10.2 Deferred Tax Effects of Share-Based Payments

ASC 718-740-25-2 indicates that the “cumulative amount of compensation cost recognized for instruments classified as equity that ordinarily would result in a future tax deduction under existing tax law shall be considered to be a deductible temporary difference in applying [ASC 740]” (emphasis added). This represents the first of two key exceptions to ASC 740’s balance sheet model contained in ASC 718 (see Section 10.2.10 for discussion of the second). Because the accounting for an equity award under ASC 718 does not result in a difference in the basis of an asset or liability recognized for income tax or financial reporting purposes (i.e., because the offsetting entry to compensation cost is equity of the issuer), no temporary basis difference would exist, and therefore no deferred taxes would be recorded for such an award. ASC 718-740-25-2, however, requires that the cumulative amount of compensation cost itself be considered a deductible temporary difference for which a DTA is recorded. Likewise, recognition of compensation cost for share-based payments that “ordinarily do not result in tax deductions” do not give rise to deferred taxes, as indicated in ASC 718-740-25-3, but the recognition of a DTA may be required if a future event gives rise to a tax deduction that ordinarily would not be available for such instruments. See Section 10.2.7 for additional information.

As indicated in ASC 718-740-25-4, the accounting for liability-classified awards that would ordinarily result in a tax deduction is the same as that for equity-classified awards. That is, the cumulative amount of compensation cost recognized for financial reporting purposes represents a deductible temporary difference for which a DTA is recorded. While ASC 718-740 does not make a distinction between equity and liability-classified awards (e.g., a SAR that requires settlement in cash) for this purpose, the deferred tax accounting for liability awards does not represent an exception to the balance sheet model under ASC 740 because the cumulative amount of compensation cost recorded for financial reporting purposes under ASC 718 does result in a temporary difference (i.e., a liability recorded for financial reporting purposes with no corresponding liability for tax purposes).

IRC Section 162(m) may limit the deductibility of an ordinarily deductible share-based payment award issued by an entity that is a “publicly held corporation” under that section’s requirements. The definition of a publicly held corporation includes entities that must register securities or file reports under Sections 12 or 15(d), respectively, of the Securities Exchange Act of 1934. IRC Section 162(m) specifically limits the deductibility of compensation paid to a company’s CEO and CFO as well as its three other highest paid officers (referred to collectively as “covered employees”) for tax years ending on or before December 31, 2026. For tax years ending after December 31, 2026, the limitation applies to the CEO, the CFO, the next three most highly compensated executive officers, and the next five highest compensated individuals (i.e., covered employees are not limited to officers). Further, such individuals do not automatically retain covered employee status in each subsequent taxable year.

The DTA associated with stock-based compensation is computed on the basis of the cumulative amount of stock-based compensation cost recorded in the financial statements and is not affected by the grantor’s current stock price. Such DTAs should not be remeasured or written off because of a decline in the grantor’s stock price, even if it has declined so significantly that (1) an award’s exercise is unlikely to occur or (2) the intrinsic value on the exercise date will most likely be less than the cumulative compensation cost recorded in the financial statements (i.e., a tax deficiency exists).

The primary difference between the deferred income tax accounting for equity-classified awards and that for liability-classified awards under ASC 718 is that the measurement of the DTA associated with liability-classified awards inherently takes into account the grantor’s current stock price in each period. This is because liability-classified awards are remeasured to their fair-value-based amount each period until settlement. The DTA (and corresponding deferred income tax benefit) is recognized in the same manner as the compensation cost (i.e., either immediately or over the remaining service period, depending on the vested status of the award). Because the DTA and the associated compensation cost are remeasured in each reporting period, the tax benefit of the liability-classified award will, upon settlement, equal the DTA. Accordingly, the settlement of a liability-classified award generally will not result in an excess tax benefit or a tax deficiency as described in Section 10.2.4 for equity-classified awards.

If an entity has non-tax-deductible awards (e.g., ISOs) that are expected to be subject to disqualifying dispositions, it should follow the guidance under ASC 718-740-25-3, which explains that an entity cannot record a tax benefit in the income statement until the disqualifying disposition of an award occurs. Therefore, no DTA and related tax benefit can be recognized in connection with such an award until a disqualifying disposition occurs.

When enacted changes occur in the tax law that cause a change in an entity’s tax rate, a DTA related to temporary differences arising from tax-deductible share-based payment awards should be adjusted in the period in which the change in the applicable tax rate is enacted into law. To determine the amount of the new DTA, an entity should multiply the new tax rate by the existing temporary difference for outstanding tax-deductible share-based payment awards measured as of the enactment date of the rate change. The difference between the new DTA and the existing DTA should be recorded as a deferred tax benefit or expense and allocated to income from continuing operations discretely. See Section 3.5.1 for a broader discussion of the accounting for deferred tax effects of changes in rates.

The grantee of a nonvested share may, within 30 days of that grant, make an election under IRC Section 83(b) to be taxed when the award is granted (i.e., when the property is transferred for IRC Section 83 purposes) rather than when it vests for tax purposes (commonly referred to as an 83(b) election). In that case, the grantee will have ordinary income equal to the fair market value of the stock on the date the award is granted and the employer will receive a corresponding tax deduction. Any subsequent appreciation realized by the employee upon sale of those shares is taxed at capital gains rates.4

Under U.S. GAAP, compensation cost may be capitalized for employees who spend time on production of inventory or construction of fixed assets. This results in an asset for financial reporting purposes with no corresponding tax basis and, under ASC 740, would ordinarily represent a taxable temporary difference and corresponding DTL. However, in accordance with ASC 718-740-25-2 (for instruments classified as equity) and ASC 718-740-25-4 (for instruments classified as liabilities), the “cumulative amount of compensation cost recognized for instruments . . . that ordinarily would result in a future tax deduction under existing tax law shall be considered to be a deductible temporary difference.” If the cost of an award that will ordinarily result in a tax deduction for tax purposes is capitalized (e.g., as part of inventory or a fixed asset), the capitalized cost also becomes part of the tax basis of the asset. This represents the second of two key exceptions to ASC 740’s balance sheet model contained in ASC 718 (see Section 10.2.1 for a discussion of the first). As a result of this exception, the book and tax basis of the capitalized compensation cost initially are considered to be equal and no DTL is recorded. If depreciation is taken for financial reporting purposes before a tax deduction (or capitalization) for income tax purposes, a temporary difference will arise. Upon generating a tax deduction (or upon capitalization) for income tax purposes, an entity should recognize any excess tax benefit or tax deficiency in the income statement. Any capitalized cost of an award that would not ordinarily result in a future tax deduction would not be treated as part of the tax basis of the asset in accordance with ASC 718-740-25-3.