Employee Stock Options and Taxes

Courtney H. Edwards, John R. Graham, Mark H. Lang and Douglas A. Shackelford

Volume 4, Number 2, Second Quarter 2006

In this paper, we investigate the effect of stock options on the tax position of the firm. We argue that option tax deductions can significantly affect a firm’s marginal tax rate and that the effect is masked by current financial reporting rules. We present an approach for factoring in option deductions in assessing a firm’s tax position and document that the effect can be substantial. In particular, many firms that appear to be profitable and face high income tax burdens (based on public financial statement data) actually pay relatively little in taxes. We provide evidence that the effect of options on taxes may help to explain managerial decisions such as why apparently profitable firms carry so little debt, lease rather than purchase, and outsource tax-advantaged activities, such as research and development, to syndicated partnerships.