ABSTRACT

We examine whether controlling shareholders who plan for stock gifts would manage earnings in an attempt to depress stock prices prior to gifting stocks to related parties. Gift taxes are levied based on the average market value of the stock transferred for a certain period known as the valuation period. This process enables controlling shareholders to be incentivized to depress stock prices during this period and thereby alleviate tax burden. We discover that the firms that have stock gift transactions in the sample significantly decrease their discretionary accruals in the quarters that precede and/or overlap with the valuation period. Earnings management that decreases income is statistically significant when stock gifts are made for individuals who are the related parties and family members of controlling shareholders. By contrast, we do not observe a similar earnings-management behavior in cases where stock gifts are donated to institutional donees who are not subject to gift taxes.

6. Conclusion

It is well known that controlling shareholders of most Korean companies transfer their corporate ownership to the next generation via stock gifts. In this paper, we examine whether controlling shareholders who plan for stock gifts would manage earnings in an attempt to influence stock prices prior to gifting stocks to related parties. Because gift taxes are levied on the basis of the average market value of the stock transferred for a certain period known as the valuation period, the controlling shareholders may be incentivized to depress stock prices during this period to alleviate the tax burden. We specifically hypothesize that controlling shareholders will engage in earnings management in the quarters that precede and/or overlap with the valuation period in an effort to adversely affect stock price. To test this hypothesis, we analyze a sample of 423 gift transactions in which controlling shareholders transferred stocks as gifts during the time of 2000–2014. We discover that the companies of these controlling shareholders significantly decrease discretionary accruals in the quarters that precede and/or overlap with the valuation period, compared with those of other quarters. Furthermore, the income-decreasing earnings management is found significant when stock gifts are made to individuals who are related parties and family members of controlling shareholders. This earnings-management behavior is not observed in the cases where stock gifts are donated to institutional donees not subject to gift taxes. This study expands the scope of earnings-management literature by providing empirical evidence of tax-motivated earnings management by controlling shareholders. This study specifically shows that controlling shareholders planning for stock gifts have incentives to decrease earnings to minimize tax costs. This study also provides important implications to policy-makers, tax authorities, and social activists who are concerned of the economic or tax inequality in society. Our results indicate that rich families tend to use all available strategies, including earnings management, to minimize the cost of wealth transfer to next generations.