Employee stock plans are a popular tool for allowing employees to share in the company’s success and for boosting their motivation. Employee or executive stock plans are particularly popular among startups and in the IT industry as a way to offer attractive compensation packages. Under these plans, executives and employees can receive shares in the company, which they can sell either immediately after they are granted or after a certain period of time. In the following, we would like to provide an overview of employee stock plans and the tax consequences of their issuance and subsequent sale in the event of an exit or when an employee leaves the company. We will focus in particular on so-called “hurdle shares” as a creative alternative to traditional forms of equity participation that offer income tax benefits.
1. Hurdle Shares and Their Tax Implications
So-called “hurdle shares” are a special form of employee stock ownership designed so that the manager or employee actually becomes a shareholder in the company—rather than merely holding a virtual stake—but only begins to benefit economically from the ownership once certain hurdles have been met. In other words, hurdle shares are structured so that the current value of the company at the time the employee stock is issued is attributed entirely to the existing shareholders, and the hurdle shares therefore participate only in the company’s future profits and increases in value.
Under corporate law, hurdle shares are classified as a negative liquidity preference. This can be particularly attractive for startups and high-growth companies, as it allows them to create incentives for their employees to increase the company’s value.
1.1 Tax Treatment Upon Issuance
When hurdle shares are issued for free or for a partial fee, this generally does not result in a monetary benefit that must be taxed immediately as part of one’s salary. The Federal Fiscal Court has already addressed this issue in a ruling dated November 16, 2022 (X R 17/20), deciding that negative liquidation preferences must be taken into account when valuing shares under certain conditions, and that taxation as wages would only be considered if the shares were transferred at a discount.
By structuring the plan correctly and taking into account a negative liquidation preference, the value of the employee stock award can thus be reduced to such an extent that, when the hurdle shares are issued to the beneficiary employee, there is no monetary benefit, thereby resolving the so-called and much-maligned “dry income” issue, which would otherwise result in a taxable income payment.
1.2 Tax Treatment Upon Sale
When hurdle shares are sold, provided the transaction is properly structured and the acquisition was made at arm’s length, the resulting gain is generally classified as capital gains. The gain is defined as the difference between the sale price and the original acquisition price (or 0 EUR, if the shares were allocated free of charge).
This was also confirmed by the Federal Fiscal Court in two rulings dated December 14, 2023 (VI R 1/21 and VI R 2/21), in which it ruled that the profit from the sale of an employee stock ownership plan at arm’s length does not constitute wages and that any capital gains are taxable solely in accordance with the relevant provisions of the Income Tax Act (in particular Sections 17 and 20 of the Income Tax Act). Accordingly, subsequent capital gains from executive or employee stock ownership plans are subject to the flat-rate withholding tax or a preferential tax rate for private individuals, or—in the case of investments made through traditional, capitalist holding vehicles—to a nearly complete tax exemption (Section 8b of the Corporate Income Tax Act (KStG)).
1.3 Recommended Procedure Before Issuing Hurdle Shares
Even though the Federal Fiscal Court holds that a negative liquidation preference must be taken into account in the case of employee stock ownership plans, there are still no statutory provisions or guidelines from the tax authorities that could serve as a legally sound basis for advisory practice. An essential prerequisite for the tax recognition of hurdle shares is sufficient and accurate documentation of the respective enterprise value, from which the hurdle values are derived and contractually determined.
Therefore, to protect the companies issuing the shares, it is advisable to submit a request to the tax office for a so-called “income tax ruling” pursuant to Section 42e of the Income Tax Act (EStG) before issuing hurdle shares, in order to verify in advance whether the specific structure of the employee stock ownership plan constitutes wages and, therefore, whether income tax would be due. However, such income tax rulings are binding only on employers. A manager or employee can obtain definitive legal certainty only through their own “binding ruling” pursuant to Section 89 of the German Fiscal Code (AO) from the tax office responsible for their personal income tax. Unlike an income tax ruling, a binding ruling from the tax authorities is subject to a fee. Furthermore, the relevant facts must not yet have materialized, so the application for a binding ruling should be submitted well in advance. In practice, the process often stops at applying for a wage tax ruling, which—even without legal binding effect—can still provide managers and employees with an indication of the future form of taxation in the event of an exit.
1.4 Competition Rules
In addition to hurdle shares, there are other legal provisions in German tax law that may apply to employee stock plans. One example is the employee stock plan model under Section 19a of the German Income Tax Act (EStG). This provision governs the tax treatment of employee stock plans and provides for deferred taxation of shares transferred to employees at a discount. In this case, the undesirable occurrence of so-called “dry income” for employees resulting from the free or discounted issuance of equity interests is addressed through a long-term deferral provision for the income tax that would otherwise be due at the time of issuance. This legal provision may be in practical competition with hurdle shares. In practice, however, it is applied with restraint due to its restrictive eligibility requirements.
Virtual employee stock plans are another way to give employees a stake in the company’s success. These plans grant employees the right to a cash payment tied to the company’s performance, without them actually receiving company shares. Under corporate law, managers and employees do not become shareholders. These plans are based on purely contractual agreements between the company and managers or employees and are designed to provide a one-time payment as a special salary bonus, which is granted in the event of an exit. They are typically structured as separate supplementary agreements to the actual employment contract. The tax consequences usually do not arise until the payment is actually made. As a general rule, special payments from VSOPs are subject to payroll tax withholding as salary income. Companies that make these exit payments to their employees can deduct the related expenses as business expenses for tax purposes, thereby reducing their corporate tax burden.
Since the obligations of VSOPs are often borne by the sold companies themselves as the subject of the transaction, separate provisions are required in the share purchase agreement between the seller and the buyer in the event of an exit.
2. Conclusion
Employee stock plans are a complex but highly attractive tool for employee retention and motivation. The various forms, such as hurdle shares and virtual equity plans, offer different advantages and disadvantages, both from a business and a tax perspective. Given the limited scope of application of the new Section 19a of the German Income Tax Act (EStG) and the economic disadvantages associated with dry income, hurdle shares represent an interesting and sensible alternative for structuring executive and employee equity plans.
