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# Accounting For Stock Option and Its Tax Consequences

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A stock option gives an employee the right to buy stock at a specific price within a specific time period. Stock options come in two varieties: the incentive stock option (ISO) and the nonqualified stock option (NSO). This post discusses about accounting for stock option and its consequences to its recipients. Read on…

Accounting For Stock Option

An option is an agreement between a company and another company (mostly an employee), that allows the company to purchase shares in the company at a specific price within a specified date range. The assumption is that the options will only be exercised if the fixed purchase price is lower than the market price, so that the buyer can turn around and sell the stock on the open market for a profit.

If stock options are issued at a strike price that is the same as the current market price, then there is no journal entry to record. However, if the strike price at the time of the issuance is lower than the market price, then the difference must be recorded in a deferred compensation account.

For example, if 5,000 options are issued at a price of \$25 each to the president of the Lie Dharma Shoe Company on a date when the market price is \$40, then Lie Dharma’s accountant must charge a deferred compensation account for \$75,000 (\$40 market price minus \$25 option price, times 5,000 options) with the following entry:

[Debit]. Deferred compensation = \$75,000

[Credit]. Options—additional paid-in capital = \$75,000

In this example, the options cannot be exercised for a period of three years from the date of grant, so the accountant regularly charges off the deferred compensation account to expense over the next three years.

If Lie Dharma’s president elects to use all of the stock options to buy stock at the end of the three-year period, and the par value of the stock is \$1, then the entry would be:

[Debit]. Cash = \$125,000

[Debit]. Options—additional paid-in capital = \$75,000

[Credit]. Common stock—par value = \$5,000

[Credit]. Common stock—additional paid-in capital = 195,000

If, during the period between the option grant date and the purchase of stock with the options, the market price of the stock were to vary from the \$40 price at which the deferred compensation liability was initially recorded, the accountant would not be required to make any entry, since subsequent changes in the stock price are beyond the control of the company, and so should not be recorded as a change in the deferred compensation account.?

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### Using SFAS 123 (a Minimum of Footnote Reporting)

The Financial Accounting Standards Board has also issued Statement of Financial Accounting Standards (SFAS) number 123, which requires a minimum of footnote reporting using a different valuation approach; or a company may use it exclusively for both financial and footnote reporting (though few have chosen to do so, since it results in higher expenses being reported).

Note: If a company chooses to use the SFAS 123 approach for its normal financial reporting of stock option transactions (as opposed to just using it in footnotes), then the decision cannot be rescinded, and the company must continue to use this method in the future.

Under the SFAS 123 approach, compensation expense must be recognized for options granted, even if there is no difference between the current market price of the stock and the price at which the recipient can purchase the stock under the terms of the option.

The compensation expense is calculated by estimating the expected term of the option (that is, the time period extending to the point when one would reasonably expect them to be used), and then using the current risk-free market interest rate to create a discounted present value of what the buyer is really paying for the option.

The difference between the discounted price of the stock and the purchase price as listed in the option agreement is then recognized as compensation expense. For example, if the current interest rate on 90-day treasury bills is 7% (let’s assume it is a risk-free interest rate), the expectation for purchase of stock is three years in the future, and the option price of the stock is \$25, then its present value is \$20.41 (=\$25 x 0.816, Note: 0.816 is present value discount). The difference between \$25 and \$20.41 is \$4.59, which must be itemized in the footnotes as an accrued compensation liability.

Under SFAS 123, the present value of the stock that is to be purchased at some point in the future under an options agreement must also be reduced by the present value of any stream of dividend payments that the stock might be expected to yield during the interval between the present time and the point when the stock is expected to be purchased, since this is income forgone by the buyer.

The use of present value calculations under SFAS 123 means that financial estimates are being used to determine the most likely scenario that will eventually occur. One of the key estimates to consider is that not all stock options will eventually be exercised—some may lapse due to employees leaving the company, for example. One should include these estimates when calculating the total amount of accrued compensation expense, so that actual results do not depart significantly from the initial estimates.

However, despite the best possible estimates, the accountant will find that actual option use will inevitably vary from original estimates. When these estimates change, one should account for them in the current period as a change of accounting estimate.

However, if estimates are not changed and the accountant simply waits to see how many options are actually exercised, then any variances from the accounting estimate will be made on the date when options either lapse or are exercised. Either of these methods is acceptable and will eventually result in the same compensation expense, but the first approach is technically better, because it attempts to recognize changes as soon as possible, and so results in an earlier representation of changes in a company’s compensation expenses.

### Tax Aspect of Stock Option To Its Recipients (ISO, AMT and NSO Plans)

Incentive stock options are taxable to the employee neither at the time they are granted, nor at the time when the employee eventually exercises the option to buy stock. If the employee does not dispose of the stock within two years of the date of the option grant or within one year of the date when the option is exercised, then any resulting gain will be taxed as a long-term capital gain.

However, if the employee sells the stock within one year of the exercise date, then any gain is taxed as ordinary income. An ISO plan typically requires an employee to exercise any vested stock options within 90 days of that person’s voluntary or involuntary termination of employment.

The reduced tax impact associated with waiting until two years have passed from the date of option grant presents a risk to the employee that the value of the related stock will decline in the interim, thereby offsetting the reduced long-term capital gain tax rate achieved at the end of this period.

To mitigate the potential loss in stock value, one can make a Section 83(b) election to recognize taxable income on the purchase price of the stock within 30 days following the date when an option is exercised, and withhold taxes at the ordinary income tax rate at that time. The employee will not recognize any additional income with respect to the purchased shares until they are sold or otherwise transferred in a taxable transaction, and the additional gain recognized at that time will be taxed at the long-term capital gains rate.

It is reasonable to make the Section 83(b) election if the amount of income reported at the time of the election is small and the potential price growth of the stock is significant. On the other hand, it is not reasonable to take the election if there is a combination of high reportable income at the time of election (resulting in a large tax payment) and a minimal chance of growth in the stock price, or if the company can forfeit the options. The Section 83(b) election is not available to holders of options under an NSO plan.

The alternative minimum tax (AMT) must also be considered when dealing with an ISO plan. In essence, the AMT requires that an employee pay tax on the difference between the exercise price and the stock price at the time when an option is exercised, even if the stock is not sold at that time. This can result in a severe cash shortfall for the employee, who may only be able to pay the related taxes by selling the stock. This is a particular problem if the value of the shares subsequently drops, since there is now no source of high-priced stock that can be converted into cash in order to pay the required taxes.

This problem arises frequently in cases where a company has just gone public, but employees are restricted from selling their shares for some time after the IPO date, and run the risk of losing stock value during that interval. Establishing the amount of the gain reportable under AMT rules is especially difficult if a company’s stock is not publicly held, since there is no clear consensus on the value of the stock. In this case, the IRS will use the value of the per-share price at which the last round of funding was concluded. When the stock is eventually sold, an AMT credit can be charged against the reported gain, but there can be a significant cash shortfall in the meantime.

In order to avoid this situation, a employee could choose to exercise options at the point when the estimated value of company shares is quite low, thereby reducing the AMT payment; however, the employee must now find the cash to pay for the stock that he or she has just purchased, and also runs the risk that the shares will not increase in value and may become worthless.

An ISO plan is only valid if it follows these rules:

• Incentive stock options can only be issued to employees. A person must have been working for the employer at all times during the period that begins on the date of grant and ends on the day three months before the date when the option is exercised.
• The option term cannot exceed 10 years from the date of grant. The option term is only five years in the case of an option granted to an employee who, at the time the option is granted, owns stock that has more than 10% of the total combined voting power of all classes of stock of the employer.
• The option price at the time it is granted is not less than the fair market value of the stock. However, it must be 110% of the fair market value in the case of an option granted to an employee who, at the time the option is granted, owns stock that has more than 10% of the total combined voting power of all classes of stock of the employer.
• The total value of all options that can be exercised by any one employee in one year is limited to \$100,000. Any amounts exercised that exceed \$100,000 will be treated as a nonqualified stock option (to be covered shortly).
• The option cannot be transferred by the employee and can only be exercised during the employee’s lifetime.

If the options granted do not include these provisions, or are granted to individuals who are not employees under the preceding definition, then the options must be characterized as nonqualified stock options.

A nonqualified stock option is not given any favorable tax treatment under the Internal Revenue Code. It is also referred to as a non-statutory stock option. The recipient of an NSO does not owe any tax on the date when options are granted, unless the options are traded on a public exchange. In that case, the options can be traded at once for value, and so tax will be recognized on the fair market value of the options on the public exchange as of the grant date.

An NSO option will be taxed when it is exercised, based on the difference between the option price and the fair market value of the stock on that day. The resulting gain will be taxed as ordinary income. If the stock appreciates in value after the exercise date, then the incremental gain is taxable at the capital gains rate.

There are no rules governing an NSO, so the option price can be lower than the fair market value of the stock on the grant date. The option price can also be set substantially higher than the current fair market value at the grant date, which is called a premium grant.

It is also possible to issue escalating price options, which use a sliding scale for the option price that changes in concert with a peer group index, thereby stripping away the impact of broad changes in the stock market and forcing the company to outperform the stock market in order to achieve any profit from granted stock options. Also, a heavenly parachute stock option can be created that allows a deceased option holder’s estate up to three years in which to exercise his or her options.

Company management should be aware of the impact of both ISO and NSO plans on the company, not just employees. A company receives no tax deduction on a stock option transaction if it uses an ISO plan. However, if it uses an NSO plan, the company will receive a tax deduction equal to the amount of the income that the employee must recognize.

If a company does not expect to have any taxable income during the stock option period, then it will receive no immediate value from having a tax deduction (though the deduction can be carried forward to offset income in future years), and so would be more inclined to use an ISO plan. This is a particularly common approach for companies that have not yet gone public.

On the other hand, publicly held companies, which are generally more profitable and so must search for tax deductions, will be more inclined to sponsor an NSO plan. Research has shown that most employees who are granted either type of option will exercise it as soon as possible, which essentially converts the tax impact of the ISO plan into an NSO plan. For this reason also, many companies prefer to use NSO plans.

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