Suppose you are an employee of HP Corporation. You face a personal marginal tax rate on ordinary income of 50%, and on capital gains the tax rate is 20%. Your after-tax opportunity cost of capital is 7% per year. You hold 100 employee stock options that have an exercise price of $20 per option, and the current stock price is $35.
a. Assume the options you hold are incentive stock options (ISOs). What is the present value of any tax due given that you intend to hold the stock for 10 years after exercise? What is the present value of any tax deduction that HP might get, assuming HP’s marginal tax rate is 10%?
b. Repeat part (a) but now assume the options are nonqualified stock options. Compare and summarize your results. Now change the facts as follows. Suppose the tax law changed such that HP’s marginal tax rate is 34% and your tax rate is 28% on both ordinary income and capital gains.
c. Repeat (a) assuming the 100 options are incentive stock options.
d. Repeat (c) assuming the 100 options are nonqualified stock options. Summarize and compare the results of (c) and (d). Do you notice any tax-planning opportunities available to the employee and HP?