How Do Executives Pay Their Taxes? By Selling Stock With Insider Information

Insider trading — or trading stocks using non-public knowledge to gain an advantage — is supposed to be a big no-no for investors. It’s something Securities and Exchange rules make it clear, as will any competent securities lawyer. When non-public but material knowledge of what is happening in a company make significant profits, that happens on the backs of ordinary stock owners who don’t have the same information. For each winner in a trade there’s going to be a loser.

How frequently does it happen? Well, 78 members of Congress apparently violated a law that the legislative branch itself helped create to prevent potentially shady stock trading by politicians, according to a report by Business Insider. Excuses included “ignorance of the law, clerical errors, and mistakes by an accountant.”

It’s rampant, and not just on Capitol Hill. A new study that appeared in the Journal of Accounting and Economics suggests that corporate executives with shares of stock routinely do this to help offset part of the taxes they would otherwise have to pay on their compensation.

Researchers Nathan Goldman, an associate professor of accounting at North Carolina State University’s Poole College of Management, and Naim Bugra Orzel, an associate professor of accounting at the Naveen Jindal School of Management at the University of Texas at Dallas, found a relationship between abnormally high profits from insider trades (a second and different use of the term meaning when insiders in a company, like managers, buy or sell shares of their own companies) and state income tax rates.

The problem, according to the two experts, is that the executives use their access to non-public private knowledge about their companies to make their trades. So, the insiders who are trading commit the bad type of insider trading.

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“Abnormally high profits” to the authors mean when an insider in a company makes a trade with their shares of the business and manage profits off the sale significantly higher than typical. The researchers looked at a sample of transactions by “chief officers, presidents, vice presidents, and general counsel” and then looked at a subsample of trades only by CEOs. They looked at state taxes because they vary and make it unlikely that some general tax change could explain the results.

The average executive was able to offset between 12.2% and 19.6% of the impact that their state taxes had on their net compensation. “We document that abnormal profitability for insider sales, insider purchases, and net insider transactions is significantly higher under higher state tax rate regimes,” they wrote. “The results are statistically and economically significant in both the all-executives sample and the CEO subsample.”

In other words, the higher the state tax, the more the insider trades just happened to make up for it. When the taxes go up, so do the executives’ abnormal trading profits. When taxes go down, so do the trading profits. As taxes rise, the executives could sell more shares to meet the costs, but somehow, they instead tend to make more profits per share.

“Our research suggests that policies that lead to higher income taxes increase executives’ incentives to trade on private information and extract profits at the expense of less informed shareholders,” they wrote.

It’s another way in which those who have more privileged positions in the workplace seem more wiling to misuse what they know to break the law when they’re inconvenienced with owed taxes.

What a world, eh?