Tax effects of stock compensation under ASC 718-740

• Record a deferred tax asset as compensation cost is recognized for deductible awards
• Identify awards that ordinarily do not produce a deduction
• Compute excess tax benefits and tax deficiencies at vesting or exercise
• Apply the ASU 2016-09 income statement, interim and cash flow rules

Book cost and tax deduction differ

Under ASC 718, compensation cost is based on grant-date fair value and recognized over the service period. The U.S. tax deduction comes later and is measured differently: for a nonqualified option it equals the intrinsic value at exercise, and for a restricted stock unit it equals the share value when the shares are delivered. The two numbers almost never match.

ASC 718-740 handles the gap in two stages.

Stage 1: deferred tax asset during the service period

For an award that ordinarily results in a tax deduction, the entity recognizes a deferred tax asset as it recognizes compensation cost (Subtopic 718-740). The asset is measured on cumulative book compensation cost times the applicable rate. It is not remeasured for changes in the share price while the award is outstanding.

An incentive stock option does not ordinarily result in a deduction for the employer, so no deferred tax asset is recorded for it. If an employee later makes a disqualifying disposition, the employer gets a deduction and recognizes the tax benefit when that event occurs.

The deduction may also be limited by tax law. For example, the deduction for compensation of certain covered executives of a public company is capped, so the deferred tax asset is recorded only for the portion expected to be deductible.

Stage 2: the deduction arrives

When the award vests or is exercised and the deduction is determined, the deferred tax asset is reversed and compared with the actual tax benefit:

• If the tax benefit exceeds the deferred tax asset, the difference is an excess tax benefit.
• If it is smaller, the difference is a tax deficiency.

What ASU 2016-09 changed

Before ASU 2016-09, excess tax benefits went to additional paid-in capital and deficiencies were charged against a pool of past excess benefits. ASU 2016-09 amended ASC 718-740-35-2 so that:

• All excess tax benefits and tax deficiencies, including tax benefits of dividends on share-based awards, are recognized as income tax expense or benefit in the income statement.
• They are recognized in the period in which the deduction arises (or, for an award that expires, the period of expiration).
• They are treated as discrete items in the interim period in which they occur, not included in the estimated annual effective tax rate.
• An excess benefit is recognized regardless of whether it reduces taxes payable in the current period. If the entity has a loss carryforward, the benefit increases the deferred tax asset and is then subject to the normal valuation allowance assessment.
• Excess tax benefits are classified with other income tax cash flows as an operating activity.

ASU 2016-09 was effective for PBEs for annual periods beginning after December 15, 2016, and for all other entities for annual periods beginning after December 15, 2017.

Because the stock price drives the excess or deficiency, a company's effective tax rate now moves with its share price. Under ASU 2023-09, a PBE presents the effect in the rate reconciliation, and the standard's own illustration shows share-based payment awards as a nondeductible or nontaxable reconciling item.

Audit focus

• Tie the deferred tax asset rollforward to the stock comp rollforward by award type.
• Confirm ISOs carry no deferred tax asset and that disqualifying dispositions were captured.
• Recompute excess benefits from payroll or broker data on exercise and vest dates.
• Check that the interim provision recorded them as discrete items.

The excess tax benefit calculator and the ASC 718 guide help with the mechanics.

RSU vesting at Harborview Software, Inc.