Susan has been granted stock options by her firm. Her exercise price is $18 per share and the current Fair Market Value (FMV) of the stock is $20 per share. Susan can elect to be taxed at ordinary income tax rates at this point in time or she can wait until she exercises the stock option at which time she will be taxed on the difference between the FMV of the stock and the exercise price at the time she exercises the option(at ordinary income tax rates). Susan has options on 10,000 shares. The capital gains tax rate if stock is held for more than one year is 15% and Susan's marginal tax bracket for ordinary income tax is 38%.
a. Assume that Susan thinks she will exercise the options in one year (at which time Susan thinks the FMV of the stock will be $23) and she will sell the stock one year after exercise for $25 per share. Under these circumstances, should Susan elect to be taxed now or wait until she exercises her options? Why? How much will Susan pay in taxes under each scenario?
b. Now assume that the price of the stock is estimated to be $21 at the time she plans to exercise and that Susan believes that her marginal tax bracket at time of exercise will be 28%. She believes that the price of the stock one year after exercise will be $25 per share but that Congress will increase the capital gains tax rate to 20% from the current 15%. Now which option should Susan choose? Why? What is her tax bill under each scenario?