Question

On Jan 1 of the current year (CY) Gates is given a nonqualified option to purchase

3,000 shares of stock in his employer at $10/ share for the next 10 years. The

current value of the stock is $10/share. If Gates resigns before the end of the

following year (12/31 CY+1) he forfeits the options. The value of the options is

determined to be $23/share. On May 1 of the 3

rd

year (CY+2) when the stock is

trading at $50/share Gates gives the company $30,000 to purchase the shares.

A.) What are the book/tax differences in each of the years? Are they favorable or

unfavorable, and are they permanent or temporary?

B.) If Gates exercised the options when the fair market value of the stock was $19 per

share how would the answer part A change?

Answer 1

A.) Taxation begins at the time of exercise. The bargain element of a non-qualified stock option is considered "compensation" and is taxed at ordinary income tax rates. As Gates is granted 3000 shares of Stock, at an exercise price of $10/share, the market value of the stock at the time of exercise is $50. The bargain element on the contract is ($50 - $10) x 3000 = $120,000. Note that we are assuming that these shares are 100% vested. Gates will be taxed for $120,000 as his ordinary income in his salary. This is a Temporary and unfavourable in the hand of Gates. It may attract further ordinary taxes at the time of the sale of the shares as a short-term or long-term, as the case may be.

B.) If Gates exercised the options when the fair market value of the stock was $19 per share there will be a change in taxable amount, that is, ($19 - $10) x 3000 = $27,000. Gates will be taxed for $27,000 as his ordinary income in his salary.