A Model of Equity Based Compensation with Tax

• Date: 01 September 2014
• Published date: 01 September 2014
• Author: Jinsha Zhao,Martin Widdicks
• DOI: http://doi.org/10.1111/jbfa.12085

Journal of Business Finance & Accounting

Journal of Business Finance & Accounting, 41(7) & (8), 1002–1041, September/October 2014, 0306-686X

doi: 10.1111/jbfa.12085

A Model of Equity Based Compensation

with Tax

MARTIN WIDDICKS AND JINSHA ZHAO*

Abstract: In this paper, we develop a two-stage continuous time model of employee stock

option (ESO) valuation under different tax regimes. We show that tax rules can have significant

effects on ESO exercise behavior. In addition, we find that incentive stock options (ISO) are

the optimal form of compensation for all levels of employees in the UK. In the US, restricted

stock plans are preferred, and tax breaks offered by incentive schemes are only beneficial to

employees with high liquid wealth (or small option holdings relative to wealth) or low risk

aversion. We also analyze 83b elections for restricted stock plans in the US and find that making

an election is a sub-optimal decision for both the employee and the firm.

Keywords: compensation, incentive, tax, option exercise, employee stock option

“Most recent analyses of executive compensation have focused on efficient-contracting

or managerial power rationales for pay, while ignoring or downplaying the causes and

consequences of disclosure requirements, tax policies, accounting rules, legislation, and

the general political climate.”

– Murphy (2012)

1. INTRODUCTION

Employee stock options and restricted stock grants are subject to a variety of tax

laws. These tax considerations could potentially have a substantial effect on the

optimal exercise (or sale) of these grants and, hence, the value of the grant to the

employee. Subject to qualifying constraints, Incentive Stock Options (ISO) in the US,

and Enterprise Management Incentives (EMI) and Company Share Option Plans

(CSOP) in the UK offer the employee the chance to pay long-term capital gains tax on

their profits from option exercise. Naturally, these plans may be more valuable to the

employee than other forms of compensation, keeping the cost of compensation to the

firm fixed. We develop a continuous time utility model where, by carefully considering

∗The first author is from the Department of Finance at the University of Illinois at Urbana-Champaign.

The second author is from the Department of Accounting, Finance and Informatics at Kingston University,

London. The authors thank an anonymous referee, Vicky Henderson, Bart Lambrecht, Grzegorz Pawlina,

Mark Shackleton, Rafal Wojakowski and seminar participants at Lancaster for helpful suggestions and

comments. (Paper received June 2014, revised version accepted July 2014)

Address for correspondence: Jinsha Zhao, Department of Accounting, Finance and Informatics, Kingston

University, London.

e-mail: j.zhao@kingston.ac.uk

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the optimal exercise and subsequent stock sale, we are able to derive the employee’s

valuation of the option and the cost to the firm of issuing the option. We compare

these plans with standard option and restricted stock grants.

The choice of the optimal compensation plan is a trade-off between the value of

the plan to the executive, the cost of the plan to the firm and the potential incentives

that the plan provides. The introduction of tax considerations contributes to all three

facets. In the US, incentive stock options are seemingly attractive to employees as they

offer the chance of paying substantially less tax on the option payoff than other options

or restricted stock plans. However, the cost of these options cannot be deducted

from the firm’s corporate tax returns. So, the potential savings to the employee are

traded off with the increased cost to the firm. In the UK, these incentive plans are tax

deductible and so would appear attractive for both employees and firms.

Hite and Long (1982) develop a simple model to find conditions on the tax rates

that leads to ISOs being preferred to other forms of compensation. However, the

problem is complicated when considering employees’ risk aversion and liquid wealth.

More risk averse employees typically exercise their options earlier leading to a lower

valuation, but also a lower cost of issuance. The trade-off between these changes

is also important, if the decline in employee value is substantially larger than the

decline in firm cost then the trade-off between the different compensation plans

could potentially depend upon the characteristics of the employee or the firm. This

is very important in the case of incentive stock options where the low tax rates are

only applied when certain holding qualifications have been met. Potentially, some

employees would find these qualifications so onerous that they would choose to forgo

the tax savings to have a guaranteed payoff earlier. We also consider the potential

impact of firm stock price volatility and its interaction with employee characteristics.

To correctly determine the outcomes of these trade-offs we develop a two-stage,

multiperiod, continuous time model of employees’ exercise and subsequent stock sale

decisions under different tax regimes. As is typical in the literature (see Kulatilaka and

Marcus, 1994:, Carpenter, 1998; Hall and Murphy, 2002 among others), the employee

optimally exercises the option holding to maximize the power utility of terminal

wealth. From this optimization problem, we determine the value of the ISO to the

employee and the cost of issuing an ISO to the firm. We also determine the employee

value and firm cost of stock options that do not qualify for the potentially lower tax

(non-qualified stock options (NQSO) in the US and unapproved option plans (UOP)

in the UK) as well as restricted stock plans. Payoffs from NQSOs/UOPs are taxed as

regular income when the option is exercised and restricted stock plans are taxed as

regular income on the vesting date. Both NQSOs and restricted stock plans are eligible

for a corporate tax deduction.

We also calculate the incentives provided by the plans by considering a pay-for-

performance measure, which is the rate of change of the employee’s option value

with respect to the firm’s stock price. These incentives also depend upon employee

characteristics as well as the tax rules applied to the compensation plans. Thus,

the effectiveness of a compensation plan depends upon the interrelation between

employee value, firm cost and the incentives provided. Incentives are only considered

for executives as for lower level employees, free-rider effects reduce the incentives

to increase the stock price. Thus, for lower level employees, the effectiveness of the

compensation plan depends only upon the trade-off between employee value and firm

cost.

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1004 WIDDICKS AND ZHAO

This work contributes to our understanding of employee compensation plans in

three different ways. First, stock options have become an important instrument for

rewarding all levels of employees in recent years, but no agreement has been reached

as to why granting options is such a popular practice. Economic theories propose

some possible explanations: providing incentive to executives (Hall and Murphy,

2002), providing non-debt tax shield (Graham, 2003), employee optimism (Oyer

and Schaefer, 2005), employee retention (Oyer, 2004), and employee preferences

(Dittmann et al., 2010; Spalt, 2013) but none of these explanations can single-

handedly explain the wide popularity of broad-based option plans. Our study provides

evidence that the optimal compensation package is tax dependent, for example when

considering the US and UK, different compensation packages are preferred purely as

a result of different tax rules.

Specifically, we find that in the UK, for most reasonable levels of wealth and risk

aversion EMIs and CSOPs provide the largest value to an employee given a fixed cost

to the firm. This is largely because in the UK, the firm is able to deduct the employee’s

option payoff from their corporate taxable income. In the US, payouts from ISOs are

not corporate tax deductible thus, for typical corporate tax rates, ISOs are the least

effective form of compensation as they provide the lowest value to the employee for a

given cost to the firm. Consistent with the simplified model of Hite and Long (1982),

our results also suggest that, in general, firms with low marginal corporate tax rates

can optimally compensate employees with ISOs. However, our results show that the

exact rate at which ISOs become preferred (to NQSOs) depends upon both employee

and firm characteristics and so the rates themselves are not perfect predictors of ISO

preference, which may explain the mixed results when predicting ISO issuance based

on marginal tax rates (see also Austin et al., 1998).

Secondly, there is also an ongoing debate regarding the best type of compensation

instruments to maximize incentives – restricted stock or options. In practice firms

continue to use options in their compensation plans but Hall and Murphy (2002)

and Dittmann and Maug (2007), argue that it is not optimal to reward options

as compensation because they are an inefficient way of rewarding employees. To

investigate the optimal form of compensation, we consider a model where employee

value and incentives are held fixed, and the most effective plan has the lowest cost.

We find that in the UK, cost effective incentives are best provided by EMIs and CSOPs

in line with the intention of creating such plans. In the US, ISOs provide the least

cost-effective incentives, unless the marginal corporate tax rate is very low. This is

a surprising result, given that the tax breaks for ISOs were seemingly designed to

provide incentives to employees. In the US, restricted stock plans provide the most cost

effective incentives. We should note that any incentives provided by a compensation

plan only last as long as the plan is held by the employee and so the expected lifetime

is an important consideration (see Pinto and Widdicks, 2014). We find that, in general,

option plans have longer expected lifetimes than restricted stock plans.

Thirdly, empirical corporate finance research (for example, Malmendier and

Tate, 2005) is interested in the possibility of inferring certain behavioral biases or

inside information from employee option exercise behavior. It is well known in the

literature that employees exercise compensation options earlier than they would

with an otherwise traded option (see, for example, Carpenter et al., 2010) and we

analyze exercise behavior and the expected lifetimes of the options. We find that

the tax rules for ISOs and NQSOs have different effects on exercise depending upon

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