JOIM www.joim.com JOURNAL OF INVESTMENT MANAGEMENT, Vol. 4, No. 2, (2006), pp. 1–10 © JOIM 2006 EMPLOYEE STOCK OPTIONS AND TAXES Courtney Edwards a,∗ , John R. Graham b , Mark H. Lang a and Doug Shackelford c 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. 1 1 Introduction A common approach for assessing a firm’s income tax status is based on current tax expense on the income statement. As a general rule, firms that have high current tax expense are firms with positive tax- able income that face a high tax burden and have strong incentives for tax planning. Options create two wrinkles. 2 a University of North Carolina. b Duke University. c University of North Carolina and NBER. ∗ Corresponding author. First, when options are exercised, the firm typi- cally receives a tax deduction equal to the “intrinsic value” of the option (the difference between the market value of the stock at exercise and the strike price). However, the firm is not required to record stock option expense on its income statement under current financial reporting standards. Except for firms that voluntarily expense stock options, the income tax expense in the income statement is like- wise not reduced to reflect the tax benefits of stock option deductions. 3 As a consequence, a firm that is option-intensive can report consistently higher profits and tax expense on its income statement while not paying any tax. The second wrinkle is SECOND QUARTER 2006 1