RSM Resources

Over the past year, there has been considerable hubbub over aFinancial Accounting Standards Board (FASB) pronouncement that requirescompanies to measure and expense the fair value of stock-option grantsto employees.

However, an equally important ripple effect fromthe pronouncement, known as FAS 123R, requires companies to recorddeferred-tax assets for the expected future tax benefit on thesenow-expensed options. If the tax deduction for the options ends upexceeding the amount expensed for books, the excess tax benefit("windfall") gets booked to additional paid-in capital (APIC), similarto the historical treatment. But what happens to the deferred-tax assetif the tax deduction for these options ends up being less than theoriginal fair-value expense ("shortfall")?

Generally, acompany can avoid extra tax expense through net income to the extent itcan apply the deferred-tax asset write-off against past windfall taxbenefits. Consequently, by November 2006, experts say, many businesseswill need to document a pool of windfall tax benefits ("APIC pool")that can handle any tax shortfalls accruing from the exercise of futureoptions.

"The bottom line is this: Companies will need to havean APIC pool if they determine the options they have granted willcreate a tax shortfall event," says Ray Stephens, a certified publicaccountant and professor of accounting at Ohio University in Athens,Ohio.

Filling the pool

FAS 123R allowstwo main approaches for establishing the initial APIC pool. The initialpool is the amount of net windfall benefits that would have accruedsince the original adoption of FAS 123 in 1994.

In thestandard, or "long," method, companies must carefully review all stockoptions, grant-by-grant, issued since Dec. 15, 1994. In this review, abusiness must analyze what the deferred-tax effect would have been ifFAS 123R were in effect during that time. It uses that information todetermine the opening amount for the APIC pool. To gather thisinformation, Stephens says most companies should rely on past pro formadisclosures, including the "fair value" of each grant and the historyof any disqualified incentive stock options during the same period.

Alternatively, companies can adopt a "shortcut" approach. As described in a Journal of Accountancyarticle by Nancy Nichols and Luis Betancourt at George MasonUniversity, this method allows a company to establish an opening APICpool balance by calculating the difference between two figures:

• Theincreases in additional paid-in capital recognized in a company’sfinancial statement related to tax benefits from stock-basedcompensation following adoption of FAS 123 but preceding adoption ofFAS 123R, and
• The "cumulative incremental" compensationexpense disclosed during the same period, multiplied by the company’scurrent blended statutory tax rate when it adopts FAS 123R. The blendedtax rate includes federal, state, local and foreign taxes.

Thetwo methods often result in differing amounts, and a company must makeany decision to use the short method within 12 months of its FAS 123Reffective date. Consequently, a company should consider both indetermining the initial pool as soon as possible.

What goes into the initial pool and adds or subtracts from the pool in future years depends a lot on the options involved.

Nonqualified and incentive stock options defined

Tounderstand the potential tax benefits or liabilities of different stockoptions under FAS 123R, it’s important to first learn how optionsdiffer from one another.

A company can compensate employees orservice providers with nonqualified stock options (NQSOs). Here’s howthey work: A company grants the employee or service provider an optionto purchase shares of stock at a fixed price. When a stock is publiclytraded, the option price at grant date is typically the quoted marketprice on that date or the average market price for some trading periodpreceding the grant date. When the stock isn’t publicly traded, thecompany determines the value of a share of stock on the date it grantsthe option. Nonqualified stock options typically lapse on a certaindate.

Since this arrangement is a form of compensation, theemployee or service provider reports ordinary income when exercisingthe option unless the stock received at exercise is subject to somerestriction. The amount of ordinary income is the excess of thefair-market value of the shares received over the option price on thedate of exercise. The company receives a tax deduction for thisordinary income the employee or service provider reports.

Theseoptions are referred to as "nonqualified" because they do not qualifyfor special treatment under the Internal Revenue Code. The most common"qualified" option is an incentive stock option (ISO).

ISOsare available only to employees and carry other restrictions. But theydo offer several advantages for the employees. For example, employeesdo not have to report any income when they exercise incentive stockoptions. And under certain circumstances, the entire gain upon the saleof the stock is subject to long-term capital-gains taxes, typically alower tax rate than ordinary income. In contrast to NQSOs, if ISOsremain qualified, no deduction is allowed to the employer on exercise.Where an employee or service provider fails to hold the stock longenough to qualify for ISO treatment, they must pay taxes under the samerules as nonqualified options — with one sometimes significantdifference. There is no Social Security tax associated with theordinary income realized on a disqualifying disposition of the ISOstock.

Different stock options, different tax events

When it comes to determining potential tax benefits or liabilities under FAS 123R, all stock options are not the same.

Whena company issues NQSOs, FAS 123R requires that, over the serviceperiod, the company log those grants as compensation expense on itsfinancial statement. However, those options also represent deferred-taxassets, which the company cannot deduct for income-tax purposes untilexercise.

When an employee exercises an NQSO, Stephens says,the company should compare the difference between the previouslyrecorded financial statement expense and any income-tax deduction thecompany receives from settling the NQSO. Depending on the result, theoption settlement results in either a tax windfall or shortfall.

"Windfallshappen when the tax deduction is more than the book compensationexpense, and shortfalls are when the tax deduction is less than thatcompensation expense," Stephens says. In a shortfall position, if thewrite-off of a deferred-tax asset is greater than your APIC pool, youcharge the difference against your income statement. But if the taxdeduction is greater than the compensation expense, that windfall taxbenefit increases the APIC pool to offset future shortfalls.

Comparedwith NQSOs, the scope of tax benefits for ISOs is far narrower. Upongrant of an ISO, no tax deduction is envisioned, and thus nodeferred-tax asset is set up for the future tax benefit. Under theInternal Revenue Code, Stephens says companies can get an ISO taxdeduction only due to a "disqualifying disposition" in which theemployee sells the stock within two years of the original grant date orwithin one year of the exercise date. Under those circumstances, thetax deduction based on the intrinsic value may be greater than theoriginal compensation expense reported under FAS 123R. This would leadto an additional tax windfall increasing the APIC pool. Unlike NQSOs,because no deferred-tax asset was set up originally, no tax shortfallwill exist if the tax deduction is less than the original expense.

Becauseof the tax complexity inherent in FAS 123R, Stephens says it’s easy forpeople to overlook some critical implementation points. For example, ifthe value of a stock option is "under water" — meaning the exerciseprice is lower than the current market price of the stock — a deferredtax asset must be charged against the APIC pool (or net income if nopool) upon expiration or cancellation of the vested option. Andcompanies that have employees outside the United States must take greatcare to use local tax laws to determine the deferred-tax asset effects."If a midsized company issued stock options to staff working in othercountries, that needs a closer look," Stephens says. "Because the lawson stock-option deductions vary greatly around the world, you mustreview the rules in those jurisdictions to determine if you’ll beallowed a tax deduction on those grants."