The Impact of Current Tax Policy on CEO Stock Option Compensation: A Quantile Analysis

By Gritsch, Martin; Snyder, Tricia Coxwell | Academy of Accounting and Financial Studies Journal, September 2005 | Go to article overview

The Impact of Current Tax Policy on CEO Stock Option Compensation: A Quantile Analysis


Gritsch, Martin, Snyder, Tricia Coxwell, Academy of Accounting and Financial Studies Journal


ABSTRACT

The increase in stock option compensation has become controversial as disclosures emerge that executives have abused stock option compensation. The Omnibus Budget Reconciliation Act of 1993 gives stock options preferential tax treatment, allowing options to not be subject to the cap on corporate tax deductions for salaries exceeding $1 million. To examine whether this increases CEO stock option compensation, we use S&P's ExecuComp data from 1992-2000. We use quantile regressions to examine whether the position in the distribution affects behavior. Findings show that the salary cap has increased stock option compensation; strongest effects are at the bottom of the distribution.

INTRODUCTION

The increase in stock option grants during the 1990s is becoming increasingly controversial as disclosures emerge that senior executives of companies such as Enron Corp. and Global Crossing reaped millions of dollars in profit by exercising their stock options as the public held onto stock that became worthless. For example, Global Crossing reported a negative net income of $10,500,000, while they still issued the CEO, Mr. Annunziata, $182,000,000 worth of stock options. In addressing the corporate scandals, Senator Carl Levin recently suggested that stock option pay encourages firms and executives to push tax law to the limit.

Our current tax code gives stock options preferential tax treatment. The Omnibus Budget Reconciliation Act of 1993, Section 162(m) of the Internal Revenue Code (IRS par. 9001B, sec. 1.162) increases the incentive of firms to pay executives in the form of stock options. Specifically, Section 162(m) allows "performance-based pay," such as stock options, to not be subject to the limits or the cap on corporate income tax deductions for salaries exceeding $1 million. To ensure the full tax deductibility of top executives' pay, companies may shift any amount in excess of $1 million to "performance based pay," such as stock options.

In this paper, we use annual data from Standard & Poor's ExecuComp on the CEO of 2,412 firms from 1992 to 2000 to examine if the 1993 SEC Section 162(m) cap on salary compensation reform has altered the mix of compensation that firms pay executives. In our analysis, we control for the changes in the stock market, firm size, firm performance and financial structure. Results will help determine to what extent the 1993 salary cap encourages firms to pay executives in stock options to obtain a tax advantage. Since companies may behave differently dependent on their position in the distribution, we then use a quantile regression technique.

STOCK OPTIONS TAX TREATMENT

Currently, a nonqualified stock option is taxed under Code Section 83, stating that an employer is allowed to deduct the full value of the employee's income from the exercise and sale of stock options. While companies can deduct stock options from their corporate taxes, salary is limited on the amount that it can be deducted from taxes. The Omnibus Budget Reconciliation Act of 1993 (OBRA 1993), Section 162(m) of the Internal Revenue Code (IRS par. 9001B, sec. 1.162), eliminated the deductibility of executive salary compensation in excess of $1 million. This regulation limits the corporate tax deduction for compensation paid to the top five highest-paid executive officers to a 1$ million cap each. However, "qualified performance based pay" was exempt by (IRS par. 9001B, sec. 1.162-7[e][1]). (1)

While this supposedly constrains executive compensation, it may have just altered the mix of compensation towards "performance based pay." For stock options to qualify for an exemption from this limit, the total number of options and the limit of their reward must be approved by the outside directors. The exemption requirements are much stricter for bonus and long-term incentive plans. As opposed to salary and bonuses, stock options are generally not subject to the limits of Section 162(m).

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