Into the Distance, a Ribbon of Black, Stretched to the Point of No Turning Back? Understanding Your Biases in Making Tax Decisions

by John Ludlum

In a former life, I studied how competent professionals made what turned out to be wrong and sometimes deadly decisions. Often under the general category of “loss of situational awareness,” we had sanitized terms like “target fixation” leading to CFIT or “controlled flight into terrain” (terrain impact caused by continued visual flight into IMC) or “instrument meteorological conditions” (how the mishap is described when a non-instrument rated pilot loses control after flying into clouds). We studied these mistakes to learn from them and to improve our own decision making.

Equity compensation tax planning can have analogous decision-making pitfalls. Target fixation on optimizing capital gains or achieving the lowest possible exercise price for a stock option can result in much greater costs when these goals lead to taking positions that might be hard to defend on audit, or more commonly, when the public company acquirer’s auditors examine the target company’s tax positions. In these situations, it can become very expensive to decide to use a company valuation for option grants that was likely superseded by Code Section 409A material changes to the business or to argue that equity awards were made at an earlier time with a lower price when the board actions are not documented.

The interesting analysis is that often these risks are known and discussed before the positions are taken. The Code Section 409A penalties for discount options are understood and should be avoided. In some cases, the decisions fail when weight is given to a perceived low audit rate or when the factors that likely changed a company’s value are arguable. This would fit into the concept of a loss of situational awareness, because if the decision makers were to look at the fact that the change in the exercise price is often relatively small, particularly in comparison to probable exit multiples, the risk for the benefit would not appear to be worth it. The problem is that we all can get target fixation, and it takes real effort to be open to considering when you may be losing perspective in trying to achieve an objective.