Question

LO 12-2 29. Haven received 200 NQOs (each option gives him the right to purchase 20 shares of Barlow Corporation stock for $7 per share) at the time he started working for Barlow Corporation three years ago when its stock price was $7 per share. Now that Barlow's share price is $50 per share, he intends to exercise all of his options. After acquiring the 4,000 Barlow shares with his stock options, he intends to hold the shares for more than one year and then sell the shares when the price reaches $75 per share. a) What are Haven's taxes due on the grant date, exercise date, and sale date, assuming his ordinary marginal rate is 32 percent and his long-term capital gains rate is 15 percent? b) What are the cash flow effects for Barlow Corporation resulting from Haven's option exercise? How would it change if Barlow's marginal rate were 0 percent? LO 12-2

Answer 1

a.

Haven has no tax consequences on the grant date.

Haven has an outflow of $28,000 on the exercise. Haven recognizes $172,000 of ordinary income and pays tax of $55,040 in the year of exercise, the calculations are as follows:

Description	Amount	Explanation
(1) Shares acquired	4,000	(200 x 20 shares)
(2) Strike price	$7.00
(3) Cash needed to exercise	$28,000	(1) × (2)
(4) Market price	$50.00
(5) Market value of shares	$200,000	(1) × (4)
(6) Bargain Element (ordinary income)	$172,000	(5) – (3)
(7) Marginal Tax Rate	32%
(8) Tax due in year of exercise	$55,040	(6) × (7)

He also recognizes $100,000 of capital gain and pays tax of $15,000 in the year of sale, the calculations are as follows:

Description	Amount	Explanation
(9) Shares acquired with NQOs	4,000	(1)
(10) Market price at sale	$75.00
(11) Amount Realized	$300,000	(9) × (10)
(12) Basis	$200,000	(5)
(13) Long-term capital gain	$100,000	(11) - (12)
(14) Capital Gain Tax Rate	15%
Tax due in year of sale	$15,000	(13) × (14)

b.

Barlow has no tax consequences on the grant date or sale date. Barlow does receive a deduction equal to the $172,000 (line (6) from part a) bargain element on the date Haven exercises the options and receive a tax benefit of $36,120. If Barlow had a tax rate of 0% it would receive no tax savings from the deduction for the bargain element ($0 = ($172,000 x 0%)).

(1) Bargain Element (ordinary income)	$172,000	(6) above
(2) Marginal Tax Rate	21%
(3) Tax benefit in year of exercise	$36,120	(1) × (2)