Suppose you are employed by MS Corporation. In year 1, you received nonqualified employee stock options (NQOs) to acquire 10,000 shares of MS’s stock at an exercise price of $40 share. On that date, the stock traded at $35 per share. In year 2, you exercised your options when the stock price was $48 per share. In year 3, you sold the stock for $50 per share.

a. What is the amount and character (ordinary or capital gain) of your income in years 1, 2, and 3 because of these transactions?

b. How much is MS’s tax deduction and when is it deductible?

c. How much will MS report as compensation expense each period?

d. How would your answers to questions (a), (b), and (c) change if the options were incentive stock options?