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Virtual employee participation through the tax lens

Virtual employee participation is very popular. Regardless of whether they are referred to as “virtual shares”, “phantom stocks”, “virtual options” or whatever else, virtual shares are in demand. One of the reasons for this is their tax treatment. And this despite the fact that they are not tax-optimized. In this article, we will explain why virtual shares nevertheless offer an attractive structuring option for employee participation – also from a tax perspective.

You can also find everything you need to know about virtual employee participation from a founder’s perspective here.

The shell game with real GmbH shares:
Where is the dry income problem hidden?

Employee stock ownership plans are programs for employees. They should allow employees to participate in the company’s success. This is intended to motivate employees to achieve outstanding performance. True to the motto: the company grows with you and you grow with the company. A model that – ideally – benefits both sides. And, of course, employees should not have to pay for this. This is why companies rarely issue real GmbH shares to them. Why?

Because the issue of genuine GmbH shares at a discount always raises the dry income problem. The dry income problem is made particularly complicated for start-ups by the fact that there are no fixed rules for valuing start-ups.

He who has, has? The dry income problem

The dry income problem describes the phenomenon that employees have to pay taxes even though they initially “only” receive GmbH shares without receiving any liquid funds. This is because the acquisition of the GmbH shares already constitutes a taxable transaction.

This is due to the fact that employees are expected to provide no or as little capital as possible as part of employee participation programs. Therefore, real GmbH shares would be issued as cheaply as possible. For example, for € 1 per GmbH share.

However, the market value of the GmbH shares will be higher. And the difference between the employee price of € 1 and the market value of € 200, for example, must already be taxed when the GmbH shares are acquired. This is because it is a benefit that is granted to employees.

The tax treatment of the benefit

Under tax law, there are two ways in which this preferential issue of GmbH shares can be treated. Either it is regarded as a gratuitous gift to a third party, i.e. as a donation. Or it is considered a wage component due to its non-cash relationship to the existing employment relationship.

What if it were a gift?

If the discounted issue of the shares is regarded as a gift, this may be subject to gift tax. An allowance of €20,000 applies to gift tax between third parties. Amounts above this allowance are taxed at a rate of 30% up to € 6 million. However, treatment as a gift is unlikely in the case of employees. This is because employees receive GmbH shares as an incentive and motivation to perform particularly well for the company.

Treatment as a salary component

Due to this close non-cash relationship between the acquisition of shares as part of an employee share ownership program and the existing employment relationship, the discounted issue of shares is more likely to be treated as a salary component. This means that it is subject to the personal income tax rate and wage tax must be paid. In addition, the benefit granted must be taken into account when calculating social security contributions.

The employer is obliged to do so. And he is liable for this. Therefore, every start-up will have to withhold and pay income tax and social security contributions on the discounted GmbH shares in its own interest. The big question, however, is how much.

This depends on the amount of the taxable benefit. And this is calculated on the basis of the company valuation. This can be used to determine the difference between the employee price and the market value of the GmbH shares. However, the valuation of start-ups is associated with major uncertainties, which is why there is always the risk of having withheld and paid too much or too little income tax and social security contributions in the end.

The uncertainties in the valuation of start-ups

Employee shareholdings are usually not granted immediately upon formation, but at a later date. By then, the start-up may already have investors on board. The investors have paid X price per GmbH share. Or perhaps a shareholder has sold GmbH shares at a price X. Or the start-up is active on the market, generates sales and earnings can be expected. Or the start-up has the rights to innovative IP or the rights of use to such IP. There are countless factors that influence the valuation of a company.

It is clear that the classic valuation methods, especially those based on earnings or net asset value, do not work for start-ups. Start-ups do not derive their value from their current earnings or their current assets; they derive their value from their potential. And it is precisely this potential that traditional valuation methods cannot reflect. This is why there are no fixed rules for the valuation of start-ups. And that is why the valuation of start-ups is associated with great uncertainty.

However, once a price X has been paid by an investor, for example, it can and will be used to value the start-up. However, even this price X is only an indication and no guarantee for the correct company valuation. Due to the many factors that influence the valuation, there is always room for maneuver. Both upwards and downwards.

Big risks, little motivation

When issuing genuine GmbH shares to employees at a discount, a start-up is therefore exposed to the risk that there is no reliable valuation on the acquisition date and, as a result, the amount of the discount and the amount of wage tax and social security contributions to be paid cannot be calculated with certainty.

To make matters worse, the employees were supposed to receive GmbH shares without having to raise their own capital. And now they suddenly have to pay taxes without having anything in their hands? Nothing but a few GmbH shares that they are not allowed to sell? The tax burden for employees can quickly reach or even exceed the amount of one month’s gross salary.

The original idea of motivating employees to work harder and perform better is likely to be ruined.

No significant improvement

The legislator has recognised this problem and responded to it with the Fund Location Act. Section 19a EstG has therefore applied since July 2021. This avoids the dry income problem under certain conditions. However, these conditions are very narrow, which is why the improvement is not significantly noticeable. And the corporate law problems with genuine employee shareholdings, which you can read about here, naturally continue to exist. This is why virtual shares are still the attractive alternative for employee share ownership for start-ups.

What is different for virtual shares under tax law

Although virtual shares are not tax-optimised, they have the great advantage that they only grant employees a contractual entitlement. This has various consequences, which we will now look at.

No dry income problem

Virtual shares are not real GmbH shares. The employees do not become shareholders of the GmbH. You only receive a contractual claim to payment of a certain amount of money. And this payment claim is (as a rule) conditional on the exit. This means that the start-up gives its employees a share of the exit proceeds without making them shareholders. Because the payment claim is conditional on the exit, a tax-relevant inflow only takes place when the employees actually receive a payment.

It is important that the virtual participation program is designed correctly. In this case, the allocation of the virtual shares to the employees does not yet constitute a taxable inflow. Therefore, there is no dry income problem with virtual shares. This means that employees only have to pay taxes if they actually receive liquid funds. The tax burden is simply paid from the income from the virtual participation.

No problems at all with the rating

This also eliminates the problem of company valuation. No taxes are incurred on the day the virtual shares are allocated to the employees. It is therefore not necessary to determine how much the company was worth on that day.

A tax-relevant inflow only occurs when the payment is made. The amount of this payout is a known quantity and is fixed on the day of payment. Wage tax and social security contributions can be calculated as usual.

No tax optimisation

However, everyone involved should be aware that virtual shares are not a tax-saving model for employees. The payment from the virtual shares is considered a salary component due to the close material connection with the employment relationship. This means that the full amount paid out is subject to the personal income tax rate. Because personal income will be particularly high in the year of payment, employees will very likely reach the top tax rate of 42% this year and, with some probability, even the so-called “wealth tax rate” of 45%. The employees receive payments from the virtual shares as employees within the meaning of social security law. Payments must therefore also be taken into account for social security contributions.

But deductible as a business expense

For the GmbH, the treatment of the virtual shares as a salary component means that the payments from the virtual participation can be recognised as operating expenses and deducted. Here too, of course, this is only possible when the exit occurs and the payout is actually made.

Conclusion:

Virtuelle Anteile sind auch durch die Steuer-Brille eine attraktive Alternative, um Mitarbeiter wirtschaftlich an der Wertsteigerung des Unternehmens zu beteiligen. Dies liegt vor allem daran, dass sich die steuerlichen Auswirkungen der virtuellen Beteiligung sicher vorhersagen lassen. Außerdem entfällt bei virtuellen Anteilen das Dry Income Problem. Die Grundidee Mitarbeiter zu tollen Leistungen zu motivieren wird also nicht durch vorab anfallende Steuerbelastungen gefährdet. Steuern fallen erst an, wenn es tatsächlich zu Auszahlungen an die Mitarbeiter kommt.

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