An overview of the most important information

ESOP & VSOP - explanations, differences, advantages, hints

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Dr. Christopher Hahn
Lawyer & Author Your Expert for Employee Shareholdings

Employee shareholdings have been the talk of the town in recent years. Why? What options do you have to involve your employees in the company's success and thus motivate them? What is an ESOP? What is a VSOP? What are the differences and which construct is ideal for your company? What are the advantages and disadvantages and how are the options treated fiscally? In the following, we summarize the most important information for you. In our guide, you will find further articles that deal with the various topics in detail.

1. why employee shareholdings - the top benefits at a glance

Finding and retaining employees and keeping them with the company for as long as possible - especially in times of a shortage of skilled workers, it becomes clear how important a sustainable strategy is for this. Ideally, such a strategy consists of several building blocks, one of which is employee share ownership. Employees receive real or virtual company shares at regular intervals. As an entrepreneur or founder, you benefit in several ways.

Employer side: Advantages of employee share ownership

At best, an employment relationship is a win-win situation - because both parties to the contract want to receive appropriate remuneration and appreciation for their efforts. In return, as an employer, you expect your employee to perform consistently well (or better: well above average) and to come to work motivated and committed. Employee stock ownership in the form of an ESOP or VSOP agreement brings you several advantages here:

  1. Company loyalty: With an employee share ownership plan, you invest directly in your employee. In addition to their regular salary, they also receive the fruits of their labor in the form of profit distributions and other shares in the company's success - for example, in the event of a sale.
  2. Increasing motivation: The most important "booster" of any company is efficient, motivated and rarely sick employees. This is exactly where you start with employee participation. Because your employees know: If they perform well, they will see the equivalent value or the result directly in their bank account!
  3. Optimizing your own liquidity: If you pay your employee a higher salary, this has a direct impact on your liquidity. Employee participation, on the other hand, is initially "only" an agreement without a direct outflow of assets. This only takes place if a profit or revenue is actually generated, which then flows to the participating employees on a percentage basis.

The highlight: If your employees perform well, they also participate in the resulting additional revenue through the participation model. If performance stagnates or declines, the payout is lower. As an employer, you thus bear a lower risk - similar to commission models - of having to "overcompensate" for unachieved or inadequately achieved successes in the form of a fixed salary.

Employee side: How employees benefit from the participation model

The win-win situation mentioned at the beginning naturally also affects your employees. After all, they also want to be able to measure their successes and visibly increase them. Employee shareholdings bring with them three key advantages:

  1. Motivation and satisfaction: An employee who benefits directly from the success of "his" company in the form of a shareholding is undoubtedly more satisfied than an employee who - irrespective of specific performance - receives a fixed salary with no performance-related components. The most significant advantage of employee share ownership is therefore the increase in motivation and satisfaction, especially among managers and employees in key positions.
  2. Wealth accumulation: Employee share ownership is comparable to other assets, such as shares and real estate - provided the participation itself does not consist of share units anyway. Year after year, as the value of the company increases, so does the value of the investment. As profits rise, so do the payouts. Employee share ownership is therefore a way of helping your employee to build up assets without having to pay him a higher salary. While you as the employer have no liquidity disadvantage, your employee has a liquidity advantage.
  3. Right to a say: Depending on the structure of the agreement, employee participation leads to increased identification with the values and goals of the employer. If employees do not already have a say and voting rights due to their position as shareholders, participation at least gives them the feeling that they can really make a difference with their commitment.

Employee shareholdings as an instrument for attracting and retaining skilled workers

The real or virtual participation of employees in the success of the company is a proven means of attracting and retaining skilled workers, and not only for start-ups. After all, it is obvious that direct financial incentives lead to increased motivation, greater willingness to perform and identification with one's own employer, irrespective of the company phase.

Virtual employee stock ownership plans (VSOPs) have the strong advantage that the usual administrative and corporate law work involved in transferring "real" shares is eliminated. All that is needed here is

2. ESOP & VSOP - the differences briefly explained

Employee share ownership is becoming an increasingly important means of retaining qualified personnel in the company for as long as possible. However, "real" shareholdings (ESOP) are also associated with a high level of expense, as extensive processes under company law have to be completed. The situation is different with virtual shareholdings (VSOP), because here the employee does not have a stake in the company in the sense of company law, but "only" under the law of obligations. An overview.

General information on employee shareholdings.

The basis of any employee participation scheme is an agreement between the employer and the employee. In this agreement, the parties stipulate under which conditions which employee receives how many shares in the company. It is also customary and expedient to include clauses specifying when the shares become vested ("vesting") or a transfer of shares is to be reversed in whole or in part, if applicable, and under what conditions the parties can withdraw from the agreement.

Above all, it is important to have firm guidelines on when people are entitled to participate. This is the only way to ensure that the motivational effect of participation really takes effect. If the employee could resign after a few months and still be entitled to the full amount of the employee participation, the model would be a blunt sword, so to speak.

ESOP - the classic Employee Stock Option Plan.

"ESOP" is the abbreviation for "Employee Stock Option Plan" and means - literally translated into German - nothing other than "employee stock option program". In other words, the employee receives a share of the company's stock, usually a certain proportion of the capital stock of a corporation. The most common legal forms in Germany are GmbH and AG (limited liability company and stock corporation).

Corporations have one thing in common: they have a share capital, which in the case of a GmbH is at least 25,000 euros. There is no upper limit.

Example: Five people jointly found a start-up in the legal form of a GmbH and pay in 25,000 euros. We assume that everyone has an equal share, i.e. each receives one fifth of the GmbH shares. Each shareholder pays in 5,000 euros of the share capital accordingly.

In the case of employee stock ownership in the form of an ESOP, the employee now has the option of acquiring a portion of this share capital under predefined conditions. For example, he receives one percent of the share capital if he works at the company for at least one year (cliff period). For each additional year with the company, he is entitled to a further one percent of the shares (vesting period) until the agreed maximum shareholding of, for example, five percent is reached.

Depending on the legal form, the shares are transferred in different ways:

  • GmbH shares can only be transferred by notarization of the contract. The employee becomes a shareholder accordingly and is entered as such in the commercial register. Any further transfer in the vesting period is associated with renewed changes in the register. The conclusion of an option agreement also requires notarization in order to be effective.
  • AG shares are usually transferred to the employee by means of a private contract. Notarization is not necessary, but very few start-ups operate directly as an AG.

In line with the shareholding, the employee is now entitled to profit distributions and exit proceeds on sale, and also has voting rights as a shareholder. If the GmbH achieves a profit of 1,000,000 euros, the employee receives 10,000 euros for a one percent shareholding. This is always income from capital assets in accordance with Section 20 EStG.

VSOP - the Virtual Stock Option Plan

"VSOP" stands for "Virtual Stock Option Plan" and also represents an employee's participation in the company's success. However, it is only "virtual", i.e. no real company shares are transferred. The basis of a VSOP is a contractual agreement which stipulates that the employee is treated in the same way as a shareholder in terms of property rights, but without being such a shareholder.

Example: In a VSOP, it is agreed that the employee will receive five percent virtual GmbH shares after five years. Depending on the contractual arrangement, the employee is entitled to a corresponding share of profit distributions and any sales proceeds, but at no time does the employee participate as a real shareholder. Rather, the contract merely states that he will be placed in such a position in terms of assets that he will have a shareholding in the aforementioned amount.

The cost-benefit ratio is correspondingly more favorable for both sides. This is because, purely in terms of the amount (subject to tax differences), the employee receives the same sum that he would also receive as a genuine shareholder. For the employer, too, it is merely a different form of asset outflow (expense). However, a large proportion of the administrative costs are eliminated.

Under commercial and tax law, the payment of profit distributions and sales profits on the basis of a VSOP constitutes expenses (= operating expenses). The employee does not generate income from capital assets as he does not hold a share in the capital stock. Rather, the distribution constitutes wages and salaries, which are treated in a manner comparable to a bonus payment (such as the "Christmas bonus").

ESOP vs. VSOP - which model is better?

Employee shareholdings are generally a wide-ranging and individual topic. There is therefore no clear-cut answer to this question; instead, the facts must always be considered with the company in mind. In principle, however, VSOP agreements are more flexible, cause less effort and avoid cumbersome processes under company law!

3. advantages of a VSOP - this is how the virtual stands out from the real participation.

Around 40 percent of employees believe that employee share ownership is a real incentive to stay with the company. In the first step, a distinction must be made between genuine and virtual employee share ownership models (ESOP and VSOP). Virtual employee stock ownership plans have a number of significant advantages over traditional stock ownership models. We show what these are.

A virtual shareholding is one in which no real transfer of shares takes place. Employer and employee therefore do not go to a notary and conclude a contract on the transfer of company shares. Instead, with a VSOP agreement, the employee is placed in the same position as if he were a shareholder, i.e. he receives part of the profit distributions and the exit proceeds (= profit on sale of the company, especially in the case of start-ups). However, he does not have any shareholder rights, such as voting rights.

Therefore, the most relevant benefits of a VSOP agreement for employers and employees are:

  1. Hardly any administrative effort: The basis of a VSOP is a contract between employer and employee. This is also the case with the ESOP, but here there is also the notarization of the ESOP itself as well as the actual transfer of shares and the entry in the commercial register. Both steps are omitted in the case of the VSOP; once the contract is "in place", nothing more needs to be done.
  2. Flexibility: By eliminating the corporate and notarial processes, employers and employees are much more flexible in designing the VSOP agreement. Adjustments can be made at any time and even at short notice. This is not possible with classic ESOPs, where the construct is rather rigid due to the narrow specifications.
  3. Securing liquidity: The employer remains liquid because - in contrast to a salary increase, for example - there are basically performance-related payments in the future. A salary, on the other hand, must always be paid as long as the employment contract is valid.
  4. Tax advantage: If real company shares are transferred to an employee under an ESOP, there may be direct taxation of a non-cash benefit, even though the employee does not have the necessary liquidity. The situation is different in the case of a VSOP, as income tax is not due until the profit distribution or the pro rata exit proceeds actually accrue (sections 8(1), 11(1) and 19(1) no.1) of the German Income Tax Act (EStG)).

4. VSOP & Tax: This is how the tax office views virtual employee stock options

ESOPs and VSOPs are the two major models when it comes to employee stock ownership. While in the former, real shares in the company are transferred, in the latter the employer only gives its employees a virtual share in the company's success. The fundamentally different structures and contractual agreements result in different tax consequences. The legal basis is always the German Income Tax Act (EStG).

VSOP income - wages or capital gains?

Particularly with regard to this question, confusion is inevitable, since Section 20 (1) of the German Income Tax Act (EStG) - the provision dealing with capital income - only refers to "distributions. However, payouts based on a VSOP contract do not fall under the tax concept of profit distribution. § Section 20 EStG is only applicable if the employee holds real shares in the company (= shareholder or partner status).

Section 17 (1) EStG also does not apply to virtual employee shareholdings. The provision stipulates that the sale of a shareholding of more than one percent in a corporation does not fall under Section 20 EStG, but under income from business operations. As a result, the final withholding tax rate is no longer relevant. However, Section 17 EStG also only applies to "genuine shareholders". We should therefore take a somewhat closer look at the regulations on income of all kinds from non-self-employed work, i.e. from activities as an employee:

"Income from employment includes salaries, wages, gratuities, royalties and other remuneration and benefits for employment in public or private service [...]"; Section 19 (1) no.1 EStG.

A VSOP agreement is a contract that is only concluded on the occasion of the employment relationship - logical, because if the virtual participant is not an employee, there is no need for employee participation.

Exception: Not a permanent employee, but a self-employed person (freelancer) receives the virtual participation. In the absence of an occasion related to a (non-existent) employment relationship, the agreement is an outflow of the self-employed activity; income then falls under Section 15 or Section 18 EStG.

Income from a VSOP therefore always represents wages within the meaning of Section 19 of the German Income Tax Act (EStG), which is taxable upon inflow (= credit to the bank account). Whether the payment is made on the basis of participation in dividends/profit distributions or in the event of an exit is irrelevant!

Settlement and taxation of VSOP profits

Since payments made on the basis of a VSOP regularly constitute wages, the final withholding tax (= maximum 25 percent for capital income; Section 32d EStG) does not apply. Instead, the wages are taxed at the progressive tax rate of between 0 and 45 percent.

Whereas the transfer of a "real participation" may be taxable at the current market value as a non-cash benefit in accordance with Section 8 (2) EStG, this disadvantage does not apply to the employee in the case of the VSOP. Income tax is only due at the time when he can dispose of the distribution resulting from the agreement (Section 11 (1) EStG).

The employer recognizes the income as wages and salaries on the payroll. At the same time, there are operating expenses ("wages and salaries"). In essence, a VSOP payment is comparable to other one-time payments, such as Christmas or vacation bonuses. It is therefore subject not only to tax but also to social security contributions, provided that the relevant maximum amounts have not yet been exhausted.

VSOP profits - basic and expert knowledge is indispensable here!

The various forms of employee participation schemes have different tax consequences for employers and employees, depending on the specific arrangement in each case. Both sides should therefore deal comprehensively with the details and, at best, bring an expert on board!

5. tax treatment of ESOP - employer & employee side

With an ESOP (Employee Stock Option Plan), employers give their employees a share in the company's capital stock or share capital. This is based on a contractual agreement under which the employee receives shares in the company at certain intervals and thus becomes a shareholder. However, there are a number of tax issues to be considered here, with the German Income Tax Act (EStG) forming the most important legal basis.

The treatment of the ESOP at the employer

Unlike a virtual shareholding (VSOP), with an ESOP the employee becomes a "real shareholder". In other words, he or she receives the shares in the GmbH by way of a notarized contract, with the amount of the shareholding and all other terms and conditions being regulated in a further contract, the ESOP (option) agreement. In the case of the AG, the shares are generally allocated to the employee from the so-called conditional capital pursuant to §§ 192 ff. AktG.

As a shareholder, the employee now participates in the economic success of the company. Profit distributions are therefore made from the employer's annual profit in accordance with Section 8 of the German Corporation Tax Act (KStG), but do not reduce taxable income (Section 8 (3) KStG).

Profit distributions from corporations, which include GmbHs and AGs, constitute income from capital assets. Therefore, the employer who distributes profits to the employee as a shareholder is obliged to withhold and pay the capital gains tax. It amounts to 25 percent + solidarity surcharge (if this is still applicable at all since 01.01.2021), which means a total withholding of 26.375 percent. The remaining 73.625 percent of the distribution accrues to the employee.

The transfer of the shares itself may constitute a non-cash benefit if the employee receives the shares at more favorable conditions than a third party. The difference to the market conditions, the so-called current value of the shares, is then taxable (if applicable after deduction of tax allowances) as wages in accordance with Section 8 (2) of the German Income Tax Act (EStG). The employer also pays the wage tax directly in this case.

Note: Under Section 19a of the German Income Tax Act (EStG), taxation of the non-cash benefit can be deferred under certain conditions. You can read more about this in the detailed tax guide on the subject of employee shareholdings.

The treatment of the ESOP in the employee

On the employee side, with regard to income tax on ESOP arrangements, a distinction must be made between three stages - acquisition, income and disposal. A brief overview.

Acquisition of the employee participation

Unless it is tax-exempt or subject to taxation at a later date under Section 19a of the German Income Tax Act (EStG), the non-cash benefit from the acquisition of the shareholding at a discount is subject to income tax.

Example: The employee is employed by an AG whose shares currently have a market value of 100 euros each. Under the ESOP agreement, however, the employee can purchase them for 80 euros. In this way, he acquires a total of 100 shares and pays 8,000 euros for them. As the normal market price is 10,000 euros, 2,000 euros is a taxable benefit under section 8 (2) EStG. The tax-free allowance under section 3 no. 39 EStG (1,440 euros) must be deducted from this, so that 560 euros is still taxable as additional income.

Caution: Wage tax can only be incurred on the transfer of employee shareholdings if they are actually made at a discount or free of charge. If the employee participates in the employer's company at regular conditions, there is no benefit and thus no additional remuneration.

Income from employee participation

If the employee holds an interest in a corporation through the ESOP - regardless of whether under domestic or foreign law - all income (dividends, profit distributions, hidden profit distributions) is part of the income from capital assets pursuant to Section 20 (1) No.1 EStG. This income is taxed at a flat rate of 25 percent plus solidarity surcharge, provided the employee's personal tax rate is not lower (= favorable tax assessment). If the latter is higher, the maximum tax rate is 25 percent.

§ Section 20 EStG always applies if the participation is private property. We will deal with the complex case of ESOPs for self-employed employees and/or freelancers in another article. Because here the participation is usually not in the private assets!

Note: A hidden profit distribution is deemed to exist if the shareholder receives a financial benefit from the GmbH that is not customary for an outside party due to his shareholder position. Example: A GmbH managing director sells a GmbH product to a shareholder at half price. The other half of the price is then taxable as a hidden profit distribution.

Sale of the employee participation

When the ESOP sells the company shares received, a distinction must be made between two provisions of the EStG:

  1. In principle, the profit from the sale of the shareholding in a corporation is part of the income from capital assets pursuant to Section 20 (2) No. 1 EStG. The profit is calculated according to the formula "sales price - acquisition costs - savings lump sum, if applicable". Like all income from capital assets, it is subject to the 25 percent final withholding tax.
  2. However, if the employee holds more than one percent of the share capital (= significant participation), this is commercial income in accordance with Section 17 (1) EStG. The regular income tax rate then applies, whereby only 60 percent of the profit, which is to be calculated according to the formula of Section 17 (2) EStG, is subject to taxation (Section 3 No. 40c EStG). The remaining 40 percent is tax-free (partial exemption).
Attention: Shares also fall under § 17 EStG. However, brokers usually always withhold 25 percent capital gains tax because they do not notice the facts of § 17 para.1 EStG. This income must therefore be stated separately in the income tax return!

Why does § 17 EStG take precedence over § 20 EStG? Because Section 20 (8) EStG stipulates that capital income is to be attributed to other types of income if it is one of them. Since according to § 17 Abs.1 EStG it concerns commercial incomes, this special regulation applies here. The same applies, for example, if a GmbH participation is held as business assets for business reasons. In this case, the original capital income is also to be allocated to commercial income.

ESOP and taxes: Comprehensive advice indispensable!

ESOP agreements can have tax consequences that no one thought of beforehand. For this reason, it makes sense to obtain detailed advice before concluding the agreement. This is the only way for employers and employees to avoid potentially high additional payments and other disadvantages!

DisclaimerThe contents of the information offered at esop-direkt.de do not constitute legal advice. If you require a legal review of your individual case, please contact our specialized team: beratung@esop-direkt.de

Questions? Talk to our expert!
free consultation
Dr. Christopher Hahn
Lawyer & Author Your Expert for Employee Shareholdings