In January Year 1, Khors Company issued nonqualified stock options to its CEO, Jenny. Because the company did not expect Jenny to leave the company, the options vested at the time they were granted with a total value of $51,000. In December of Year 2, the company experienced a surge in its stock price, and Jenny exercised the options. The total bargain element at the time of exercise was $62,000. For Year 2, what is the book–tax difference due to the options exercised?

Question

BlackTom AI · Accepted Answer

To tackle this, first identify what is recognized for book purposes and what is deductible for tax purposes regarding nonqualified stock options (NSOs).
Option 1: "$11,000 unfavorable". This would imply a negative book-to-tax difference in Year 2. Since the grant vested immediately, the company would have recognized the entire $51,000 as book compensation expense in Year 1, not in Year 2. In Year 2, there is no additional book expense related to these options. Meanwhile, the tax deduction upon exercise is the bargain element, which is $62,000. A higher tax deduction relative to any book expense creates a favorable difference (not unfavorable) in Year 2. Therefore, this option misstates the direction and magnitude of the difference.
Option 2: "$11,000 favorable". This suggests that the tax deduction exceeds the book expense by $11,000 in Year 2. However, since the book expense in Year 2 is effectively zero (the $51,000 was already expensed in Year 1 when vesting occurred), the difference is not $11,000 but $62,000, representing the complete bargain element recognized for tax purposes in Year 2. Hence this option is incorrect.
Option 3: "$51,000 unfavorable". This would imply a large unfavorable gap, but again, the book expense recognized in Year 2 is not $51,000; that amount was already incurred in Year 1. In Year 2, the only relevant factor is the tax deduction difference relative to any book expense still outstanding, which does not align with an $51,000 unfavorable difference. This option confuses the timing of expense recognition with the magnitude of the tax deduction.
Option 4: "$62,000 favorable". Here, the bargain element at exercise is $62,000 for tax purposes. Since the only book expense related to these options was recognized in Year 1 (the $51,000 vesting compensation), Year 2 shows no additional book expense. The tax deduction ($62,000) exceeds the Year 2 book expense by $62,000, creating a favorable temporary difference (a deferred tax asset possibility) in Year 2. This matches the standard treatment for NSOs where tax deductions on exercise exceed any new book expense in the exercise year, yielding a favorable book–tax difference.
In summary, because the Year 1 books already captured $51,000 of compensation expense at vesting and Year 2 has a $62,000 tax deduction upon exercise with no corresponding Year 2 book expense, the net book–tax difference for Year 2 is $62,000 favorable.

SU25-BL-BUS-A329-2695 Quiz 15

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