Recoverability of Equity-Based Compensation Deferred Tax Assets

BY ELIZABETH MULLEN AND GREG GIUGLIANO

As the stock market slides, more stock options and related deferred compensation instruments are “underwater,” and the related deferred tax assets may no longer be recoverable. The balance sheets and tax footnotes of many entities highlight the magnitude of these equity-based compensation deferred tax assets. When and how they are written off could have a significant impact on the income statement. As a result, and in light of the recent trends in market prices, equity-based deferred compensation plans need to be monitored quarterly for events that trigger the fixing of the corporate tax deduction and the recoverability of the related tax asset.

W AITING FOR WRITE-O FFS
Generally, FASB Statement no. 109, Accounting for Income Taxes, requires a reduction to the deferred tax asset by a valuation allowance if it is more likely than not that the deferred tax asset will not be realized. Typically, the valuation allowance is set up through the income statement. FASB Statement no. 123(R), Share-Based Payment, however, does not permit the reduction of a deferred tax asset by a valuation allowance if it is related to a reduction in the underlying value of an entity’s shares. Not until the nonqualified option is exercised or forfeited, or restricted stock vests, is any related write-off of a deferred tax asset recognized. At that time, any reduction in anticipated tax benefits shall be written off first from excess tax benefits previously recorded in the APIC (additional paid-in capital) pool and second from the income statement.

A V ARIETY OF P LANS
The bull market of 2003–2006 and the ensuing wave of initial public offerings resulted in a proliferation of equity-based deferred compensation plans. Employees of public companies watched their personal wealth grow in restricted stock plans, stock bonus plans and qualified and nonqualified option plans, among many others.

T AX VS. BOOK ACCOUNTING T REATMENT
Restricted stock plans, stock bonus plans, qualified and nonqualified option plans, and other deferred compensation plans are subject to differing tax treatment. For purposes of the following discussion, all are assumed to be nonqualified deferred compensation plans in which the employer generally is eligible for a tax deduction equal to the full amount of the stock when the employee vests in the restricted stock or the intrinsic value of the stock when the option is exercised.

Under FASB Statement no. 123(R), for book purposes, a company generally measures the cost of employee services received in exchange for an award of equity instruments based on the grant date fair value of the award. That cost is amortized over the vesting period. When a restricted stock vests or a nonqualified option is exercised, the amount of the employer’s corporate tax deduction is fixed. At that time, it is evident whether the amount deductible on the tax return is greater or less than the cumulative compensation cost amortized over the vesting period. Excess tax benefits, if any, are credited to additional paid-in capital and referred to as the APIC pool. At that time also any tax deficiencies will first offset the balance in the APIC pool, and any excess will be recorded in the income statement.

I N A RISING M ARKET
The difference between the tax and book accounting treatment results in both a temporary difference and a permanent difference under Statement no. 109. The temporary difference arises from the book amortization of the vesting expense, which builds up before the vesting or exercise event. The temporary difference reverses when the entity is eligible to take the tax deduction. The permanent difference occurs when the tax expense is greater or less than the book expense. Typically, in a rising market, the permanent difference results from the tax benefit (additional corporate tax deduction) related to the appreciation of the stock over the grant/exercise price. This additional tax benefit is recorded to the APIC pool, as opposed to the income statement.

I N A FALLING M ARKET
If restricted stock vests when the market price is lower than the grant price, or the nonqualified option is exercised when the intrinsic value (the excess of the market price over the strike price) is less than the Statement no. 123(R) fair value for book purposes, the tax deduction is less than the amount recorded as a future tax benefit for book purposes. The original deferred tax asset is then no longer recoverable. This excess deferred tax asset is first written off to the APIC pool and then to the income statement.

A T RIPLE P LAY
To illustrate how the reduction in the deferred tax asset is calculated and recorded, assume that Corporation X has three deferred compensation plans:

Plan A. Restricted stock units—500 shares unvested, with no shares vesting in 2008; weighted average grant price $10.

Plan B. IPO stock award program—1,000 shares unvested, with 500 shares vesting on Dec. 31, 2008; weighted average grant price $15.

Plan C. Bonus stock award program—250 shares unvested, with all shares vesting on Dec. 31, 2008; weighted average grant price $20.

As of Dec. 30, 2008, Corporation X has $600 recorded in its APIC pool, mostly related to Plan A. Also, as of Dec. 31, 2008, the company’s stock price trades at $14 per share. Its effective tax rate for the year is 42%.

With respect to Plan A, nothing happens because none of the restricted stock units vest in 2008.

With respect to the stock of Plans B and C that vests as of Dec. 31, 2008, the amount deductible on Corporation X’s return is less than the cumulative compensation cost recognized for financial statement purposes. This is because the trading price is less than the grant price of the stock awards. As a result, as of Dec. 31, 2008, Corporation X has a deferred tax asset of $840 that will never reverse.

The $840 is calculated as follows: The market price of Corporation X’s stock is lower than the original grant price for Plan B by $1 ($15 – $14) and for Plan C by $6 ($20 – $14). The tax deduction for the shares that vested in 2008 is lower by $500 (500 shares $1) for Plan B and $1,500 (250 shares $6) for Plan C. The company must reduce the deferred tax asset by $840 ($2,000 42%) for the deficiency in future tax benefits.

I NTO THE APIC P OOL
Can Corporation X’s write-off of the deferred tax asset be recorded against the APIC pool? Most of those excess benefits resulted from the vesting of restricted stock in Plan A, not from Plan B or Plan C. As it turns out for Corporation X, the $840 write-off is recorded first as an offset to paid-in capital for $600 and second to the income statement for $240. This is because a company is permitted to consider the excess tax benefits recorded in the APIC pool on a combined basis, as opposed to a plan-by-plan basis. Statement no. 123(R), paragraph 63, states that the amount of the APIC pool that qualifies to offset the tax deficiency includes excess tax benefits attributable to different types of equity awards, such as restricted shares or options.

The combination of the tax and accounting rules related to equity-based deferred compensation plans are complicated indeed. However, the monitoring of deferred tax assets relative to these plans is imperative given current market conditions. v

By Elizabeth Mullen, CPA, and Greg Giugliano, CPA. Mullen is a senior manager and Giugliano a partner at Marcum & Kliegman LLP. Mullen can be reached in New York City at 212-981-3014 or elizabeth.mullen@mkllp.com. Giugliano can be reached in Melville, N.Y., at 631-414-4222 or gregory.giugliano@mkllp.com.

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