Stock-Based Compensation Expense: Catching Up Missed Years

How is stock-based compensation expense calculated?

Stock-based compensation expense is the fair value of each award on its grant date, recognized over the period the holder must work to earn it. US GAAP sets this out in ASC 718. The journal entry each period debits compensation expense (in the department where the person works) and credits additional paid-in capital, so total equity does not change.

The tax side runs on a different clock. The company deducts compensation only when, and to the extent, the holder is taxed on it (26 U.S.C. 83(h)). An incentive stock option (ISO) held for the full holding periods gives the company no deduction at all (26 U.S.C. 421(a)).

A catch-up is not simple when grants span several 409A valuations, people have left, advisors or contractors hold awards, founders' shares vest, or financial statements were already given to investors. Those cases turn on judgment the auditor will test.

Gather before anyone builds the schedule:

• Board consents approving every grant, with grant dates
• The option and stock ledger: holder, award type, shares, exercise price, vesting start and schedule
• Every 409A valuation report and its valuation date
• Leavers, with termination dates, and any forfeited or expired awards
• Advisor and contractor agreements that include equity
• Founder stock purchase agreements with vesting, and any 83(b) elections
• Exercises, with dates, spreads and the Forms W-2 or 3921 issued

Why does the auditor want stock compensation from the first grant?

The auditor wants it because every award still vesting, or vested during the years presented, was earned by work in those years. The expense for a grant made years ago keeps landing in each year until the award fully vests. Missing grants also leave paid-in capital and the accumulated deficit wrong, and a first audit has to tie equity to the cap table. See audited financials for investors for the rest of the first-audit list.

What do we need for each grant?

Each grant needs six things: grant date, number of shares, exercise or purchase price, the vesting schedule and start date, the fair value per share of the underlying stock on the grant date, and whether the holder is an employee, advisor, contractor or founder. Option grants also need the inputs the valuation model uses. A grant whose date or terms cannot be proved from a board consent is the first thing to fix, because the grant date drives the value.

How is a grant's fair value worked out, and where does the 409A value fit?

A stock option's fair value is estimated with an option-pricing model, using the stock's fair value on the grant date, the exercise price, the expected term, expected volatility, the risk-free rate and expected dividends. Restricted stock is valued at the stock's fair value on the grant date less any price the holder pays.

The 409A value is the usual starting point for the stock's fair value, but it is an input, not the expense. Tax rules presume an independent appraisal reasonable for a grant made within 12 months after the valuation date, unless later information may materially affect the value (26 CFR 1.409A-1(b)(5)(iv)(B)). The auditor applies its own test: a grant made just before a priced round, or long after the valuation, may need a different value for the books. Setting the exercise price at the 409A value is covered in granting stock options after a valuation.

How is the expense spread over vesting, and what happens when someone leaves?

The grant's total fair value is spread over the vesting period. For awards that vest only with time, ASC 718 lets the company choose straight-line over the whole award or a front-loaded pattern that treats each vesting tranche separately; the choice is a policy applied consistently.

ASC 718 also lets the company either estimate future forfeitures or record them when they happen; that is another policy choice. Repricing is covered in repricing stock options after a down round.

Are grants to advisors and contractors, and founder stock that vests, included?

Yes, awards to advisors and contractors are measured under ASC 718 like employee awards. Founder stock is in scope when it vests only if the founder keeps working: the expense is the stock's grant-date fair value less what the founder paid, which is often small for stock bought at formation.

On the tax side, advisors and contractors cannot hold ISOs, because an ISO requires an employee (26 U.S.C. 422(a)(2)); their options are nonqualified. A founder who filed an 83(b) election was taxed when the shares were issued, so any company deduction belongs to that year, not to the vesting years (26 U.S.C. 83(h)). The regulations allow no deduction at all for stock transferred to a promoter when the corporation is organized (26 CFR 1.83-6(a)(4)). The founder's side is in founder stock and the 83(b) election; early-exercised options are in early exercise of startup stock options.

How do we book the missed years: one catch-up entry or restated years?

The answer depends on whether financial statements for those years were ever issued. Build the schedule year by year either way: the expense for each grant in each year since the first grant.

Materiality is judged by the company and tested by the auditor under the US GAAP rules for correcting errors; this page cannot settle it. Whichever way, the total recorded to date equals the schedule's total, and paid-in capital rises by the same amount. Monthly reporting going forward is covered in monthly financials for investors and the board.

Why is the stock compensation tax deduction different from the book expense?

The book expense is fixed at grant and spread over vesting. The tax deduction equals what the holder includes in income, in the company's tax year in which the holder's tax year of inclusion ends (26 U.S.C. 83(h); 26 CFR 1.83-6(a)). The amounts and years rarely match.

Three traps:

• Reporting. The holder is treated as having included the amount if the company timely reports it on Form W-2 or 1099 (26 CFR 1.83-6(a)(2)). A nonqualified option spread belongs in boxes 1, 3 and 5 of the employee's W-2 and in box 12 with code V (Publication 525). For a disqualifying disposition, a W-2 or W-2c furnished and filed by the date the return claiming the deduction is filed counts as timely.
• Disqualifying dispositions go unseen. The company often learns of an early ISO sale only if it asks; without it, the deduction is missed.
• Capitalized costs. No deduction is allowed to the extent the compensation is a capital expenditure, a deferred expense or inventory cost, such as research costs the company must amortize (26 CFR 1.83-6(a)(4)); see deducting US software development costs.

The gap between book and tax creates deferred taxes, covered in the income tax provision for a first audit. Granting, Form 3921 and withholding on exercise are in granting stock options after a valuation.

Do Form 1120 returns already filed need changing?

Usually taxable income does not change, because the tax deduction never depended on the book expense. What the catch-up changes is the book side of the return: book income on Schedule M-1, line 1, book expense not deducted on line 5, deductions with no book expense this year on line 8, and paid-in capital on Schedule L, line 23 (Instructions for Form 1120); these schedules are not required when total receipts and total assets are both under $250,000. A corporation with total assets of $10,000,000 or more files Schedule M-3, which reports book stock option expense and the tax deduction on Part III, line 9, and restricted stock on line 10; below $50,000,000 it may complete Part I and keep Schedule M-1 instead of Parts II and III (Instructions for Schedule M-3).

Taxable income does change if the company missed a deduction it was entitled to, such as nonqualified option spreads or disqualifying dispositions. A corporation corrects a filed return on Form 1120-X, generally within 3 years after filing the original or 2 years after paying the tax, whichever is later (Instructions for Form 1120-X). For a loss company a missed deduction mostly changes the net operating loss carried forward. Whether any year is amended is the preparer's call, made year by year.

Example

These examples are illustrative; figures are in US dollars.

One grant, three years never booked

A startup grants options worth $900,000 on the grant date, vesting evenly over four years, and books nothing. No one leaves.

• Year 1: $225,000 of expense
• Year 2: $225,000
• Year 3: $225,000

Three years in, $675,000 belongs in the books, with paid-in capital up by the same amount. If no statements were issued for those years, the first audited statements show each year's share; if statements went to investors, the company and auditor decide between restating and one adjustment. The remaining $225,000 is booked in year 4.

ISO exercised and held

An employee exercises an ISO while still employed, with a $50,000 spread, and keeps the shares more than 2 years from grant and 1 year from exercise. The books already carried the option's grant-date fair value over vesting. The company deducts nothing.

Nonqualified option exercised

An employee exercises a nonqualified option with an $80,000 spread. The company reports $80,000 as wages on the employee's W-2 on time and, if none of the pay must be capitalized, deducts $80,000 that year, whatever the option's grant-date fair value and whenever it was expensed in the books.

Different for you?

• You are granting options now, or need Form 3921 and exercise withholding right: see granting stock options after a valuation.
• Options were repriced after a down round: see repricing stock options after a down round.
• Holders exercised early: see early exercise of startup stock options.
• The auditor also wants deferred taxes: see the income tax provision for a first audit.
• Statements already went to investors, missed deductions span several filed years, or the schedule covers many grants and valuations: get startup accounting and tax help.