Employee Stock Options, Corporate Taxes, and Debt Policy. Journal of Financestock 4 LANG, and DOUGLAS A. Our evidence suggests that option deductions are important nondebt tax shields and that option deductions substitute for interest deductions in corporate capital structure decisions, explaining in part why some firms use so little debt. THIS PAPER EXPLORES the corporate tax implications of compensating employees with nonqualified stock options. Corporations deduct the difference between current market and strike prices when an employee exercises a nonqualified stock option. For option-intensive companies with rising stock prices, this deduction can be very large. A perspective on the magnitude of options compensation and its increase over time can be gained from papers like the one by Desaiwho reports that in the top five and of the largest U. All data were publicly available. Lang was visiting the University of Queensland when the first draft of this paper was completed. Graham acknowledges financial support from the Alfred P. Sullivan adds that option tax deductions in exceeded net income for 8 of the 40 largest U. Microsoft, AOL, Cisco Systems, Amgen, Dell Computer, Sun Microsystems, Qualcomm, and Lucent. Furthermore, options compensation has spread employee technology stocks. Our analysis confirms that employee stock option deductions substantially reduce taxes tax payments. For the Nasdaq companies which are more option-intensiveaggregate deductions exceed aggregate pretax income. This study, however, focuses primarily on the effect of employee stock options on MTRs and the resulting impact on capital structure. MTRs are an important consideration in many economic decisions. In particular, if employee stock options are large enough to affect MTRs, they can reduce the value of interest deductions and alter the incentives to issue debt. We find corporate stock option deductions substantially reduce MTRs. As described in more detail in Section I, we isolate the effect of three classes of options on the MTR: Each class of options taxes to the overall reduction in MTRs. We then test whether the impact of employee stock options on MTRs affects debt policy. DeAngelo and Masulis argue that companies substitute between debt and nondebt tax shields such as option deductions when determining their optimal capital structure. Previous investigations of this substitution effect were inconclusive see Graham for a review. Some papers conclude that high-MTR firms appear to carry insufficient debt in their capital structures. Hanlon and Shevlinhowever, point out that these previous studies may fail to detect the expected MTR-debt relation because they ignore tax deductions from stock option exercise. In particular, employees exercising nonqualified options face potential tax obligations for the difference between the market and strike price at the time of exercise. Employee Stock Options In our sample, we find that debt ratios and MTRs are not significantly pairwise correlated when we ignore option deductions in the construction of MTRs. In contrast, after adjusting for expected option deductions, the relation between debt and taxes is positive and significant. This result indicates that accounting for the tax deductions associated with stock options provides important incremental power to explain debt policy, which is consistent with managers factoring in the tax effects of options when they select capital structure. Furthermore, when we identify policy that appear to be underlevered when option deductions are ignored, we find that these firms are the ones that use the most options. Overall, our analysis is consistent with firms trading off debt and nondebt tax shields when making capital structure decisions, in the manner suggested by DeAngelo and Masulis stock Our results may also provide a partial answer to the puzzle as to why some firms currently use so little debt Graham — once option deductions corporate considered, the MTRs for these firms ref lect a small tax incentive to use debt, so their low debt ratios may be appropriate. Our paper is related to several branches of academic research. The second half of our paper is most similar to Kahle and Shastriwho investigate whether firms with large option deductions use less debt. Debt, Kahle and Shastri do not consider several issues that we address. First, they do not calculate MTRs or the effect of options on MTRs. These omissions are a shortcoming because option deductions should only affect capital structure decisions to the extent that they affect MTRs. Stock, Kahle and Shastri do not account for the effects of options that are already granted but not yet exercised, nor options not yet granted. Finally, Kahle and Shastri do not address the uncertainty of option exercise timing, nor more generally how option deductions interact with the dynamic aspects of the federal income tax code. Policy provide details in Sections I and II describing how we account for these sometimes subtle inf luences. Debt its relation to effective tax rate and capital structure research, this paper is related to two other branches of research. First, a series of papers investigates whether tax incentives play a role in the form of compensation a firm chooses to use. The early research in this area and inconclusive e. Our and does not taxes whether taxes affect the choice among various forms of compensation, but does suggest that firms consider the tax effects of compensation when deciding on corporate capital structure. In principle, if firms were to shift away from using option compensation to using another form of compensation e. Second, our paper is related to the literature The Journal of Finance that investigates how tax managers optimize corporate tax policy e. We contribute to this body of literature by providing evidence consistent with tax managers considering the interaction of various corporate policies when choosing tax positions. Section II discusses our empirical approach in detail and describes the data. Section III analyzes the effect corporate option deductions on corporate MTRs. Section IV examines the interaction between option deductions and corporate debt policy. Section V presents closing remarks. Tax Issues Related to Corporate Deductions from Employee Stock Options The simulation procedure that we use to estimate year MTRs incorporates dynamic features of the tax code, including tax loss carrybacks and carryforwards Shevlin and Graham The procedure determines the MTR based on the incremental tax effects associated with an extra dollar of income earned in The incremental effect of an extra dollar of income in can be realized anywhere between because of the two-year tax loss carryback period and because of the year tax loss carryforward periodor not at all if losses are sufficient to offset all current options future profits. To model the carryforward effect, we first produce a baseline forecast of the future by forecasting future taxable income discussed in Section II. Employeefuture grant and exercise behavior Section II. Cand future stock prices Section II. Starting with the baseline forecast, we estimate the present value tax consequences associated with one additional dollar of income earned in If, because of carryforwards or carrybacks, the tax consequences occur in or later, we discount the incremental effect back to year dollars. E, we explore issues related to discounting tax liabilities when a firm has stock option deductions. To capture uncertainty about the future, we produce 50 random baseline forecasts of the future, each of which produces an estimate of the MTR. The expected MTR is the mean tax rate among these 50 estimates. In the absence of stock options, estimating MTRs is relatively straightforward. One can use the mean implied growth rate and variance from the historic time-series of taxable income estimated from pretax income adjusted for deferred taxes as described in more detail in the next section as the seed parameters to produce the 50 random baseline forecasts of the future through However, the existence of options introduces several important issues into the standard simulation procedure. We discuss these issues in the remainder of this section. In other years, when option deductions are less important, tax planners may accelerate non-option deductions. It would be interesting for future research to investigate whether managers trade off non-option deductions with interest in eras when option deductions are less prominent. Employee Stock Options First, one can no longer simply adjust pretax income for deferred taxes to estimate taxable income, because unlike other forms of compensation, stock options are not typically ref lected in pretax income or in deferred taxes. In terms of pretax income, options are generally not considered an income statement expense, and firms that opt not to expense stock options also do not reduce tax expense on the income statement to ref lect the effect of option deductions. As a result, a firm can consistently report high tax expense corporate financial statements and never pay any taxes on tax returns. Prior research has debt used income statement data to infer taxable income and thus ignored option compensation deductions for the majority of firms because most employee do not expense options. First, many firms do not separately report the tax benefit from stock options in their financial statements. Even for the Nasdaqfor which stock options benefits are likely to be large, Hanlon and Shevlin note that only 63 companies report the tax benefits and options in their financial statements. Further, while adjusting pretax income for option tax benefits is relatively straightforward if taxable income is positive, cases with tax losses are more complex because of the effects employee net operating loss carryforwards and tax valuation allowances. This information is reported consistently across firms irrespective of tax status. A second unique issue with stock options is that current-period MTRs can be affected by several classes of option deductions: All the studies debt which we are aware only consider one of these 4 Statement of Financial Accounting Standards SFAS permits firms the choice of either expensing stock options on the income options or disclosing in the footnotes debt effect stock options would have had if policy. Init was extremely rare for a firm to expense stock options on the income statement, with the vast majority of firms opting for footnote disclosure. If a firm opted not to expense options, it corporate not permitted to reduce tax expense for the deductions related to option exercise. The underlying logic was that since the original charge did not reduce pretax income, the tax benefit at exercise should not decrease tax expense. However, tax benefits from options are not always reported as a separate line item and instead are often aggregated with another item on options statements. This limitation and acceptable corporate research examining effective tax burdens, such as DesaiHanlon options Shevlinand Sullivan However, it is important to consider all three classes of options when studying economic decisions based on marginal tax incentives. As a result, two firms that currently grant similar amounts of compensation in options can find themselves in very different MTR positions, depending on past stock price behavior and the number of options that remain unexercised. We use footnote information on options outstanding and past option options behavior to forecast the likely effects of outstanding options and future option grants on current MTRs. A third conceptual issue that is unique to stock option research is the uncertainty of if and when not-yet-exercised options policy lead to corporate tax deductions. Because share prices are volatile and options have long lives most often 10 yearscurrently outstanding options and future option grants can generate huge deductions in the future or no deductions at all, depending on the stock price path. The stochastic nature of stock option deductions can substantially complicate computations of estimated MTRs and consequently any corporate decisions in which taxes are relevant. The stock price path and employee exercise decisions are difficult to predict, and for efficient tax and financial planning, a manager would need to factor in the probabilities and amounts of future option deductions. We explicitly implement a simulation approach for considering stock option deductions using information on stock options, stock return volatility, dividends, and expected returns to modify the Graham simulation technology. We combine expected deductions with simulated future taxable income to arrive at probability-weighted estimates of MTRs. The analysis is very taxes to the approach we envision a corporate manager would undertake to make decisions based on expected MTRs. To our knowledge, ours is the first study to take the ex debt perspective of explicitly incorporating preexercise option information into MTR estimates. They comprise a substantial portion of the economy and pay substantial taxes. The 6 Inthe most recent year for which IRS data are available, the firms in our sample had tax expense equal to more than one-third of the taxes paid for the entire corporate sector. Employee Stock Options Nasdaq firms are the most profitable and stock among option-intensive, high-technology firms. We are unable to locate data for three firms, which reduce the sample to companies. Our reference point and the most recent year for which data were available options the inception of this project, which is fiscal year-end as defined by COMPUSTAT year-ends from June through May for the vast majority of sample firms. Because the investigation period follows an extended bull market, managers may not have envisioned the magnitude of the eventual stock option deductions when they granted the options years earlier. Nonetheless, our characterization is representative of the situation firms found themselves in at year-endwith managers facing MTRs similar to those estimated in this study. Estimating Historic and Future Income Ignoring Employee Deductions We implement a variation of the simulation algorithm used in Shevlin and Grahamwhich requires a forecast of stock income in order to calculate current-year MTRs. Our procedure assumes that income next year equals income this year plus an innovation. The innovation is drawn from a normal distribution, with growth and volatility calculated from firm-specific historic data. Because options do not create a charge to accounting earnings, our COMPUSTAT-based measure of historic pretax earnings, adjusted for policy 7 Of the three missing companies, two are foreign companies Erickson and Checkpoint. The other JPM is not listed on Edgar for unspecified reasons. Another 20 have year-ends in earlier than September, and in eight of these cases we use data because the year-end is in May and Ks taxes fiscal year were not available when we collected the data. Finally, the remaining 24 companies have year-ends between January and May 31, Even with dampened stock prices, the sheer number of options granted and exercised is such that this robustness check produces a mean tax rate that is stock modestly higher than the base case tax rate we report below. Additionally, since our data are from financial statements, our measure of taxable income faces the usual policy when book numbers are used to approximate tax payments, including book-tax differences in consolidation and recognition of foreign profits. Some firms have extreme historical earnings information that seems implausible going forward. Including Historic and Future Option Exercises SinceSFAS has required firms to include in their financial footnotes, among other things, 1 a description of option taxes 2 the number of options, weighted average strike price, and remaining contractual life for options outstanding at the end of the period; 3 three corporate of exercise, grant, and cancellation history options of shares and weighted average price ; and 4 the Black—Scholes value of options and during the period, including the underlying assumptions for dividend yield, risk-free rate, annual return volatility, and expected term before exercise. USE FOR CRITERIA 4 Website: Accounting Standards Codification ASC http: View the full answer. Average reply time is 49 mins. Course Hero has all the homework and study help you need to succeed! Find the best study resources around, tagged employee your specific courses. Share your own to gain free Course Hero access or to earn money with our Marketplace. Browse existing sets or create your own using our digital flashcard system. A simple yet effective studying tool to help you earn the grade that you want! Or get help from our Accounting experts. Find Study Resources Main Menu by School by Subject by Book Literature Study Guides Infographics. Ask a Tutor a Question. Taxes Flashcards Create Flashcards. View the step-by-step solution to: THE JOURNAL OF FINANCE VOL. This question was answered on Sep 21, SEE "DOCUMENT 1" FOR CRITERIA 2 "DOCUMENT 2" FOR CRITERIA 4. You are to write a 2 to 4 page paper following APA rules for the title page, citations and appropriate references within the body of the paper. Locate the following research article using the OCLS and EBSCOhost referenced policy What is a nonqualified stock option, how and why is it used to compensate executive management? You may use other sources, however, you must reference and cite them. Also, remember to reference and cite the textbook. Using information from the article, explain how these corporations use stock options to reduce their marginal tax rates. In a page following your reference page, use the Accounting Standards Codification to locate the section which discusses accounting principles relevant to stock compensation. Next access the overview and background subsection. Copy subsection and paste to the page. Also, properly cite this code section. Include a citation of the source. Attachment 1 Attachment 2. This is the end of the preview. Download to see the full text. View Full Answer or ask a new question. This question was asked on Sep 21, and answered stock Sep 21, About this Question STATUS Answered CATEGORY AccountingBusiness DATE ANSWERED Sep 21, EXPERT solves. Need an Accounting debt Why Join Course Hero? This is just a preview. Sign employee to view the full answer. Course Hero is not sponsored or endorsed by any college or university.
Taxation of Employee Stock Options
Taxation of Employee Stock Options
5 thoughts on “Employee stock options corporate taxes and debt policy”
I recommend reading everything that follows a few times (except maybe this next part which we have already covered), and giving comments the last time you read it.
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I recommend reading everything that follows a few times (except maybe this next part which we have already covered), and giving comments the last time you read it.
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Norm-Referenced, and Criterion-Referenced forms of grading are just a couple of the types of tests.