Virtual shares for employees are very popular. Whether you call them "virtual shares", "phantom stocks", "phantom stock options" or any other way, there is a great demand for virtual shares. One reason for the popularity of virtual shares is their tax treatment. And this despite the fact that virtual share incentive plans are not tax optimized. In this article, we would like to explain to you why virtual shares nonetheless constitute an attractive solution for employee participation schemes - also through the lens of taxation.
In addition, you can find further information on virtual shares form a founders’ perspective here.
Playing the Shell Game:
Real GmbH Shares and the Dry Income Problem
Virtual incentive plans are participation schemes for employees. Their aim is to give employees a share in the success of the company. This is supposed to motivate the employees to achieve outstanding performances. The idea is that the company grows with you and you grow with the company. A model from which - ideally - both sides benefit. And, of course, employees should not have to invest any personal money for it. That's why companies rarely issue real GmbH shares to their employees. Why is that?
Because whenever real GmbH shares are issued with a discount, the dry income problem comes into play. For start-ups the dry income problem is particularly complicated because there are no general rules with respect to the valuation of start-ups.
The Flow of Income and the Dry Income Problem
The dry income problem results out of the following phenomenon: employees have to pay taxes, although they do not receive any cash payment but “only” GmbH shares. The reason for this is that the acquisition of the GmbH shares with a discount is already a transaction subject to taxation.
The taxation is triggered by the fact that employees should not raise any or as little capital as possible under an employee participation scheme. Therefore, real GmbH shares will be issued at the cheapest price per share possible. For example, 1 € per GmbH share.
However, the market price of the GmbH shares will be higher. And the difference between the employee price of 1 € and the market price of, for example, 200 € must already be taxed at the moment of the acquisition of the GmbH shares. Because such discount represents a benefit granted to the employees.
The Tax Treatment of Employee Benefits
Under tax law, there are two ways of treating the benefit granted by means of a discount on the price per share. Either it is considered as a gift to a third party. Or it is considered as a wage component because of its link to the existing employment contract.
If It Were a Gift?
In the case the discount on the price per share is considered a gift, gift tax may be due. Between third parties, an allowance of 20,000 € applies for gift tax. Amounts exceeding the tax-free allowance up to 6 million € are taxed at a rate of 30%. However, it is unlikely that benefits vis-à-vis employees will be treated as gifts. Because usually, employees receive GmbH shares as an incentive and as a motivation to perform well for the company.
The Treatment as Wage Component
As a consequence of the close link between the acquisition of shares under a virtual share incentive plan for employees and the existing employment contract, the discount on the price per share is more likely to be treated as a wage component. Accordingly, it is subject to the individual income tax rate, so that wage tax must be withheld. In addition, the benefit granted must be taken into account when calculating social security contributions.
The employer is obliged to do so. And the employer is liable for this obligation. Therefore, every start-up, in its own interest, will have to withhold and pay wage tax and social security contributions in the context of the discounted issue of GmbH shares to employees. However, the big question is how much.
It depends on the value of the taxable benefit which is calculated on the basis of the company valuation. The company valuation allows us to determine the difference between the employee price and the market price for the GmbH shares. However, the valuation of start-ups is subject to significant inaccuracies, in consequence there is always a risk of having withheld and paid too much or too little wage tax and social security contributions in the end.
The Inaccuracies of the Valuation of Start-ups
Usually, employee participations are not allocated directly at the time of incorporation of the company, but at a later stage. By then, the start-up may already have investors in its cap table. The investors have paid a price X per share. Or perhaps one of the shareholders has sold GmbH shares at a price X. Or the start-up’s activity on the market is generating significant turnover and a return is expected, too. Or perhaps the start-up holds the rights to innovative IP or has licensed such IP. There are multiple factors influencing the valuation of the company.
It is certain that the common valuation methods, especially those based on the capitalised income value or the current value of net assets, are inadequate for start-ups. The value of a start-up is not determined by its’ current earnings or assets, but by its’ future potential. And the common valuation methods cannot take into account this potential. As a result, there are no stable rules applying to the valuation of start-ups. And in consequence, the valuation of start-ups goes along with great inaccuracies.
However, once a price X has been paid for example by an investor, the valuation of the start-up can be based and is actually based on such price X. However, even this price X only serves as an indication and not as a guarantee for the accurate company valuation. As multiple factors influence the valuation, there is always a margin of error. Both upwards and downwards.
High Risks, Little Motivation
Thus, when issuing real GmbH shares to employees with a discount on the price per share, a start-up runs the risk that there is no 100% accurate valuation on the date of acquisition and, as a consequence, the value of the benefit resulting from such discount and the amount of the wage tax and social security contributions to be paid cannot be determined free of doubt.
On top of this, the employees were supposed to receive shares in the GmbH (limited liability company) without investing their personal funds. But now they suddenly must pay taxes without having any cash at their disposal? They have nothing but a few GmbH shares which they are not allowed to sell? In plain language, the tax burden for the employees can quickly reach or even exceed the amount of a month's gross salary.
The initial plan to motivate employees to become personally engaged and to perform outstandingly has most likely become obsolete because of these issues.
No Significant Amelioration
The legislator is aware of the issue and addressed it by adopting the Investment Funds Facility Act (Fondsstandortgesetz). Section 19a of the German Personal Income Tax Act (EstG) has therefore been introduced and applies since July 2021. The latter provides for a possibility to avoid the dry income problem under certain conditions. However, these conditions are very extensive and as a result, there is no significant amelioration. In addition, the corporate law issues with respect to a participation of employees in the share capital with real GmbH shares, which you can learn more about here, of course, persist. This is the reason why virtual shares are still considered by start-ups as an attractive solution for employee participation schemes.
What Is Different in the Tax Treatment of Virtual Shares?
Virtual shares are not tax-optimised, but they have the great advantage that they only confer a contractual claim to employees. This has various consequences, which we will have a look at now.
No Dry Income Problem
Virtual shares are no real GmbH shares. The employees do not become shareholders of the GmbH. They only receive a contractual claim to the payment of a certain amount of money. And this claim (in general) is subject to the condition that an exit event occurs. I.e. the employees receive their part of the exit proceeds without being shareholders of the start-up. As the payment claim is conditional on the exit, a taxable income only arises when the employees actually receive a cash payment.
It is important that the virtual share incentive plan is drafted properly. Provided that this is the case, the allocation of the virtual shares to the employees itself is not considered as taxable income. Therefore, there is no dry income problem with regard to virtual shares. The employees only have to pay taxes once they actually receive a cash payment. The tax burden can simply be settled thanks to the cash-out payment from the virtual shares.
Without Any Inaccuracies Regarding the Valuation
As a consequence, the issue of determining an accurate company valuation is eliminated. No taxes are due on the day the virtual shares are allocated to the employees. Therefore, there is no need to determine how much the company was worth on that day.
A taxable income only results of the cash-out payment. And the amount of the cash-out payment is known free of doubt, it is determined on the day of the payment. On that basis wage tax and social security contributions can be calculated as usual.
No Tax Optimisation
However, all parties should be aware that virtual shares provide no tax-saving scheme for employees. The cash-out payment from the virtual shares is considered a wage component because of its’ close link to the employment contract. In consequence, the total amount of the cash-out payment is subject to the individual income tax rate. As the personal income will be particularly high in the year of the cash-out payment, employees are likely to reach the top tax rate of 42% in that year and maybe even the so-called "rich tax rate" of 45%. In addition, the employees receive the cash-out payment from the virtual shares as employees in the meaning of social security law. The cash-out payments must therefore be taken into account, too, with regard to social security contributions.
Deductible Business Expenses
For the GmbH, the treatment of the virtual shares as wage component has the effect that the cash-out payments from the virtual shares can be recorded in the books as deductible business expenses. Again, this is of course only possible once the exit occurs and the cash-out payment actually takes place.