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Determining the substitution rate between incentive stock options and non-qualified stock options

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This paper develops a multi-lateral tax model that can be used to determine (1) the number of non-qualified stock options (NQOs) that will have the same after-tax cost to the firm as one incentive stock option (ISO), and (2) the number of NQOs that will provide the grantee with the same after-tax value as one ISO. The model is based on a characterization of the grantee's optimal behavior when the options grant is not completely hedged or diversified and the grantee is therefore not compensated for bearing the underlying stock's unsystematic risk. A key result of the model is that the tradeoff between ISOs and NQOs that the firm can offer and the minimum number of NQOs that the grantee will substitute for one ISO are functions of the grantee's ability to hedge or diversify the underlying stock's unsystematic risk. An application of the model provides a multi-lateral scenario in which some employees will select ISOs even after the Tax Reform Act of 1986 (TRA86), despite the fact that TRA86 resulted in a higher tax rate on corporate income than on personal income. Another application of the model provides a multi-lateral scenario in which, after TRA86, some employees, but not all, of a given firm disqualify their ISOs in response to incentives provided by the firm. The scenarios occur when the firm's stock has substantial unsystematic risk and its grantees bear different amounts of that risk.

This paper develops a multi-lateral tax model that can be used to determine (1) the number of non-qualified stock options (NQOs) that will have the same after-tax cost to the firm as one incentive stock option (ISO), and (2) the number of NQOs that will provide the grantee with the same after-tax value as one ISO. One motivation for developing the tax model is...