ASC 718 and the Tax Implications of Stock Option Exercises
Stock options have become an integral part of employee compensation packages because of the flexibility and tax benefits they offer for both employees and employers. The two key sets of accounting guidelines for stock options are ASC 718 and ASC 740. Adhering to terms and conditions ensures smooth audits and tax compliance.
These accounting guidelines to founders and company owners tell us how to allocate expenses, create and adjust permanent items, make the necessary disclosures, and record journal entries.
Following the recommended accounting treatments of ASC 718 and ASC 740 for stock options ensures that you do not miss any opportunities for tax deduction.
This article dives deeper into the intricacies of ASC 718 and ASC 740 and offers valuable insights for budding finance professionals and founders.
Possibility of tax deductions
Employers can make tax deductions when certain stock options are exercised. Stock options can be broadly divided into incentive stock options (ISOs) and non-qualified stock options (NSOs).
When an NSO is exercised, the employee will recognize the difference between the fair market value (FMV) and the exercise price as their ordinary income. Employers can make a tax deduction equal to the ordinary income recognized by the employee.
Typically, ISOs being exercised will not result in tax deductions for employers. However, if an ISO does not meet its qualifying holding period requirements, it is treated as an NSO and thus, can result in tax deductions. These holding period requirements are:
- Stocks must be held for 2 years after the grant date
- Stocks must be held for 1 year after the exercise date
When an ISO does not meet these requirements, we say that it is sold with disqualifying dispositions.
For publicly traded companies, Section 162(m) of the Internal Revenue Code (IRC) places an annual per-employee tax deduction limit of $1 million for compensation paid to the 5 highest paid employees.
So, if one of the top 5 employees makes $3 million in a year, tax deductions will be available for only $1 million. If another one of the top 5 makes more than $1 million a year, the company can only deduct another $1 million from their taxable income.
The best practices with tax deductions on compensation to the top 5 highest paid employees are:
- Making deductions from the compensation first recognized for recording financial statements
- Make deductions from the cash compensation first since stock-based compensation is a deferred compensation and deductible only on exercise which may take years
- Applying the limit in the ratio of stock-based compensation and cash compensation paid out in a year
Expensing stock options issue as per ASC 718
Before we learn how stock option exercises are recorded, let us recap the accounting guidelines in ASC 718 for issuing stock options which are as follows:
Calculating the fair market value (FMV) of stock options
Under ASC 718, the fair market value (FMV) of stock options must be calculated on the issue date. You must use a 409A valuation to establish the FMV of the underlying asset, i.e. the stocks.
Typically, the value of stock options is calculated using models like the Black-Scholes Model. The recommended inputs for these models are FMV of the underlying asset, strike price, remaining vesting period, risk-free interest rate, volatility, and dividend yield.
Expense allocation
You must allocate the expense of stock options over the vesting period. As per the ASC accounting guidelines, companies can use the straight-line method or the FIN28 method to allocate the expense over the vesting schedule. In the straight-line method, the expense is allocated equally over the vesting schedule.
In the FIN28 method, the stock options vested in each year are treated as separate awards with their own vesting schedules. Stock options vested in year ‘n’ will vest over ‘n’ years. So, stock options vested in the 2nd year will vest over 2 years, and stock options vested in the 3rd year will vest over 3 years.
Recording expenses and making disclosures
Once you have allocated the expenses, you must record a journal entry debiting the stock-based compensation expense and crediting the additional paid-in capital. In your financial statements, you must also disclose details like outstanding stock options at the beginning of the year, stock options exercised, and stock options vested.
For a more detailed recap, please take a look at this article.
ASC 740 and the exercise of ISOs
ASC 740 is the accounting guideline that governs the accounting treatment of exercise of stock options. In this section, we will look at the accounting treatment of ISOs exercised without disqualifying dispositions.
The ASC 740 recommendations are as follows:
Adjustments to permanent items
When ISOs are created, the compensation expense is recorded as a permanent item. As ISOs are exercised, we must reduce this permanent item by the amount of stock options exercised.
Suppose a company issued 100,000 ISOs and the original per share FMV was $40. So, it ended up creating a permanent item of $4 million. Then, if 10,000 of these ISOs were exercised without disqualifying dispositions, we must reduce the ISO permanent item by 10,000 times $40 which is $400,000. After this adjustment, the ISO permanent item will be $3.6 million.
Journal entries
Since cash is being received, it must be debited. The common stock must be credited at the par value for the number of shares exercised. Since the par value may be lower than the exercise price, the difference must be credited to additional paid-in capital (APIC).
Let us understand this with an example.
Suppose, four years ago, StreamVerse issued 5,000 ISOs to May Hearns at a strike price of $40 and a vesting schedule of 5 years. The par value of 1 StreamVerse share is $5. This year, May Hearns exercised 1,000 ISOs. So, the journal entries will look like this.
| Particulars | Debit | Credit |
|---|---|---|
| Cash | $40,000 | - |
| Common stock | - | $5,000 |
| Additional paid-in capital | - | $35,000 |
ASC and the exercise of NSOs and ISOs with disqualifying dispositions
Now, let us see the accounting treatment recommended under ASC 740 for ISOs exercised with disqualifying dispositions and the exercise of NSOs.
Adjustments to permanent items
Once again, the permanent item must be reduced by the number of stock options exercised.
Recording excess benefit
The excess benefit is the difference between the FMV of exercised stock options on the issue date and the exercise date.
Suppose a company issued 100,000 stock options when the per share FMV was $40. 1 year later, 10,000 stock options were vested and exercised. At this point, the FMV had risen to $60. The company immediately bought back these shares.
So, excess benefit = Number of stock options exercised × (FMV on exercise – FMV on issue)
= 10,000 × ($60 – $40)
= $20 × 10,000
= $200,000
Calculating the amount of tax deduction
The amount of tax deduction will be equal to the difference between FMV on exercise and the exercise price.
Suppose 10,000 stock options were exercised at an exercise price of $20 when the FMV was $40.
Then, amount of tax deduction = Number of stock options exercised × (FMV on exercise – Exercise price)
= 10,000 × ($40 – $20)
= 10,000 × $20
= $200,000
Journal entries
In the previous section, we have already seen the journal entries for exercise price received and stocks awarded to employees. When ISOs are sold with disqualifying dispositions, we may also record the sale of stocks.
Let us see this with an example.
Suppose StreamVerse issued 100,000 stock options for a strike price of $10. The par value of StreamVerse shares is $5. At the time of issue, the FMV of each share was $30. Later, the FMV increased to $40, and 10,000 of these stock options were exercised. The company bought back these stocks.
So, in the current year, the journal entries will look like this:
Exercise of stock options
| Particulars | Debit | Credit |
|---|---|---|
| Cash | $100,000 | - |
| Common stock | - | $50,000 |
| Additional paid-in capital | - | $50,000 |
Repurchase of stocks
| Particulars | Debit | Credit |
|---|---|---|
| Common stock (Par value of $5 × 10,000 stock options) | $50,000 | - |
| Additional paid-in capital (Cash received originally – Common stock) | $50,000 | - |
| Excess benefits (Cash – Additional paid-in capital – Common stock) | $300,000 | - |
| Cash (FMV of $40 × 10,000 stock options) | - | $400,000 |
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It is important to note the differences in tax treatment of incentive stock options (ISOs) and non-qualified stock options (NSOs). While ISOs normally do not provide tax benefits to employers, the exercise of ISOs with disqualifying dispositions, and the exercise of NSOs can result in tax deduction benefits.
While ASC 718 governs the allocation of stock compensation expense, ASC 740 governs the exercise of stock options.
As per the accounting guidelines of ASC 740, companies must adjust permanent items, record excess benefits if any, and record appropriate journal entries for all transactions.
If a company fails to comply with ASC 740, it may face a challenging audit from the Internal Revenue Service (IRS).
At Eqvista, we support companies that issue stock options to their employees through 409A valuations and filing services. Contact us to know more!
