asset adjustment)• Excess tax benefit (Assuming no 83(b) election):

• Employer’s tax deduction ($45,000) greater than expense previously recognized ($30,000), employer credits additional paid-in capital (actual journal entry) for excess tax benefit

• With vesting of award, a right to a current deduction results and Company’s deduction of $45,000 will remove gross deferred tax asset of $30,000 (tax effected $10,500 = 30,000 x 35%)

• Additional credit equals $45,000 tax deduction - $30,000 cumulative book deduction = $15,000 tax > book deduction X 35% tax rate = $5,250 credit to “additional paid in capital – excess tax benefits” account. (Due to “windfall” that resulted, increase to tax benefit APIC Pool (memo account) for $5,250 results)

• If 83(b) election filed, $15,000 tax > book deduction would not have resulted

Restricted stock cont.• Special rule: Retirement

• Be aware of retirement provisions that vest awards if individual reaches a certain retirement age or combination of age plus service

• Reaching retirement eligibility date is a taxable event even if individual must retire to vest in awards

• Employee will have a tax obligation but no shares to sell to cover taxes (since often employee must actually retire in order to get shares)

• Accounting treatment: Compensation expense must be recognized over shorter of vesting period or date participant reaches retirement eligibility – must be tracked separately

Restricted stock units (RSUs)/performance units• Similar to restricted stock except that shares are not transferred/placed in

name of participant on date of grant• Employee receives right to receive future delivery of actual stock or cash

subject on date of vesting (a promise to pay shares at vesting)• Unlike restricted stock: IRC Section 83(b) is not available• In general, income tax and accounting treatment on date of grant and date of

vesting for employee and employer are similar to restricted stock (with no 83(b) election)

• Stock-settled RSUs/performance shares vs. cash-settled RSUs/performance share units

• Cash-settled RSUs/performance share units require liability (i.e., variable) accounting

Other key issues relating to equity-based compensation• APIC Pool vs. Additional Paid in Capital• Earnings per share (EPS)• Cash flow statement• Process & practical administration practices• Million dollar cap – section 162(m)

APIC Pool vs. Additional Paid-in Capital• Underlying calculations of APIC as disclosed in financial statements and

APIC “Pool” are different• Additional paid-in capital is part of stockholder’s equity and represents

investment made by holders of common stock (actual journal entry)• APIC Pool can be considered a “memo account”

• Not disclosed and not actual entry in financial statements• Important because APIC Pool can absorb potential negative impact

of shortfalls on income statement which impacts a company’s earnings

APIC Pool• Two methods of calculating initial APIC Pool as of date of adoption of ASC 718

• Long-form method• Method calculates changes to APIC Pool on a grant-by-grant basis• Required to be used annually by companies on a go-forward basis

• Calculate as if FAS 123 had been adopted at time it was released• Data Intensive

• Short-form method• One time “transition phase” election to calculate Initial APIC Pool• No longer applicable and cannot be used to calculate post-adoption changes

to APIC Pool• If company adopted short-form method, then subtle yet significant transition

issues and modifications to post-adoption calculations• Fully vested awards vs. partially vested awards as of date of adoption

Statement of cash flows• Under ASC 718, cash savings resulting from excess tax benefits should be

presented as a financing cash in-flow with a corresponding deduction from operating cash out-flow

• Excess tax benefit is benefit of tax deduction for a share-based payment that exceeds recognized compensation cost for that award

• Calculation must be performed on option-by-option basis• Based on a gross calculation without offset from any deferred tax asset

write-offs to additional paid-in capital• Under APB 25 and FAS 123, cash flow effects of these excess tax benefits

were recognized in operating cash in-flows• Under modified prospective transition method, excess tax benefit to be

presented as a financing cash in-flow must include consideration of “pro forma deferred tax asset”

Process & practical administration practices• Modifications

• Some changing in vesting conditions can result in new measurement of compensation cost for entire award

• Cancellations• Company should ensure accurate documentation and tracking of post-vesting

cancellations. • Company must track type of award. For example, since ISOs do not generate a

tax benefit, should be omitted from post-vesting cancellation data. Company should be careful not to “true-up” DTA since it was never recognized during vesting period

• Underwater Options• Stock plan professionals should monitor stock options and watch for groups of

expiring options that may be underwater in order to forewarn Finance of any potential and impending negative impacts to income statement

Process & practical administration practices cont.• Alternative awards and considerations

• Increased collaboration and communication with stock plan professional, as well as Finance and Tax, is vital

• Especially important if company is considering outsourcing equity plan administration.

• Stock administrators should develop processes to ensure that proper information is received regarding 83(b) elections.

• Typically, someone in HR or tax maintains election information. • Consider developing a process so that HR promptly notifies stock

administration of 83(b) elections

Process & practical administration practices cont.• Alternative awards and considerations cont.

• Stock administrators should ensure processes are in place to track disqualifying dispositions.

• Establishing process that requires recipients to notify company of disqualifying dispositions is crucial to validating additional tax deduction and appropriately determining impact to APIC Pool

• Stock administrators can assist Tax Department in monitoring all equity-based awards to executives.

• Consider creating a flag or field in stock administration software system to track equity awards to executives identified in Summary Compensation Table of company’s proxy

IRC Section 162(m) considerations• Consideration must be given to whether a deduction is expected to be denied pursuant

to IRC Section 162(m)• Restricted stock that does not contain performance vesting provisions is a

common example• Effect on DTA of IRC Section 162(m) limitation

• Actions to avoid IRC Section162(m) limitation• Company control (requirement to defer compensation until after retirement)

– OK• Employee control (employee must make election to defer) – no tax benefit

• Accounting policy election to determine how IRC Section162(m) impacts stock compensation

• Pro rata• Share based payment last

Questions?