Question

On January 1, year 1, Tyra started working for Hatch Corporation. New employees must choose immediately between receiving 7 NQOs (each NQO provides the right to purchase for $5 per share 10 shares of Hatch stock) or 50 restricted shares. Hatch's stock price is $5 on Tyra's start date. Either form of equity-based compensation will vest in two years. Tyra believes that the stock will be worth $15 per share in two years and $25 in four years when she will sell the stock. Tyra's marginal tax rate is 32 percent and her long-term capital gains rate is 15 percent. Assuming that Tyra's price predictions are correct, answer the following questions (ignore present value, and use nominal dollars):

Required:

a. What are the cash-flow effects to Tyra in the year she receives the options, the year the options vest and she exercises the options, and in the year she sells the stock if she chooses the NGOs?

b. What are the cash-flow effects to Tyra in the year she receives the restricted stock, in the year the stock vests, and in the year she sells the stock if Tyra chooses the restricted stock?

c. What are the cash-flow effects to Tyra in the year she receives the restricted stock, the year the stock vests, and the year she sells the stock if she makes an S83(b) election?

d. What recommendation would you give Tyra? Explain.

Answer 1

Making an S83(b) election for the restricted stock might provide tax advantages, but the decision depends on Tyra's tax planning and cash flow needs. Consulting a tax advisor is advisable for a suitable decision.

How to solve

a. If Tyra chooses the NQOs, the cash-flow effects are as follows:

Year she receives the options: No cash flow effects.

Year the options vest and she exercises them: No cash flow effects if she doesn't exercise.

Year she sells the stock: Cash inflow of $500 (10 shares * ($25 - $5)) per NQO, taxed at the long-term capital gains rate.

b. If Tyra chooses the restricted stock:

Year she receives the restricted stock: No cash flow effects.

Year the stock vests: Taxable as ordinary income based on the fair market value.

Year she sells the stock: Cash inflow of $1,000 (50 shares * ($25 - $5)) per share, taxed at the long-term capital gains rate for gains.

c. If Tyra makes an S83(b) election:

Year she receives the restricted stock: Ordinary income tax on the fair market value.

Year the stock vests: No additional tax.

Year she sells the stock: Cash inflow of $1,000 per share, taxed at the long-term capital gains rate for gains.

d. Recommendation: Making an S83(b) election for the restricted stock might provide tax advantages, but the decision depends on Tyra's tax planning and cash flow needs. Consulting a tax advisor is advisable for a suitable decision.