10.1 Background and Scope

ASC 718-740

Overview and Background

05-1 Topic 740 addresses the majority of tax accounting issues and differences between the financial reporting (or book) basis and tax basis of assets and liabilities (basis differences).

05-2 This Subtopic addresses the accounting for current and deferred income taxes that results from share-based payment arrangements, including employee stock ownership plans.

05-3 This Subtopic specifically addresses the accounting requirements that apply to the following:

The determination of the basis differences which result from tax deductions arising in different amounts and in different periods from compensation cost recognized in financial statements
The recognition of tax benefits when tax deductions differ from recognized compensation cost
The presentation required for income tax benefits from share-based payment arrangements.

05-4 Income tax regulations specify allowable tax deductions for instruments issued under share-based payment arrangements in determining an entity’s income tax liability. For example, under tax law, allowable tax deductions may be measured as the intrinsic value of an instrument on a specified date. The time value component, if any, of the fair value of an instrument generally may not be tax deductible. Therefore, tax deductions may arise in different amounts and in different periods from compensation cost recognized in financial statements. Similarly, the amount of expense reported for an employee stock ownership plan during a period may differ from the amount of the related income tax deduction prescribed by income tax rules and regulations.

Scope and Scope Exceptions

15-1 This Subtopic follows the same Scope and Scope Exceptions as outlined in the Overall Subtopic, see Section 718-10-15, with specific transaction qualifications noted below.

15-2 The guidance in this Subtopic applies to share-based payment transactions.

Understanding the tax law relevant to share-based payment awards is critical to understanding the proper accounting for the income tax effects of such awards. An entity must carefully consider the specific facts and circumstances of its share-based payment awards to determine the appropriate income tax treatment for them, and consultation with the entity’s tax advisers is encouraged. Taxation of transfers of property (including shares) to employees and vendors in connection with performance of services and delivery of goods is generally governed by IRC Section 83. This chapter summarizes U.S. tax law related to share-based payment awards under IRC Section 83.

10.1.1 Nonvested Shares

Under IRC Section 83, the grantee of a nonvested share award is generally taxed on the date the grantee becomes substantially vested in the share for income tax purposes (which may be different from the vesting date for accounting purposes). The fair market value of the share on the income tax vesting date is treated as ordinary income for the grantee, and the employer generally will receive a corresponding tax deduction.

10.1.2 Share Options

For share options, taxation depends on whether the transfer of shares resulting from exercise of the option is considered a qualifying transfer under IRC Sections 421 and 422.

For the transfer of shares resulting from the exercise of an option to be considered a qualifying transfer, the following must be true of the option and option plan:

The option plan is approved by the stockholders of the company.
The option is granted within 10 years of adoption of the plan or, if earlier, the date on which the stockholders approve the plan.
The maximum term of the option is 10 years from the grant date. For employees who own more than 10 percent of the total combined voting power of the employer or of its parent or subsidiary corporation, the maximum term is 5 years.
The option price is not less than the fair market value of the stock at the time the option is granted. For employees who own more than 10 percent of the total combined voting power of the employer or of its parent or subsidiary, the option price must not be less than 110 percent of the fair market value.
The option is transferable only in the event of death.
The employee is employed by the employer (or its parent or subsidiary) for the entire period up to three months before the exercise date of the option.

Share options that meet these criteria are commonly referred to as incentive stock options (ISOs) or statutory stock options, and shares transferred or issued in connection with the exercise of such options are referred to as statutory option stock. Options that do not meet these criteria are commonly referred to as nonqualified stock options (NQSOs). ISOs may be issued only to employees, whereas NQSOs may be issued to nonemployees.

To continue being considered as a qualifying transfer, the transfer of shares resulting from the exercise of an option must meet the criteria above, and the individual acquiring statutory option stock may not dispose of it within two years of the grant date or within one year of the exercise date. If these requirements are violated, a disqualifying disposition occurs, and the transfer is no longer considered a qualifying transfer. Also, the maximum amount of ISOs that may first become exercisable by an employee in a calendar year is $100,000. That maximum is determined by reference to the fair market value of the shares underlying the option on the grant date (i.e., the fair value of the shares, not the fair value of the option, on the grant date). Generally, options to acquire shares that exceed the annual maximum should be treated as NQSOs.

10.1.2.1 Qualifying Transfers

Qualifying transfers receive favorable tax treatment from the perspective of the employee. These transfers are not taxable to the employee (or former employee) for “regular” tax purposes until the statutory option stock has been disposed of (although there may be AMT consequences — see the next paragraph). Upon disposition of the stock, the employee will be subject to long-term capital gains tax for the difference between the proceeds received upon disposal and the exercise price, as long as the employee has held the stock for the required periods. If the employee holds the stock for the required periods, the employer does not receive a tax deduction related to the ISO.

Under the tax law, an individual must recognize a “tax preference” item upon exercise of an ISO that is equal to the difference between the exercise price and the fair market value of the underlying shares on the exercise date. This tax preference item may cause the individual to owe AMT. Generally, the AMT may be avoided by selling the ISO shares in the same calendar year in which they were purchased (a disqualifying disposition; the tax consequences are noted below). An employer does not receive a tax deduction corresponding with an employee’s AMT liability upon exercise of an ISO.

10.1.2.2 Nonqualifying Transfers

If the transfer is considered nonqualifying because the terms of the award preclude it from being considered an ISO, the intrinsic value of the option on the date of exercise is included in the employee’s ordinary income and the employer receives a corresponding tax deduction.

If the transfer is considered nonqualifying because of a disqualifying disposition, the lesser of (1) the excess of the fair market value of the stock on the exercise date over the strike price or (2) the actual gain on sale is included in the employee’s ordinary income as compensation in the year of the disqualifying disposition. The employer receives a tax deduction for the amount of income included by the employee.

10.1.3 Restricted Share Units and Share Appreciation Rights

Share-settled RSUs and share appreciation rights (SARs) are both generally taxed when the shares are transferred in settlement of the award. Taxation of share-settled RSUs is the same as that for deferred compensation, resulting in ordinary income for the employee equal to the value of shares when distributed and a corresponding tax deduction for the employer. RSUs are not considered legally issued shares and therefore do not represent actual property interests (e.g., equity in the company). Unlike nonvested shares, RSUs can be structured to defer income beyond the vesting date.

Taxation of SARs is similar to that of NQSOs. Like NQSOs, SARs result in income on “exercise” or settlement. The employee has ordinary income on the basis of the fair value of the cash or shares transferred at settlement, and the employer receives a corresponding tax deduction.

10.1.4 Employee Stock Purchase Plans

Employees may also have the option to acquire stock of their employer in accordance with an employee stock purchase plan (ESPP). In a manner similar to ISOs, the acquisition of stock in connection with an ESPP that meets the criteria in IRC Section 423 also generally does not result in income to the employee at the time the stock is purchased. Therefore, the employer would not ordinarily receive a tax deduction related to shares purchased under an ESPP unless a disqualifying disposition occurs. The maximum amount of stock that can be purchased under an ESPP is $25,000 per year.

Confidential and Proprietary — for Use Solely by Authorized Personnel

This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.