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JONES APPAREL GROUP - additional questions (doc)

By Tim Arnold,2015-01-15 06:01
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JONES APPAREL GROUP - additional questions (doc)

    JONES APPAREL GROUP, INC

    TAX IMPLICATIONS & JOURNAL ENTRIES

    Acct 592 Spring 2009

    Information regarding taxation of stock-based employee compensation

    From authors of the case so it might have been a change in tax laws after 2005.

    Restricted Stock

    Section 83 of the Internal Revenue Code states the general rule that the receipt of property in connection with the performance of services is included in the taxpayer‘s income in the year of receipt. The general rule puts the taxpayer on notice that when cash or property is received for the performance of services, a taxable event occurs. The general rule goes on to defer the recognition of income if the property received is subject to a ‗‗substantial risk of forfeiture.‘‘ The deferral would continue until the property is no longer

    subject to a ‗‗substantial risk of forfeiture‘‘ or the property can be transferred to another taxpayer free of

    the risk of forfeiture.

    Upon the company‘s issuance of restricted stock, there would be a receipt of property by Mr. Boneparth.

    However, Mr. Boneparth would not recognize income upon the receipt of property because the requirements of continued employment and the company meeting operating cash flow requirements before the restrictions would lapse make the restricted stock subject to a ‗‗substantial risk of forfeiture.‘‘

    As the restrictions lapse in the future, there would be income recognition.

    Nonqualified Stock Options

    The general rule of Section 83 does not apply to nonqualified stock options. Regulation 1.83-7 provides a different rule for the deferral of income when nonqualified options are issued, by stating that at the time options are issued no income is recognized if the options do not have a ‗‗readily ascertainable fair market

    value.‘‘ By definition, nonqualified stock options are issued with an exercise price equal to or higher than

    the market value of the stock at the time the options are issued. Because the cost to exercise equals or exceeds the market value the options do not have a ‗‗readily ascertainable fair market value.‘‘ The

    deferral of income recognition for nonqualified stock options continues until the options are exercised by the employee.

    If the company issued nonqualified stock options to Mr. Boneparth, then the exercise price would be equal to or higher than the current fair market value of the company‘s stock. Therefore, at the time issued

    the options would not have a ‗‗readily ascertainable fair market value‘‘ and no taxable income would be

    recognized. The deferral of income would continue until Mr. Boneparth decided to exercise his options by purchasing stock for the exercise price at some future date of his choosing.

    Note that the deferral established at the time of issuing options under the ‗‗readily ascertainable fair market value‘‘ test continues even after there is a vesting of the options and a value is able to be

    determined. This is unlike the restricted stock situation where income is recognized when the restrictions lapse and vesting occurs. [Reference: IRC Section 83(a), Reg. 1.83-1, Reg. 1-83-7]

    1

    In early 2003, Mr. Boneparth had two possible forms of equity compensation available to him, stock options or performance-contingent restricted stock. Let us consider the taxable income he would receive under the two forms of compensation. 1. On February 28, 2003, Mr. Boneparth was awarded 250,000 shares of restricted

    stock when the market price was $28.36 per share. Assuming that the requirements

    for vesting are met (continued employment for the next three years and the

    company meeting the cash flow targets), and the market price on the anniversary

    date for the lapsing of the restrictions is $31 in 2004, $25 in 2005, and $35 in 2006,

    when and how much income must Mr. Boneparth recognize?

    SUMMARY ENTRIES FOR ENTIRE 3 YEAR PERIOD

    Assume 35% tax rate for Jones Apparel and $1 par common stock

    Compensation cost

     Additional paid-in capitalrestricted stock

    To recognize compensation cost

Deferred tax asset

     Deferred tax benefit (on income stmt)

    To recognize anticipated tax benefit from vesting of restricted shares

Additional paid-in capitalrestricted stock

     Common stock (shares * $1 par value)

     Additional paid-in capital

    To recognize the issuance of stock when restricted stock is fully vested

Deferred tax expense (on income stmt)

     Deferred tax asset

    To write off deferred tax asset related to deductible share

    award at vesting date

Current taxes payable

     Current tax expense

     Additional paid-in capital (excess tax deduction)

    To adjust current tax expense and current taxes payable to recognize the current tax benefit from deductible compensation cost upon vesting of share award. The credit to additional paid-in capital is the excess tax benefit:

    2

    2. An alternative to the awarding of the 250,000 shares of restricted stock might have

    been the originally negotiated award of 1,500,000 stock options. Assume that the

    award of 1,500,000 stock options had in fact occurred on February 28, 2003 with an

    exercise price equal to the market price of $28.36, and the vesting was at the same

    rate as the restricted stock. When and how much income must Mr. Boneparth

    recognize? The fair value of the options is $40.03 at the measurement date.

    Assume: (a) All options were exercised in January 2007 when the market price was

    $35.00; (b) all options were exercised in June 2007 when the market price was

    $29.00; (c) the options expired when the stock was trading at January 2008 when

    the price was $14.00.

    SUMMARY ENTRIES FOR ENTIRE 3 YEAR PERIOD

    Compensation cost

     Additional paid-in capitalrestricted stock

    To recognize compensation cost

Deferred tax asset

     Deferred tax benefit (on income stmt)

    To recognize anticipated tax benefit from vesting of restricted shares (35%)

Cash

    Additional paid-in capitalrestricted stock

     Common stock (shares * $1 par value)

     Additional paid-in capital

    To recognize the issuance of stock when restricted stock is fully vested

Deferred tax expense (on income stmt)

     Deferred tax asset

    To write off deferred tax asset related to deductible share

    award at vesting date)

Current taxes payable

     Current tax expense

     Additional paid-in capital (excess tax deduction)

    To adjust current tax expense and current taxes payable to recognize the current tax benefit from deductible compensation cost upon vesting of share award. The DEBIT to additional paid-in capital is the excess tax benefit is the short-fall and would only be made if there was a credit balance available in the APIC-excess tax deductions acct. If there was insufficient amount available, the debit would be to “current tax expense”

    3

Comparison:

    Restricted stock Stock options

    (same at all market prices) (exercised when market price = $35)

     Taxable Income to Boneparth

    and tax deduction for Jones Apparel

    Compensation Expense for

    Jones Apparel (reduces reported net income)

    Increase in shares outstanding 250,000 shares 1,500,000 shares

    (dilutive effect to EPS)

     Net after-tax ―cost‖ per share

    What if the options had been exercised when price was $29?

    As a shareholder, which one compensation plan would you prefer?

    3. What would be the tax implications for the company and Mr. Boneparth when Jones

    declares and pays a dividend before the restricted stock becomes fully vested?

    4

PERFORMANCE CONDITIONS

    Consider alternative arrangements for the ―performance condition‖ related to the restricted stock

    (may require research in the authoritative literature):

    Mr. Boneparth received the 250,000 shares of restricted stock on February 28, 2003 when the stock was trading at $28.36. There is a performance condition related to operating cash flows. The specific terms of the restricted stock impact the recognition of compensation expense. In all cases (for simplicity), assume that it is probable the performance goals will be met and that they are ultimately accomplished. Assuming Jones‘ stock price fluctuates as follows: $31 at the end

    of year 1, $25 at the end of year 2, and $35 at the end of year 3, consider each of the following three contractual conditions related to the restricted stock granted:

    (a) the operating cash flow requirement for each of the three years is determined on the original issue date, and the successful achievement of the performance requirement in one year is not dependent on any other year‘s results;

    (b) the operating cash flow requirement is determined at the beginning of each of the three years, and the successful achievement of the performance requirement in one year is not dependent on any other year‘s results; and

    (c) the cash flow requirement for each of the three years is determined on the original issue date, but the successful achievement of the performance requirement in prior year(s) is a requirement for successful achievement each subsequent year. In each of these cases, assume the achievement of the performance condition is probable.

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