CLS Blue Sky Blog

How Director and Officer Liability Affects Corporate Tax Avoidance

In a recent paper, we use the law protecting directors and officers of Nevada-incorporated firms from liability to study how such laws relate to corporate tax avoidance. Under the 1987 law, those directors and officers are liable only if they breach the duty of loyalty and engage in intentional or illegal misconduct.  Not only is the standard of liability higher in Nevada than in any other state, but it also applies to officers and directors rather than, as in other states, just directors.

Current theory, largely following the work of Desai and Dharmapala (2006, 2008), suggests that corporate tax avoidance is associated with greater agency conflicts between managers and their companies.  That is, techniques that hide earnings from the tax authorities also provide greater latitude for managers to pursue self-serving behavior. We predict that greater liability protection allows officers and directors to pursue self-interested behavior.  Corporate tax avoidance, because it makes a firm more complex and opaque, allows for more private benefits to these officers and directors.  An alternative possibility would be that managers have a duty to shareholders to avoid taxes.  Nevada’s higher standard for holding managers liable could decrease managers’ efforts to meet this duty and thus prompt them to engage in less tax avoidance.

An empirical paper by Blaylock (2016) argues that the managerial agency problems (i.e., self-serving behaviors by managers at the firm’s expense) associated with tax avoidance are not a major issue for U.S. firms.  Atwood and Lewellen (2019) echo this finding and suggest that the managerial agency problems associated with tax avoidance are largely confined to countries with weak investor protection. In contrast, we find that Nevada’s liability protection is associated with significantly greater tax avoidance.  Moreover, consistent with greater agency problems, this avoidance helps to explain the lower payouts to shareholders of Nevada-incorporated firms.  Thus, Nevada-incorporated firms tend to avoid more taxes while also paying out less in dividends or repurchases to their shareholders.

Economically, we find large effects: Nevada-incorporated firms avoid 32 percent more federal tax than similar Delaware-incorporated firms and 40 percent more than firms in other states.  Nevada firms also have 15 percent lower cash effective tax rates, 8 percent lower GAAP effective tax rates, and 3.7 times higher residual book-tax differences (another measure of tax avoidance) than firms incorporated in other states.  The increase in tax avoidance associated with liability protection is largest for firms over $75 million in market capitalization, and this may be because the management of small firms can be more easily monitored.

The results are consistent across a variety of specifications including ones where we match similar Nevada-incorporated firms with firms incorporated in other states.  Additionally, they hold using an instrumental variable estimation procedure, where the instrument is whether the firm is headquartered in a state adjacent to Nevada.  Firms headquartered near Nevada are more likely to incorporate in Nevada, but this location should not otherwise be related to the amount of federal taxes paid by these firms, and therefore the headquarters location provides a reasonable instrument for checking whether there is a causal relation between Nevada-incorporation and tax avoidance.

In 2001, when the liability-protection law became applicable to all Nevada-incorporated firms, there was a significant increase in most measures of tax avoidance.  A differences-in-differences analysis suggests that greater director and officer liability protection leads to an increase in tax avoidance.

The results of our study address several key topics. First, we show that differences in legal regimes across U.S. states affect federal tax avoidance. Relatively little is known about the role of legal regimes, especially differences in liability protections for managers, in tax avoidance. That is, a firm’s legal environment may influence its tax-paying behavior in ways that the strength of the firm’s corporate governance does not. The lower liability for Nevada directors plausibly leads to less monitoring; that is, the directors provide less of the oversight necessary to ensure that a firm acts in the best interests of shareholders.  The lower liability for Nevada officers further allows for more self-serving behavior by senior management.  By using a setting where a state’s law leads to the possibility of more managerial agency problems, we find evidence of a connection between tax avoidance and rent extraction in the U.S. Thus, this relation does not just hold in developing countries with weak investor protection, as other studies have concluded. Finally, our study’s empirical analysis fills the gap in the tax law scholarship regarding the application of corporate law fiduciary duties to tax avoidance.

This post comes to us from professors Sarfraz Khan at the University of Louisiana at Lafayette, Sung-Jin Park at Indiana University South Bend, Stan Veliotis at Fordham University – Gabelli School of Business, and John K. Wald at the University of Texas at San Antonio. It is based on their recent paper, “Director and Officer Liability and Corporate Tax Avoidance,” available here.

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