ADVANCES IN TAXATION Series Editor: Suzanne Luttman Recent Volumes: Volumes 1–3: Edited by Sally M. Jones Volumes 4 and 5: Edited by Jerold J. Stern Volumes 6–13: Edited by Thomas M. Porcano Volume 14: Edited by Thomas M. Porcano Volumes 15 and 16: Edited by Thomas M. Porcano Volume 17: Edited by Suzanne Luttman ADVANCES IN TAXATION VOLUME 18 ADVANCES IN TAXATION EDITED BY SUZANNE LUTTMAN Department of Accounting, Santa Clara University, CA, USA United Kingdom – North America – Japan India – Malaysia – China EDITORIAL BOARD Kenneth E. Anderson University of Tennessee Caroline K. Craig Illinois State University Anthony P. Curatola Drexel University Ted D. Englebrecht Louisiana Tech University Philip J. Harmelink University of New Orleans D. John Hasseldine University of Nottingham Peggy A. Hite Indiana University-Bloomington Beth B. Kern Indiana University-South Bend Suzanne M. Luttman Santa Clara University Gary McGill University of Florida Janet A. Meade University of Houston Michael L. Roberts University of Colorado-Denver David Ryan Temple University Dan L. Schisler East Carolina University Toby Stock Ohio University ix LIST OF CONTRIBUTORS Steven Balsam Department of Accounting, Fox School of Business, Temple University, Philadelphia, PA, USA Richard Cummings Department of Accounting, University of Wisconsin-Whitewater, Whitewater, WI, USA Jennifer L. Fecowycz – Tonya K. Flesher Patterson School of Accountancy, University of Mississippi, University, MS, USA Ernest R. Larkins Georgia State University, School of Accountancy, J. Mack Robinson College of Business, Tucker, GA, USA Teresa Lightner Rawls College of Business, Texas Tech University, Lubbock, TX, USA Gary A. McGill Fisher School of Accounting, University of Florida, Gainesville, FL, USA Karen C. Miller McAfee School of Business Administration, Union University, Jackson, TN, USA Thomas M. Porcano Department of Accountancy, Farmer School of Business, Miami University, Oxford, OH, USA Robert Ricketts Frank M. Burke Chair in Taxation, Texas Tech University, Lubbock, TX, USA David Ryan Department of Accounting, Fox School of Business, Temple University, Philadelphia, PA, USA vii J. Riley Shaw Patterson School of Accountancy, University of Mississippi, University, MS, USA Peter J. Westort College of Business, University of Wisconsin-Oshkosh, Oshkosh, WI, USA Brett R. Wilkinson Hankamer School of Business, Baylor University, Waco, TX, USA LIST OF CONTRIBUTORSviii JAI Press is an imprint of Emerald Group Publishing Limited Howard House, Wagon Lane, Bingley BD16 1WA, UK First edition 2008 Copyright r 2008 Emerald Group Publishing Limited Reprints and permission service Contact: booksandseries@emeraldinsight.com No part of this book may be reproduced, stored in a retrieval system, transmitted in any form or by any means electronic, mechanical, photocopying, recording or otherwise without either the prior written permission of the publisher or a licence permitting restricted copying issued in the UK by The Copyright Licensing Agency and in the USA by The Copyright Clearance Center. No responsibility is accepted for the accuracy of information contained in the text, illustrations or advertisements. The opinions expressed in these chapters are not necessarily those of the Editor or the publisher. British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library ISBN: 978-1-84663-912-8 ISSN: 1058-7497 (Series) Awarded in recognition of Emerald’s production department’s adherence to quality systems and processe s when preparing scholarly journals for print AD HOC REVIEWERS Bruce Busta St. Cloud State University Michael Calegari Santa Clara University Anne Christensen Montana State University Shirley Dennis-Escoffier University of Miami Peter Frischmann Idaho State Jeffrey Gramlich University of Southern Maine Robert Halperin Hong Kong Polytechnic University Yongtae Kim Santa Clara University Jane Livingstone North Carolina at Greensboro Steve Matsunaga University of Oregon David Monarchi University of Colorado, Boulder Kevin Murphy Oklahoma State University Michael Schadewald University of Wisconsin, Milwaukee Dennis Schmidt Montana State University Roxanne Spindle Virginia Commonwealth University xi THE EFFECT OF INTERNAL REVENUE CODE SECTION 162(m) ON THE ISSUANCE OF STOCK OPTIONS Steven Balsam and David Ryan ABSTRACT Internal Revenue Code section 162(m) limits tax deductibility of executive compensation to $1 million per covered executive, with an exception for performance-based compensation. Both stock options and annual bonuses can qualify as performance-based, but they vary in the difficulty of qualification and the degree of additional compensation risk that qualification imposes on the executive. Most stock-option grants easily qualify with little change in risk, but qualification increases the risk associated with annual bonus compensation relative to what it was prior. The results of this study show that the propensity to issue stock options has increased for affected executives as a percentage of total compensa- tion. Additional analysis suggests that this increase in stock-option compensation is substituting for lower increases in salary for affected executives, but not for annual cash bonuses. In fact, the results suggest that bonus compensation is also increasing as a percentage of total compensation. In summary, the results indicate that firms and their executives are acting in a way consistent with the incentives provided by section 162(m). Advances in Taxation, Volume 18, 3–28 Copyright r 2008 by Emerald Group Publishing Limited All rights of reproduction in any form reserved ISSN: 1058-7497/doi:10.1016/S1058-7497(08)18001-2 3 INTRODUCTION The Revenue Reconciliation Act of 1993 added section 162(m) limiting the corporate tax deduction for executive compensation to $1 million per individual for the top five executives of a corporation and providing an exception for compensation in excess of $1 million if it qualifies as ‘‘performance-based.’’ This chapter extends the prior research on the effect of section 162(m) on executive compensation by focusing on whether 162(m) is achieving its intended effect of increasing the use of such performance-based compensation as stock options in executive compensa- tion. Using the population of firms available on Standard & Poor’s ExecuComp database, the results show that the propensity to issue stock options has increased for affected executives, not onl y in absolute terms, but also as a percentage of total compensation. Additional analysis shows that the increase in stock-option compensation may be substituting for lower increases in salary for affected executives. But, there is no evidence that stock-option compensation is substituting for annual cash bonuses. The Congressional intent of section 162(m) was to reduce excessive, non-performance-based executive compensation (U.S. Congress, House, 1993). The results indicate that firms and their executives are acting in a way consistent with the incentives provided by section 162(m). Under section 162(m), firms that wish to pay an executive more than $1 million either have to forfeit deductions or structure the compen sation package so that the excess over $1 million qualifies under the performance- based exception. While a variety of compensation forms can qualify as performance-based, they vary in the difficulty of qualification, the risk qualification imposes on the executive, etc. For example, for amounts paid under a bonus plan to qualify as performance-based, the payout must not exceed that determined using objective plan parameters set at the beginning of the year. In contrast, stock-option plans are relatively easy to qualify under section 162(m) and as long as the exercise price is set at or above the market price on the date of grant, are assumed to be performance- based. This study continues in Section 2 with a discussion of section 162(m), and a review of the relevant literature in Section 3. Section 4 develops our research question and models, while Section 5 discusses our sample selection. Section 6 presents the empirical results. The findings of the study are summarized in Section 7. STEVEN BALSAM AND DAVID RYAN4 SECTION 162(m) Section 162(m) was a response to the concern about the perceived link between the international competitiveness of United States industry and the substantial salaries paid to United States executives ( Brownstein & Panner, 1992). Corporate governance critics (e.g., Crystal, 1992; McCarroll, 1993) argued that executive compensation was excessive, both in comparison to that paid to lower level employees and that paid to overseas executives; and that executives were setting their own pay with no shareholder input. Section 162(m), which became effective for tax years beginning on or after January 1, 1994, places a $1 milli on cap on the annual deduction for non- performance-based compensat ion to the top five executives (the chief executive officer (CEO) and the next four highest compensated officers). Executive compensation generally consists of salary, fringe benefits, annual cash incentives, and long-term cash or stock-based incentives. The section 162(m) limit does not apply to (1) commissions, (2) non-taxable fringes and qualified retirement plan contributions, and (3) performance-based com- pensation. Prior to the imposition of section 162(m), most firms claimed to tie compensation to performan ce. However, compensation committees had substantial discretion in awarding executive bonuses. Specific goals and performance criteria were rarely set in advance and even more rarely made public. Under section 162(m), to qualify bonus plans for the performance- based exception, firms are required to adopt a performance-based plan that is based on the executive’s attainment of one or more performance goals that were establis hed ex-ante by a compensation committee composed solely of independent directors. The performance goals must be based on objective formulae and the material terms of the plan must be disclosed to and approved by shareholders. The compensation committee, which has the discretion to award less, but not more than the objectively determined amount, must certify that the performance goals have been met before payment is made. Any compensation awarded by the committee based on discretionary assessments of performance that is in excess of the objectively determined amounts does not qualify for the performance-based exemption. By definition, salary will not qualify as performance-based since it is not contingent on the attainment of any criteria. Thus, any salary amounts earned in excess of $1 million are not deductible unless payment is deferred until after the executive’s retirement or unless paid under a contract The Effect of Internal Revenue Code Section 162(m) 5 [...]... PCROAit change in net income before extraordinary items and discontinued operations deflated by total assets for executive i’s firm in year t; LESSit indicator variables taking the value of one if net income before extraordinary items and discontinued operations was less than prior year, and zero otherwise for executive i’s firm in year t; LOSSit indicator variables taking the value of one if net income before... performance measures, reported in Table 7, are also examined For accounting-based performance measures, ROA is replaced first with LESS (an indicator variable equal to one if net income before extraordinary items and discontinued operations was less than in the prior year) and then with LOSS (an indicator variable taking the value of one if net income before extraordinary items and discontinued operations was... CONSTRAINT is included There should be a positive coefficient on this variable To account for any macro-economic year-to-year or industrywide effects, indicator variables for each year and industry (2-digit SIC codes) in the sample are included Tables 1 & 2 provide the sample distribution by year and industry (1-digit SIC codes) Table 1 Industry Distribution One-Digit SIC Code Agriculture, mining, extraction,... gains income ranged from 0 to 30 percent (Table 1).2 Thus, if corporations consider the tax implications of their distribution policy, firms with taxable investors should be more inclined to engage in share repurchases rather than dividend payments as the tax-rate differential widens favoring capital gains.3 In a related article, Lie and Lie (1999) examine four types of distribution methods to determine... Effect of Internal Revenue Code Section 162(m) 17 while the mean (median) change in ROA (income before extraordinary items and discontinued operations deflated by total assets) was 0 (1) percent The mean (median) variance of ROA (VARROA) is 2 (0) percent Sixteen percent of the firm year observations in the sample had a loss in the current year, 36 percent had income lower in the current year than in the... of the compensation package increased after 1993, with the largest increase coming in the form of stock-option grants This finding that compensation increased post-section 162(m) is consistent with the theoretical predictions of Halperin, Kwon, and Rhoades-Catanach (2001) However, while prior research shows the increase post-section 162(m), it does not show that the increase in stock options is disproportionate... Consequently, observations are lost in those instances where prior year information on the executive’s holdings is not available because the executive was not a listed officer in the company in the prior year 7 Variables are winsorized at two standard deviations from the mean 8 Recall that in the model, this period’s equity compensation is based in part, on the equity and option holdings at the end of the period;... changes involving the deductibility of executive compensation: A model explaining behavior Journal of the American Taxation Association, 18, 1–12 Balsam, S., & Ryan, D (2007) Limiting executive compensation: The case of CEOs hired after the imposition of section 162(m), the million-dollar cap on executive compensation Journal of Accounting, Auditing and Finance, 22(4), 599–621 The Effect of Internal... Revenue Code Section 162(m) 27 Balsam, S., & Yin, J (2005) Explaining firm willingness to forfeit tax deductions under Internal Revenue Code section 162(m): The million-dollar cap Journal of Accounting and Public Policy, 24, 300–324 Bergstresser, D., & Philippon, T (2006) CEO incentives and earnings manipulation Journal of Financial Economics, 80, 511–529 Brownstein, A., & Panner, M (1992) Who should set... CONSTRAINTit FCFit BKMit YEAR IND an indicator variable taking the value of 1 if cash compensation of executive i is greater than $900,000 in year t, 0 otherwise3 an indicator variable taking the value of 1 if cash compensation of executive i is greater than $900,000 in year t and year t is 1994 (1995 if non-December fiscal year end) or later, 0 otherwise value of executive i’s shares held plus the intrinsic . Luttman ADVANCES IN TAXATION VOLUME 18 ADVANCES IN TAXATION EDITED BY SUZANNE LUTTMAN Department of Accounting, Santa Clara University, CA, USA United Kingdom – North America – Japan India –. compensation is also increasing as a percentage of total compensation. In summary, the results indicate that firms and their executives are acting in a way consistent with the incentives provided. compensation by focusing on whether 162(m) is achieving its intended effect of increasing the use of such performance-based compensation as stock options in executive compensa- tion. Using the population