Subsequent shareholdings by co-founders: now more tax-efficient?

Subsequent shareholdings by co-founders: now more tax-efficient?

1. The fundamental problem

The subsequent direct acquisition of shares by co-founders can be a tax minefield. In particular, if the shares are granted at their nominal value, there is a risk of taxation at the very moment of grant. The co-founder acquires the shares on the basis of their past or future work for the company. Or to put it another way: no external third party who does not work for the company would receive the shares on these terms.

If, at the time of the transfer, the shares are worth more than the co-founder paid for them, the transfer of the shares results in a monetary benefit for the co-founder equal to the amount of the capital gain. Under the Income Tax Act, this monetary benefit is taxable as remuneration at the co-founder’s personal tax rate. And, as a general rule, this applies from the moment the shares are granted. So not just when the shares are sold (exit).

The problem is that no cash has yet been derived from the shares at this stage. No profit distributions have yet been made. The beneficiary is therefore liable to tax on a monetary benefit which has not yet accrued to them, but is tied up in the shares (so-called. Dry Income).

It is not uncommon for a co-founder to have no (other) liquid assets available to meet their tax liabilities. Furthermore, tax is levied at the time the shares are granted on a value that may never be realised later on – particularly if the start-up fails.

2. Market value of the shareholding

Depending on the company’s value, substantial tax liabilities may arise: the taxable benefit in kind is based on the market value of the shares granted and thus on the proportionate value of the company. If a funding round has already taken place, the market value is based on the company’s valuation used as the basis for that funding round – regardless of the fact that investors, particularly in early rounds, factor in „future potential“. The company’s valuation can therefore skyrocket quickly and exceed the nominal value of the shares many times over.

The co-founder’s tax burden therefore increases in line with the market value – which means that he at the time the shares are granted is correct.

3. Relief measures from July 2021

With the entry into force of the Act to Strengthen Germany as a Fund Centre (FoStoG) in July 2021, the aim is to counteract the effect of the Dry Income be counteracted: under certain conditions, the monetary benefit arising from the grant of shares is not to be taxed at the time of the grant, but only when the beneficiary receives cash proceeds from the „realisation“ of the shares.

Under Section 19a of the Income Tax Act (EstG) (currently still at the draft stage), a benefit in kind arising from the grant of shares in a company is only taxable once the shares have been transferred, in whole or in part, for consideration or free of charge, or have been contributed to business assets.

4. Restrictions

However welcome these relief measures may be, they still carry the risk that the original grant of shares will be subject to tax even before any exit (i.e. without any inflow of liquidity), namely if:

• 12 years have passed since the transfer of the shares.
• the employment relationship is terminated;
• the beneficiary is not an employee;
• the company issuing the shares is not a start-up within the meaning of Section 19a of the Income Tax Act; or
• the shares were granted before 1 July 2021.

Caution is therefore advised when the employment relationship – on the basis of which the shares were transferred to the beneficiary – is terminated. The same applies if, since the transfer of the shares, 12 years have elapsed. Taxation can therefore also be triggered by the passage of time. Co-founders should therefore bear in mind that the investment horizon is thus limited to a maximum of 12 years.

Furthermore, the new regulations apply exclusively to start-ups. The company to which the shares are granted must not exceed the thresholds set out in commercial law for micro-enterprises and for small and medium-sized enterprises at the time of the transfer. In addition, the company must have been established within the last 12 years.

It should also be noted that Section 19a of the German Income Tax Act (EStG) applies only to income from employment. There must therefore be an employment relationship between the co-founder and the company. The co-founder should therefore be remunerated under an employment contract or a managing director’s contract. The applicability of the relief provided for under Section 19a of the Income Tax Act (EStG) is therefore particularly problematic in the case of consultancy contracts „on account“.

In addition, the shares must in addition be granted in addition to the remuneration already due (Section 19a(1), first sentence, of the Income Tax Act). The conversion of salary components into direct shareholdings therefore does not qualify.

Whether the tax relief available for the acquisition of direct shareholdings applies in a specific case therefore requires careful consideration. We would be happy to advise you on co-founders’ shareholdings!

5. An alternative to direct investment?

As an alternative to direct shareholding, the co-founder could also be granted virtual shares (VSOP). For co-founders (and, in particular, for employees who do not have co-founder status), virtual shares offer a straightforward way of allowing beneficiaries to share in the company’s growth and success.

The allocation of virtual shares is tax-neutral. The beneficiary is only required to pay tax once payments are actually received from the virtual shares, e.g. in the event of profit distributions or exit payments – and this is subject to no time limit. Virtual shares do not make the beneficiary a shareholder; they receive neither actual shares nor voting rights or any other shareholder rights. This keeps the cap table clear and straightforward. A further advantage of virtual shares is that they can be granted flexibly and without additional notary fees.

By contrast, in the case of a direct holding, the gain on the disposal of the holding and any profit distributions are taxed at the preferential flat-rate withholding tax rate or under the partial income procedure.

However, the additional costs and time involved in implementing a direct shareholding should not be underestimated. In order to grant a co-founder a stake in the company at a later stage, the founders must either transfer existing shares to the beneficiary by means of a share purchase and transfer agreement, or the share capital must be increased and new shares issued. The co-founders must also be carefully incorporated into any existing shareholders’ agreements. This involves notary and consultancy fees. Granting virtual shares, on the other hand, can be done by private deed and offers greater flexibility.

Whether a direct stake makes sense for the co-founder is therefore something that should be carefully considered. We would be happy to advise you on this matter.

6. Note:

This article is intended to provide a general overview. In particular, this article does not constitute legal advice and cannot replace it.