Question

Assume that on January 1, year 1, DEF, Inc. issued 6,000 stock options with an estimated value of $8 per option. Each option entitles the owner to purchase one share of DEF stock for $20 a share (the per share price of DEF 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 6,000 stock options were exercised in year 3 when the DEF stock was valued at $26 per share. Identify DEF’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:

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a. The stock options are incentive stock options.

b. The stock options are nonqualified stock options.

Answer 1

Answers a. The stock option are incentive stock option DEF Inc will not deduct any compensation expense for the options for book purposes. Further, for tax purposes DEF Inc is not allowed any deduction related to incentive stock option. Consequently, there is no book tax differences associated with the stock options in years 1,2, or 3. b. The stock options are non qualified stock option There is no book deduction for non qualified stock options. However, for tax purpose DEF Inc can deduct the bargain element (Fair Market Value (FMV) - Exercise Price) of the options when they are exercised in year 3. Thus there are no book tax differences for year 1 and 2, but a $ 36,000 ($ 26-$20 x 6000) favorable, permanent book tax difference in year 3.