Question

Assume that on January 1, year 1, ABC Inc. issued 5,000 stock options with an estimated value of $10 per option. Each option entitles the owner to purchase one share of ABC stock for $25 a share (the per share price of ABC stock on January 1, year 1, when the options were granted). The options vest at the end of the day on December 31, year 2. All 5,000 stock options were exercised in year 3 when the ABC stock was valued at $31 per share. Identify ABC’s year 1, 2, and 3 tax deductions and book–tax differences (indicate whether permanent and/or temporary) associated with the stock options under the following alternative scenarios:

a) The stock options are incentive stock options and ASC 718 applies to the options.

b) The stock options are nonqualified stock options and ASC 718 applies to the options.

Answer 1

a) In case of incentive stock options, no deductions are allowed to ABC Inc. for tax purpose. However under ASC 718 the intial expenses of stock options are allowed as deduction for book purpose. In the said case the estimated value of per option is $10.

In year 1, since options were not vested hence nothing will be compensated in year 1.

In year 2, 5,000 options are vested; hence ABC will deduct $50000 (5000*10) as compensation expense in year 2. Thus ABC Inc. will report permanent unfavourable book tax difference of $50,000 in year 2.

In year 3, options are exercised. No book tax difference is reported in year 3.

b) For book purpose, ABC Inc. can claim initial expenses on options as the options vest under ASC 718. In the said case, the estimated value per option is $10.

In year 1 no comepnsation expense will be deduction since options are not vested yet.

In year 2 since options are vested hence $50,000 (5000*$10) will be deducted as compensation expense by ABC Inc.Thus ABC will report unfavourable temporary book tax difference of $50,000 in year 2.

In year 3, options are exercised. Thus unfavourable book tax difference of $50,000 in year 2 will now be reversed with $50,000 favourable book tax difference in year 3.

Further for the tax purpose, ABC Inc. can deduct the bargain element, i.e., FMV-Exercise Price, of the options in year 3 when the options are exercised, Hence it can deduct $30,000 ( ($31-$25)*5,000 )for computing the taxable income.

Moreover now ABC Inc. will report $20,000 as unfavourable permanent difference due to $50,000 that was deducted for book purpose from options and $30,000 that was deducted for tax purpose.