Chapter 12 discussion Questions and Answers

Chapter 12 discussion Questions and Answers What nontax and tax reasons explain why a corporation may choose to cap its executives' salaries at $1 million? • Nontax: A corporation may choose to cap its executives' salaries at $1 million, even if it is not concerned about the loss of the tax deduction, to send a signal to shareholders. Not exceeding the limit signals to the shareholders that the corporation is being fiscally responsible by (1) not overpaying executives, and (2) ensuring that all compensation paid to executives is tax deductible. Tax: Publicly-traded corporations may cap their executives' salaries at $1 million to ensure that the company is able to deduct the compensation expense for the full amount of the compensation. This is important because the government no longer subsidizes salary for covered employees over $1 million. This means for a corporation with a 21 percent marginal tax rate that the government would effectively be paying $210,000 for the first $1 million in salary. • Covered employees are the CEO, CFO, and of the other three highest compensated officers (plus all covered employees from prior years. Lynette is the CEO of publicly traded TTT Corporation and earns a salary of $200,000 in the current year. What is TTT Corporation's after-tax cost of paying Lynette's salary excluding FICA taxes? 200,000 x (1-.21)= 158,000 Marcus is the CEO of publicly traded ABC Corporation and earns a salary of $1,500,000. What is ABC's after-tax cost of paying Marcus's salary? 1,000,000 (.21)= 210,000 1,500,000 - 210,000= 1290000 From an employee perspective, how are ISOs treated differently than NOs for tax purposes? In general, for a given number of options, which type of stock options should employees prefer? • Unlike NQOs, the bargain element of ISOs are not taxable income on the exercise date. Instead, the bargain element is deferred until the stock acquired is sold assuming the employee meets the holding period required for ISOs (at least two years after grant date and one year after exercise date). Further, with ISOs, the bargain element is treated as LTCG rather than ordinary income when the stock is sold. For these reasons, employees generally prefer ISOs over an equivalent number of NQOs From an employer perspective, how are ISOs treated differently than NOs for tax purposes? In general, for a given number of options, which type of stock options should employers prefer? • In contrast to NQOs, employers never receive a deduction for ISOs. Thus, employers generally prefer to issue NQOs over an equivalent number of incentive stock options. Why do employers use stock options in addition to salary to compensate their employees? For employers, are stock options treated more favorably than salary for tax purposes? Explain. • Because stock options reward employees for making choices that increase the share price of the corporations where they are employed, this form of compensation is considered to be superior to salary in terms of motivating employees to behave more like owners in short, stock options align the incentives of employees and owners. In addition, employers may use stock options to compensate their employees without a cash outlay. For tax purposes, NQOs are treated the same as salary and wages. The employer receives a deduction equal to the bargain element (FMV of shares on exercise date less the strike price). • NOs may allow employers to deduct executive compensation above $1 million, and NQOs can generate tax deductions without a cash outlay. Cammie received 100 NQ0s (each option provides a right to purchase 10 shares of MNL stock for $10 per share). She started working for MNL Corporation four years ago (5/1/Y1) when MNL's stock price was $8 per share. Now (8/15/Y5) that MNL's stock price is $40 per share, she intends to exercise all of her options. After acquiring the 1,000 ML shares with her stock options, she held the shares for over one year and sold (on 10/1/6) them at $60 per share. a. What are Cammie's taxes due on the grant date (5/1/Y1), exercise date (8/15/Y5), and sale date (10/1/Y6), assuming her ordinary marginal rate is 32% and her long-term capital gains rate is 15%? - Grant date: 0 • Exercise date: 1000 (40-10) x .32= 9600 • Sale date: 1000 (60-40) x .15= 3000 Cammie received 100 NQ0s (each option provides a right to purchase 10 shares of MNL stock for $10 per share). She started working for MNL Corporation four years ago (5/1/Y1) when MNL's stock price was $8 per share. Now (8/15/Y5) that MNL's stock price is $40 per share, she intends to exercise all of her options. After acquiring the 1,000 ML shares with her stock options, she held the shares for over one year and sold (on 10/1/6) them at $60 per share. b. What are ML Corporation's tax consequences on the grant date (5/1/Y1), exercise date (8/15/Y5), and sale date (10/1/Y6)? - Grant date: 0 • Exercise date: 1000 (40-10) x .21= 6300 • Sale date: 0 '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% and his long-term capital gains • Grant date: 0 • Exercise date: 200 x 20= 4000 4000 x 7 = 28,000 200,000-28,000= 172,000 x .32= 55,000 • Sale date: 4000 x 75= 300,000 - 200,000= 100,000 x .15= 15,000 '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. 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 • Grant date: 0 • Exercise date: 172,000 x .21= 36,120 - Sale date: 0 • Rate of 0%: 0