1. You begin work with Gadgets Corp in Year 1. In Year 1, you are granted nonqualified employee stock options (NQOs) to acquire 5,000 shares of the company stock at an exercise price of $30 per share, which happens to equal the market value of the stock on that day. You vested 50% in the options in Year 2 and the remaining 50% in the options in Year 3. The stock value remained steady at $40 per share in both Year 2 and Year 3. You exercised your options as soon as you vested; so you exercised 2,500 shares in Year 2 and 2,500 shares in Year 3. Then, in year 4, when the stock price was $55 per share, you sold all 5,000 shares.
   1. What is the amount and character (ordinary or capital gain) of your taxable income in years 1, 2, 3, and 4 because of these transactions?
   2. How much was Gadgets Corps tax deduction and, in which year(s), was it deductible?
   3. How much will Gadget Corp report as compensation expense each period if all years are pre-SFAS 123R? What about post-SFAS 123R assuming the firm valued the options at grant date at $50,000?

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