Final Exam

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Please note: This issue’s contest is now closed. 

The answer and Grand Prize winner are posted below. (Feel free, of course, to still test your wits!)

In each issue of Wharton Magazine, we test your knowledge with a question crafted by one of the School’s esteemed faculty members (often straight from an actual Wharton course). Submit the correct answer and you’ll be entered into our drawing for our grand prize—a $400 gift certificate to the Wharton Store. This Final Exam challenge comes from Jennifer Blouin, an associate professor of accounting. Good luck!

The Basics:

An executive of a publicly traded company has been awarded 10,000 shares of restricted stock when the share price is $100. The shares vest and, hence, the restrictions lift on all 10,000 shares in three years. Under U.S. tax rules, the grant of restricted stock is typically not taxed until the shares vest. At vesting, the value of the restricted stock grant (including any change in value over the vesting period) is taxed as salary income to the executive. Any change in share value after vesting will be taxed as capital gains or losses. However, there exists a special election, called “83B” election, that allows an employee to accelerate the taxation of a restricted stock grant to the date of grant. Although the 83B election accelerates the taxation of the stock award, any change in stock price after grant will be taxed as capital gains or losses. Assume that the executive’s discount rate is 5 percent and that this executive has no tax loss carry-forwards (capital or otherwise) available to offset any income from the restricted stock grant. In addition, suppose that the tax rate on salary income is 40 percent, whereas the tax rate on capital gains is only 20 percent. Finally, assume that this company does not pay dividends.

finalexam

The Question:

Would you recommend that the executive make the 83B election: yes, no or it depends?

The Answer:

No, the executive should not make the election. The “trick” is that the only way for the election to make sense is if the executive believes that the stock price is going to go up. If the stock price is going up, then the executive should take the cash that he/she intends to use to pay the taxes and buy more shares of the company’s stock. This action always results in more net earnings to the executive: i.e., it is a dominant strategy. This problem is an example of the “early exercise” fallacy. Many people might answer “it depends” because they think that the rate of appreciations affects the outcome. It doesn’t.

The Winner:

Out of all correct submissions, one winner was randomly selected to receive a $400 gift certificate to the Wharton Store. (Prize may be subject to taxation; must be 18 years or older to win.)

That winner was … George Benz, GED’73, WG’78.

Congratulations, George!

 

 

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