Controlling Shareholders' Tax Incentives and Classification Shifting *

Although prior studies provide evidence on the financial reporting incentives to inflate core earnings through classification shifting (e.g., shifting core expenses to income‐decreasing noncore items), few examine the tax‐related incentive to report lower core earnings through classification shifting. We examine the effect of controlling shareholders' tax incentives on firms' classification shifting using the introduction of a tax law in Korea that imposes a gift tax on controlling shareholders based on firms' reported core earnings. This tax law creates incentives for managers to report lower core earnings through classification shifting, even though doing so would incur significant financial reporting costs. Using a difference‐in‐differences research design, we find that firms with controlling shareholders subject to the gift tax exhibit a significant decline in classification shifting in the post‐tax period, while those not subject to the tax do not. We also predict and find that the extent to which managers reduce classification shifting decreases with financial reporting costs and increases with the tax benefits. Overall, our results indicate that firms forgo financial reporting benefits associated with reporting higher core earnings for the tax savings of their controlling shareholders.