Corporate Tax Strategies Mirror Personal Returns of Top Execs

Top executives who are inclined to reduce personal taxes might also benefit shareholders in their companies, concludes research by Gerardo Pérez Cavazos and Andreya M. Silva.
by Roberta Holland
Tax strategies used by top executives on their own taxes can also
show up in the companies they run. Source: Melpomenem

New research shows that top executives who prefer to reduce personal taxes appear to also influence the strategies of their companies, resulting in reduced tax bills for both the companies and their shareholders.

It’s no secret that companies with similar financials often pay very dissimilar amounts of tax in a given year. The same is true of individuals. One need look no further than Republican presidential nominee Donald Trump, who has suggested he paid no income tax for several years while fellow billionaire Warren Buffett paid $1.8 million in taxes for 2015.

“The decision to accelerate that dividend was driven in large part by the executives’ preferences”

The issue is not that Trump knew about tax loopholes and Buffett didn’t, especially since both undoubtedly use financial advisers and accountants. It boils down to personal preference, according to Harvard Business School Assistant Professor Gerardo Pérez Cavazos.

“High net worth individuals have a wide range of strategies available to decrease their taxes, but not everyone takes them,” Pérez Cavazos says. “There is actually a lot of heterogeneity with the actions that executives take. For me that was very surprising.”

Pérez Cavazos, part of the Accounting and Management Unit, initially doubted his colleague Andreya M. Silva would find anything of interest when she started the research three years ago.

“When Andreya started the project my initial reaction was, you’re going to find that everybody (wants to reduce their tax bill as much as possible)—and she didn’t. So I was thinking, maybe you’re doing something wrong. But it turns out that you find those preferences,” says Pérez Cavazos, who did not delve into the psychology behind those choices.

He and Silva, now husband and wife, co-authored the 2015 working paper Tax-Minded Executives and Corporate Tax Strategies: Evidence from the 2013 Tax Hikes.

A correlation on tax preferences found

Their research was two-fold: to identify “tax-minded” executives using tax minimization strategies, and to see whether that correlated with the tax strategies of the corporations they run. Spoiler alert: They do.

The 2013 tax increases due to the American Taxpayer Relief Act and the Healthcare Act provided an opportunity to determine which executives were tax-minded based on their personal actions before the 8.8 percent increase took effect.

Pérez Cavazos and Silva used the Execucomp database and SEC Form 4 filings to examine the positions and behavior of the top five executives of S&P 1500 companies. The top five, they reasoned, would have influence over the corporate tax strategy. They then reconstructed insider holdings portfolios and built-in capital gains in order to get a precise estimate of their incentives.

There were three measures for determining which executives were tax minded: Did they decrease their built-in capital gains during 2012? Did they increase gains throughout the year but then very aggressively decrease them before year-end? Did they sell 80 percent or more of their capital gains during the year?

They wound up with a pool of 2,281 tax-minded executives who strategically realized capital gains before the tax increase, saving themselves a combined $741 million.

Accelerating dividends the tipoff

Like individuals, companies could use simple strategies to minimize taxes before the increase took effect, although again not all took advantage. Accelerating dividends was the clearest indicator. If companies paid in January, shareholders would pay 8.8 percent more in taxes than if dividends were paid on Dec. 31.

Executives who saved on their personal taxes reduced tax bills for shareholders. The group saved shareholders $700 million in taxes by distributing $8 billion in special and accelerated dividends.

“The decision to accelerate that dividend was driven in large part by the executives’ preferences,” Pérez Cavazos says. While executives with a large stake in the company had added incentive to minimize taxes, that “doesn’t explain what we found.”

The strong correlation between personal and corporate tax strategies is not as obvious as it may seem. Costs and benefits are vastly different for individuals than they are for large corporations.

“If you optimize taxes in your personal life, it is not visible to outsiders, so it’s relatively costless,” Pérez Cavazos says. “The firm’s actions are a lot more visible.”

Companies need to weigh the benefits of maximizing profits against the potential cost of looking like they’re not paying their fair share. “As a firm it can be reputationally damaging to act in that way because of public perception,” Pérez Cavazos says.

To test whether their findings weren’t an isolated situation due to the 2013 tax hike, Pérez Cavazos and Silva went back and looked at the companies’ long-run cash effective tax rates. In line with their other results, they found that the companies with more tax-minded executives were more likely to have a lower cash effective tax rate.

Both investors and MBA students can benefit from the research, Pérez Cavazos says. Because executives’ preferences should be sticky over time, investors can get a sense of how the company will likely handle tax minimization.

“If you’re a shareholder who cares about taxes, it might not be the best decision to invest in a company with a manager who doesn’t have a preference for minimizing them as much,” he says.

Many MBA students come to HBS with backgrounds in private equity, investment banking, or M&A, Pérez Cavazos says.

“Taxes are a large part of those transactions and they definitely shape how they are structured. I think there is a lot of value for MBAs to understand how taxes or tax changes affect the design of optimal transactions.”

About the Author

Roberta Holland is a writer based in Boston.

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