The Choice of Incentive Stock Options vs. Nonqualified Stock Options: A Marginal Tax Rate Perspective
Compensation committees seeking to minimize the joint tax liability of executives and their firms will grant tax-qualified Incentive Stock Options (ISOs) when the corporate marginal tax rate is low. Otherwise, nonqualified stock options are tax-advantageous. We test the proposition that tax motivations determine the choice between ISOs and nonqualified options by examining a sample of 364 option grants by 195 firms during the 1981 to 1984 period. Our tests employ four alternative measures of tax status, ranging from a simple dummy variable based on the firm's net operating loss carryforward position to a sophisticated simulation of expected exercise year and projected marginal tax rate in that year. We find that the univariate relation between tax status and option granting behavior is insignificant for all four tax variables. However, when we control for firm size in a multivariate logistic regression, we find that one of the four variables is significant in the direction predicted by the tax hypothesis. Interestingly, it is one of the simpler measures. Our results indicate that tax considerations offer only a partial explanation for the ISO/nonqualified option choice.
SMU Cox School of Business Research Paper Series