What is the book–tax difference for DEF Company in Year 1 due to Lavensa, CFO, exercising DEF Company incentive stock options ($60,000 bargain element) in December Year 1 that were issued and immediately vested on January Year 1 ($50,000 initial value)?

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BlackTom AI · Accepted Answer

We are asked to analyze the book–tax difference in Year 1 for DEF Company related to an ISO exercise by the CFO.

Option A: "$50,000 favorable, temporary". This would imply that the book expense reduces tax expense now but will reverse in future periods, creating a temporary difference that lowers taxes currenty and then reverses. However, for incentive stock options (ISOs) the regular tax deduction is not generated when the options are exercised, so the tax effect does not reverse in a future period in the way temporary differences typically do. So this option incorrectly characterizes the timing and the direction.

Option B: "$50,000 favorable, permanent". A permanent favorable difference would mean the company pays less tax than book forever by $50,000. In the case of ISOs, the typical treatment is that the compensation expense recognized for financial reporting is not deductible for regular tax purposes, which would create an unfavorable (not favorable) permanent difference, not a favorable one. Therefore this option misstates both the direction and the permanence.

Option C: "$50,000 unfavorable, temporary". A temporary unfavorable difference would imply that the excess of book expense over tax would reverse in a future year, restoring tax to its regular level. With ISOs, the regulatory tax deduction does not align with the book compensation expense, and the mismatch generally persists rather than reverses, especially since ISO deductions under regular tax are not allowed for the bargain element at exercise. Thus, labeling this as temporary and unfavorable is inconsistent with ISO mechanics in this context.

Option D: "$50,000 unfavorable, permanent". This option captures the standard ISO treatment: the compensation expense recorded for GAAP (often tied to the grant/vesting of the option, here $50,000) is not deductible for regular tax purposes. That creates a book–tax difference that is unfavorable (book expense reduces pretax income more than tax expense reduces it) and permanent (the mismatch does not reverse in future years because the regular tax deduction associated with ISO compensation is not allowed). The given values align with the scenario: $50,000 initial value recognized as expense, with no corresponding regular tax deduction, yielding a permanent, unfavorable difference.

In summary, among the choices, only option D correctly reflects the usual treatment of ISO-related book–tax differences in Year 1: an unfavorable, permanent difference of $50,000, arising from the GAAP compensation expense that has no regular tax deduction. The other options either misstate the direction (favorable vs unfavorable), the reversibility (temporary vs permanent), or both, given ISO tax rules and the immediate vesting/exercise timing described.

SU25-BL-BUS-A329-2695 Quiz 15

What is the book–tax difference for DEF Company in Year 1 due to Lavensa, CFO, exercising DEF Company incentive stock options ($60,000 bargain element) in December Year 1 that were issued and immediately vested on January Year 1 ($50,000 initial value)?

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