Question

Assume that on January 1, year 1, ABC Inc. Issued 7,550 stock options with an estimated value of $12 per option. Each option entitles the owner to purchase one share of ABC stock for $33 a share (the per share price of ABC stock on January 1, year 1, when the options were granted). The options vest at the end of the day on December 31, year 2. All 7,550 stock options were exercised In year 3 when the ABC stock was valued at S38 per share. Identify ABC's year 1, 2, and 3 tax deductions and book-tax differences (Indicate whether permanent and/or temporary) associated with the stock options under the following alternative scenarios: Required a. The stock options are Incentive stock options and ASC 718 applies to the options b. The stock options are nonqualified stock options and ASC 718 applies to the options. Complete the following table. (For all requirements, leave no answer blank. Enter zero If applicable.) Year 1 Year 2 Year 3 Book-Tax Diff Book-Tax Diff Book-Tax Diff Fav/Unfav Temp/Perm Fav/Unfav Temp/Perm Fav/Unfav Temp/Perm Under ASC 718 a. Incentive Stock Options Unfavorable Permanent Unfavorable Permanent b. Nonqualified Stock Options Unfavorable Temporary Unfavorable Temporary Favorable Temporary Unfavorable Permanent

Answer 1

a) ABC is not allowed any deductions for incentive stock options for tax purposes. For book purposes, ABC expenses the initial value of the stock options as the options vest under ASC718. The options are valued at $12 per option. In year 1, 3775 options vest. ABC will deduct (3775*12) $45300 of compensation expense. In year 2, 3775 more options vest. ABC will deduct $45300 compensation expense in year 2 for book purposes.

ABC will have an unfavorable permanent book tax difference of $45300 in year 1 and in year 2. There will be no book tax difference in year 3.

b) For book purposes, ABC expenses the initial value of the stock options as the options vest under ASC718. The options are valued at $12 per option. In year 1, 3775 options vest. ABC will deduct (3775*12) $45300 of compensation expense. In year 2, 3775 more options vest. ABC will deduct $45300 compensation expense in year 2 for book purposes.

In year 3, ABC can deduct bargain element i.e. fair market value minus exercise price, of the options for tax purposes.  

Deduction = [($38 - $33) * 7550] = $37750

$37750 will be deducted while computing taxable income on the tax return.

year 1: $45300 unfavorable temporary book tax difference

year 2: $45300 unfavorable temporary book tax difference

year 3: favorable $90600 (45300+45300) temporary difference

(90600-37750) $52850 unfavorable permanent book tax difference.

		YEAR 1			YEAR 2			YEAR 3
		Book tax diff	Fav/unfav	Temp/perm	Book tax diff	Fav/unfav	Temp/perm	Book tax diff	Fav/unfav	Temp/perm
	Under ASC 718
a.	Incentive stock options	$45300	Un-favorable	permanent	$45300	Un-favorable	Permanent	0
b.	Non-qualified stock options	$45300	Un-favorable	temporary	$45300	Un-favorable	temporary	$90600	favorable	Temporary
								$52850 ($90600 - $37750)	Un-favorable	Permanent