Compensation or capital gain tax treatment?
ARTICLE | October 10, 2021
Authored by RSM US LLP
With increasing regularity, companies are choosing to remain private for a longer period of time than in the past. As a result, founders whose companies went public in 2019 held an average equity stake of 7% immediately prior to going public. By comparison, founders of major tech companies, e.g., Facebook, Amazon, Netflix, and Google, held an average equity stake of nearly 35% immediately prior to IPO. The takeaway here is a founder of a startup, as well as employee shareholders, must plan and prepare for multiple sales of their shares.
A secondary sale of equity is the sale of shares in a private company by existing shareholders to a third-party which does not occur in connection with a change in control of the company. Sometimes, as part of a secondary sale, the company or current major shareholders may purchase shares from some of the current shareholders, either at the request of the third-party buyer or to retain control of the company.
The shares sold in such a transaction would typically be subject to capital gain tax rates (either long-term or short-term gain depending on how long the shareholder held the shares). The current long-term capital gains tax rate is 15% or 20% depending on the selling shareholder’s income tax bracket, though most such shareholders may also be subject to the 3.8% Net Investment Income Tax.
However, when an employee of a company sells shares of that company, the IRS sometimes questions whether that sale may be a way to provide disguised compensation to the employee. Compensation is taxed as ordinary income; the highest federal ordinary tax rate in effect for 2021 is 37%. Additionally, compensation is subject to payroll taxes that might add up to an additional 7.65% tax (Federal Insurance Contributions Act (FICA)/Medicare) for the shareholder. In many cases the employee will have other compensation above the FICA taxable wage base and thus a compensatory sale of equity would only be subject to Medicare and possibly Additional Medicare. This generally amounts to up to a 39.4% tax rate (not including state income tax) to the selling shareholder. If the sale of company stock is compensatory, the company is also subject to employment taxes on the equity compensation.
Deciding whether the sale of equity by employee-shareholders is compensation depends heavily on the facts and circumstances of the transaction. Based on IRS regulations and various case law examples, the IRS will generally consider the following factors: fair market value (FMV), consistent use of a valuation methodology, intent of the parties, identity of the seller, identity of the purchaser, and the role of the company.
Fair market value
For there to be compensation on the sale of shares between an employee and employer or investor, the employer or investor must pay a premium, that is, an amount in excess of the FMV of the shares. For stock that is regularly traded on the open market, FMV is generally easily established, as most public companies have a consistent method (based on the last traded price of the day, the average of the high and low prices for the day, or the last traded price on the prior trading day).
In a transaction involving stock that is not regularly traded, FMV is generally determined using a formula prepared by the company or a section 409A valuation. Technically, the valuation of compensatory shares starts out using section 83 valuation rules. However, because section 83 governs stock options but section 409A provides valuation rules for granting stock options at FMV, many companies use a section 409A valuation for options, share transfers and other compensatory programs tied to the FMV of the underlying shares. Pursuant to IRS regulations, an independent section 409A valuation using the section 401(a)(28) valuation rules is generally presumed to be valid for 12 months from the date of issuance unless the facts indicate the valuation or use of the valuation would be grossly unreasonable. Under this section 409A regulation, if the company does not use an independent valuation, the company must revisit the valuation and update the valuation based on the current facts.
Additionally, the sale of shares between unrelated parties (e.g., the company and a new investor) may, in certain cases, help establish a FMV that can be relied upon for compensatory purposes, but this needs to be separately considered; sometimes a buyer may have pressing reasons to buy shares and may be willing to pay a premium above a FMV determined based on an appropriate method.
Consistent Use of a Valuation Methodology
IRS regulations suggest that a company should consistently use the same valuation method. The section 409A regulations do acknowledge that a company may have a separately stated valuation method for separate types of transactions but, if the company does so it must use each method consistently for that type of transaction. Most companies only use one valuation (though the valuation may state a discount for minority shares or illiquid shares that would not be applied to a major owner’s shares).
For example, a company that uses a formula to determine the exercise price when issuing valid incentive stock options to employees and uses the same formula to determine the repurchase price from a departing employee has less risk of the repurchase transaction being treated as compensation than a company that uses one formula to issue stock options and a different formula for repurchasing shares.
One of the areas that may raise concerns that a payment is compensation is when a company or investor buys shares from employees at a higher premium price and then uses a lower price to grant stock options around the same time or in the near future.
Intent of the Parties
The overall intent of the parties can be considered and the payment terms of the contract should be reviewed. If the company wishes to reward an employee-shareholder for a job well done and does so by repurchasing company shares from the employee, the transaction is likely to be viewed as compensatory by the IRS. This is especially true where the company is selective about who can sell shares at the premium price, such as only allowing executives or long-time employees to sell.
If an investor is purchasing shares from an employee-shareholder at a premium and has a valid business reason for doing so other than benefitting from the employee-shareholders services, the IRS may not view the amount in excess of FMV as compensation. As an example, an investor may have a minimum purchase target for buying into a company when making an initial investment. If the company’s current shareholder group does not want to significantly dilute their equity by having the company issue new shares, the company may instead allow the investor to purchase currently outstanding shares from other shareholders to meet the investor’s desired equity amount. If the investor is willing to purchase the shares at a price above FMV to encourage sales from current shareholders, and the facts do not suggest that the company is selecting a few treasured employees as the only ones who can benefit from the premium price, the transaction may not be viewed as compensatory and all resulting gain would likely be capital.
Additionally, the courts have regularly determined that if no direct relationship can be drawn between the payment and either services previously rendered or the provision of future services, then it may be easier to argue that the premium price is not compensation for income tax purposes.
Identity of the Purchaser
The identity of the individual or entity that is purchasing equity from employee-shareholders must be considered when determining whether a portion of the gain on the sale is compensatory. The risk that a premium paid to acquire stock is compensation is higher if the purchaser holds significant influence over the company (e.g., officer, executive, or member of the board), a fund associated with company management, or is a significant investor (holds an interest >5%) before the secondary purchase. Treasury regulations provide that property transferred by a shareholder of the corporation to an employee for services provided to the company (here, the payment for the shares), is considered a contribution to the corporation and a subsequent compensatory transfer from the company to the employee.
Revenue Ruling 84-68 provides additional guidance on this topic through the use of an example. In the example the facts are:
- Parent Corporation (P) established a bonus program for the employees of a subsidiary (S).
- P pays cash bonuses to employees of S in recognition of services performed over the course of the current year.
The example held that P may not deduct the cash bonuses. Rather, the bonus payment is viewed as a contribution to S’s capital accompanied by a payment from S to the employees. The payment from S to the employees is deductible as an ordinary and necessary expense of S under section 162.
While this guidance focuses on transfers of bonuses or property TO an employee (or other service provider) the same thought process can be applied where a company buys back shares from employees at more than FMV. This can be seen as a contribution to the employer that is used to reward the service provider.
Identity of the Seller
By limiting the pool of individuals that may sell shares in a secondary sale to entirely or mostly current employees of the company, or by the company giving preference to executives, key employees, or highest paid or longest tenured individuals, there is an increased risk that the transaction could be treated as partly compensatory.
The inclusion of a broad group of current employees, former employees, or investors as a significant portion of shares sold reduces the risk of compensation – as long as all sellers receive the same terms and price as current employees.
Role of the Company
If the company played a role in negotiating a premium price on behalf of its employees, selected specific employees that are eligible to sell shares, or the company later converts or commits to convert acquired common shares into preferred shares, the risk that any premium paid could be treated as compensation is higher. It is best practice if the company has a very limited role in the secondary transaction and the shares purchased from employee-shareholders are the actual shares that the investor will hold after the completion of the transaction.
Secondary sales are complex and are often negotiated over time. There are also significant drivers based on the desires and needs of the parties. For example while this article focuses on factors that are helpful in classifying the sale of equity by employee-shareholders as capital gain, there are instances where a company may prefer to treat the repurchase of shares as compensation income. Compensation is deductible by the company but a non-compensatory arrangement is unlikely to support a company tax deduction.
Thus, there is no “one size fits all” rule. Each transaction should be analyzed separately given its specific facts and circumstances. Sometimes even minor differences can yield vastly different tax results, and the IRS always has the right to challenge the chosen tax treatment.
Companies should work with their tax advisors as soon as possible and throughout the entire secondary sale process to understand the tax classification. It may also be prudent to involve the company’s audit team because the financial statement rules can be different from the tax rules in this area. In addition, if there is uncertainty whether the payments should be treated as compensation for tax purposes, they may need to consider applying reserves based on the payroll risks. This discussion is out of the scope of this article but is often an important factor in the process.
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This article was written by Karen Field , John Tiemeyer and originally appeared on Oct 10, 2021.
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