Corporate Tax Deduction
I’m going to start this discussion from the end and start with the company’s tax deduction. Certain employee stock compensation transactions that result in taxable income (e.g., non-qualified stock option exercises and restricted stock vests) are eligible for a corresponding company tax deduction. For example, if an employee realizes $1,000 income on an NQSO exercise and the company’s applicable tax rate is 40%, the company is eligible for a tax deduction of $400.
However, under FAS123(R), a company can’t just wait for the transaction to take place and then book the entire tax deduction. Instead, it must try and anticipate what that tax benefit will be and book it over the same schedule as the expense accrual for the award. Because the company can’t know for sure what income will result from eligible transactions, FAS123(R) details how to go about anticipating that unknown with as a deferred tax asset (DTA).
Calculating DTA
DTA, unlike the actual tax deduction, is calculated based on the FAS123(R) valuation of the grant using the company’s current tax rate and is generally booked over the vesting schedule. For example, if the company is expensing $5,000 for an NQSO each year over a four-year vesting schedule and the company’s tax rate is 40%, the company books a DTA of $2,000 each year of the same schedule (adjusted for expected forfeitures until the actual vest date).
Back to the End
When a transaction does take place the company can calculate the actual tax deduction, which will most likely be either more or less than the DTA amount. The company reverses the DTA that was previously booked and takes the actual tax deduction. However, the difference between these two numbers must also be reconciled. If the DTA is less than the actual tax deduction (i.e., the company realized more than the anticipated tax benefit), the company adds the excess tax benefit to the paid in capital account–often referred to as the APIC pool. However, if the actual tax deduction turns out to be less than the booked DTA (i.e., the company anticipated more tax benefit than it realized), then the company reduces the existing APIC pool by the unrealized tax benefit amount–or takes a tax expense if the APIC pool isn’t sufficient.
Get More
This is, of course, just the beginning of tax accounting for equity compensation under FAS123(R)–or even just a full conversation on deferred tax assets. We have a wealth of information on the NASPP’s Stock Plan Expensing portal. We also have an in-depth webcast in the NASPP webcast archive, “Practical Guide to Tax Accounting Under FAS 123(R).” However, if you are looking for the total information package on financial reporting, including accounting for tax effects, I highly recommend the NASPP’s course, Financial Reporting for Equity Compensation. The first class is today at 12:00 PM PT, but if you miss it, don’t worry. Not only are there four more fact-filled sessions, you can catch up on the recording of today’s class and take advantage of all the bonus materials. Register now!
-Rachel
Tags: deferred tax asset, DTA, FAS123(R), financial reporting, tax accounting, tax deduction
On June 23, the IRS and Treasury proposed new regulations under Section 162(m) relating to the requirements for options and SARs to be considered performance-based compensation and the transition period for newly public companies.
Not-So-Surprising Proposed Regs for Section 162(m) (Well, Maybe a Little Surprise for IPO Companies)
Section 162(m) limits the tax deduction public companies can take for compensation paid to specified executive officers to $1 million per year. As I’m sure you all know, however, performance-based compensation is exempt from this limitation.
The recently issued proposed regs are not nearly as controversial as the IRS’s 2008 surprise ruling on 162(m), but are still worth taking note of–especially since, as the Morgan Lewis memo we posted on the proposal points out, some of these clarifications are the direct result of compliance failures the IRS has encountered during audits.
Stock Options and SARs
Normally, for compensation to be considered performance-based, it must meet a number of rigorous requirements. At the time that Section 162(m) was implemented, however, at-the-money stock options and SARs were considered inherently performance-based, so the requirements applicable to them are significantly more relaxed (a decision I can only imagine regulators regret today, given current public sentiment towards stock options). The primary requirements are that the options/SARs be granted from a shareholder approved plan, individual grants are approved by a committee of non-employee directors, the exercise price is no less than the FMV at grant, and the plan states the maximum number of shares that can be granted to an employee during a specified period.
The proposed regs clarify that, for this last requirement, the plan must state a per-person limit; the aggregate limit on the number of shares that can be granted under the plan is insufficient (although, the stated per-person limit could be equal to the aggregate limit).
Disclosure
For all performance-based compensation, including stock options and SARs, the regs already require that the maximum amount of compensation that may be paid under the plan/awards to an individual employee during a specified period must be disclosed to shareholders. For stock options and SARs, it’s pretty hard to determine what the maximum compensation is, since this depends on the company’s stock price over the ten years or so that the grant might be outstanding. The proposed regs clarify that it is sufficient to disclose the maximum number of shares for which options/SARs can be granted during a specified period and that the exercise of the grants is the FMV at grant.
Newly Public Companies
For a limited “transition” period, Section 162(m) doesn’t apply to arrangements that were in effect while a company was privately held (provided that the arrangements are disclosed in the IPO prospectus, if applicable). This transition period ends with the first shareholders’ meeting at which directors are elected after the end of the third calendar year (first calendar year, for companies that didn’t complete an IPO) following the year the company first became public (unless the plan expires, is materially modified, or runs out of shares or the arrangement is materially modified before then).
For stock options, SARs, and restricted stock, the current regs are even more generous–any awards granted during this transition period are not subject to 162(m), even if settled after the transition period ends. The proposed regs don’t change this, but they do make it clear that RSUs and phantom stock are not covered by this exemption. My understanding from some of the memos we’ve posted in our alert on this is that this reverses a couple of private letter rulings on this issue (see the Morrison & Foerster, Morgan Lewis, and Edwards Angell Palmer & Dodge memos). The current regs specifically state that the exemption applies to stock options, SARs, and restricted stock, but are silent as to the treatment of RSUs and phantom stock–providing the IRS/Treasury with the leeway to exclude them now.
Subtle Changes
Several of the changes are pretty subtle–so subtle that when comparing the proposed regs to the current regs, I couldn’t figure out what had changed. So I used the handy-dandy document compare feature in Word to create a redline version of the new regs, which I’ve posted for the convenience of NASPP members.
Chickens, Stock Plan Administrators, and Whiskey
The author of the joke that appeared in last week’s blog entry is John Hammond of AST Equity Plan Solutions (and poet laureate of the NASPP blog). Ten points to Erin Madison of Broadcom, who was the only person to email me the correct the answer. I can’t believe no one else figured it out!
Tags: 162(m), corporate tax deduction, initial public offering, IPO, IRS, performance awards, proposed regulations, RSU, RSUs, Section 162(m), tax deduction, tax regulations, Treasury, Wisconsin Dells