Analyzing the Tax Benefits from Employee Stock Options




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    • Both authors are from the Department of Finance, Hong Kong University of Science and Technology. We thank the editors, John Graham and Cam Harvey, and an anonymous referee for many helpful comments. We are grateful to Alan Auerbach, Chris Hennessy, Steven Huddart, Michael Lemmon, and Douglas Shackelford. Thanks also to all seminar participants at the University of Wisconsin, Hong Kong University of Science and Technology, University of South Carolina, University of North Carolina Tax Symposium 2007, Australian National University, City University of Hong Kong, and the University of California at Berkeley for useful comments. We thank Man Ying for research assistance.


Employees tend to exercise stock options when corporate taxable income is high, shifting corporate tax deductions to years with higher tax rates. If firms paid employees the same dollar value in wages instead of stock options, the average annual tax bill for large U.S. companies would increase by $12.6 million, or 9.8%. These direct tax benefits of options increase in the convexity of the tax function. In addition, profitable firms can realize indirect tax benefits because stock options increase debt capacity. Although tax minimization is probably not the main motive for option grants, firms with larger potential tax benefits grant more options.