Tax treatment of real and virtual employee stock options

Employee share ownership offers companies the opportunity to allow their employees to participate directly or indirectly in the company's success. Through participation, employees receive direct consideration and financial recognition for their own (increased) performance. Employers benefit from greater employee satisfaction and loyalty to the company. However, a distinction must be made between real and virtual shareholdings (ESOP and VSOP), both under civil law and for tax purposes.

Employee Stock Option Plan (ESOP): The real employee stock ownership plan

Genuine employee participation is characterized by the fact that the employee becomes a shareholder in the company. He or she thus receives corresponding shares - usually in a limited liability company - transferred at a discount or free of charge by notarized contract. Larger companies operating as stock corporations can also transfer the shares directly to an existing or newly established securities account of the employee. The legal basis is an ESOP agreement between employer and employee. It provides for two periods that are of particular importance for the transfer:

• Cliff period: This indicates the minimum number of years or months the employee must be employed before he or she is credited with a shareholding. For example, it can be agreed that the employee is entitled to an employee participation at the earliest after one year.
• Vesting period: This specifies when and in what amount individual shares are credited to the employee. According to the case law of the BAG, the vesting period should not exceed five years. Employer and employee can agree, for example, that a total of five percent of the shares will be transferred evenly over a period of five years.

Practical example: The employer agrees a vesting period of one year with the employee. In each of the first four years of service (cliff period), the employee receives one percent of the shares in the company.

Solution: After the first year, the employee receives the first percent, after the second year the second percent, and so on. If he leaves after the third year, he is entitled to three percent of the share capital.

Variant: The employee leaves the company after only nine months. As the cliff has not been reached, he is not entitled to a share.

Current income from real investments

Profit distributions and other income accrue from shares in corporations. In accordance with the principles of Section 20 (1) Sentence 1 No. 1 EStG, this income is subject to capital gains tax for the employee. It amounts to 25 percent plus solidarity surcharge and, if applicable, church tax (Section 32d (1) EStG).

If the employee applies for a favorable tax assessment pursuant to Section 32d (6) of the German Income Tax Act (EStG), a lower tax rate than 25 percent may also be set. The so-called final withholding tax rate thus only represents an upper limit, but not a lower limit.

Disposal of employee stock ownership plan (ESOP)

If the employee decides to sell his shares, the capital gains fall under Section 20 (2) Sentence 1 No. 1 EStG. They are taxed like current profit distributions, i.e. are regularly subject to a tax rate of 26.375 percent. Pursuant to Sec. 20 (6) Sentence 1 EStG, the gain is determined by deducting the acquisition costs from the disposal proceeds.

Both current gains (Section 20 (1) EStG) and capital gains (Section 20 (2) EStG) allow for the deduction of the saver's lump sum. From the beginning of 2023, this will amount to 1,000 euros for single persons and 2,000 euros in the case of joint assessment (Section 20 (9) EStG).

If the shareholding sold is a shareholding of more than one percent of the share capital or capital stock, the gain falls under Section 17 (1) sentence 1 EStG. The participation limit of one percent must have been reached or exceeded at least once in the last five years prior to the disposal. Pursuant to Sec. 17 (2) Sentence 1 EStG, the profit is also determined by deducting the acquisition costs from the disposal price and any disposal costs (in particular for the notarial agreement).

Pursuant to Sec. 3 No. 40 letter d EStG, only 60 percent of capital gains within the meaning of Sec. 17 EStG are taxable. The individual income tax rate of up to 45 percent is then applicable to this 60 percent. In addition, employees may claim an allowance of up to €9,060 (Sec. 17 (3) EStG). 

Dry income issues in the case of genuine employee shareholdings

Almost all ESOP agreements provide that employees can acquire the respective shareholding free of charge or at a discount. However, this leads to a non-cash benefit within the meaning of Sec. 8 (2) Sentence 1 EStG, as the employee can acquire the respective shareholding below its fair market value. Such a non-cash benefit is subject to wage tax.

The problem is that the employee has to pay tax on an amount of money that he or she did not receive in cash. Depending on the value of the company, this can quickly add up to several tens or even hundreds of thousands of euros, resulting in an immense additional payment of up to 45 percent income tax. This is the so-called "dry income problem.

With Section 19a of the German Income Tax Act (EStG), the legislature has attempted to compensate for the competitive disadvantage that Germany has vis-à-vis other countries, such as the USA, as a result of the provisions of Section 8 (2) of the EStG. However, three problems remain:

• Taxation of the non-cash benefit is deferred - for a maximum of twelve years or until the employee leaves the company. The sale of the shares also triggers retroactive taxation, resulting in double taxation - once on the capital gain and once on the "old" non-cash benefit.
• The regulation only applies to companies with fewer than 250 employees. In addition, annual sales may not exceed 50 million euros.
• § Section 19a of the German Income Tax Act (EStG) has no effect on social security contributions. These are already incurred when the shares are transferred.

Section 3 No. 39 of the German Income Tax Act (EStG) provides for a further tax exemption. According to this standard, a non-cash benefit from the transfer of employee time off is tax-exempt if and to the extent that

• the value to be assessed in accordance with Section 8 (2) EStG does not exceed 1,440 euros,
• the transfer by the employer is a voluntary benefit to which there is no legal entitlement,
• in principle, all employees of the company have the opportunity to participate in the ESOP,
• the employment relationship (the employment contract) has existed for at least 12 months - calculated from the time of the transfer - and
• the reason for the payment in kind within the meaning of Section 8 (2) of the German Income Tax Act (EStG).

If subsequent taxation occurs due to the provisions of Section 19a EStG, the tax-free amount is deducted from the taxable non-cash remuneration in the respective year of inflow (Section 11 (1) EStG). However, tax allowances from previous years that could not be used due to a lack of share transfer are lost.

Virtual Stock Option Plan (VSOP): The virtual employee stock ownership plan

Especially due to the necessity of notarized contracts, genuine employee participation quickly causes considerable cost and administrative effort. The benefits for both sides - employee and employer - are often out of proportion. An optimal alternative can therefore be virtual employee profit participation The so-called VSOP agreement between employer and employee can therefore be an optimal alternative. The difference to "real" participation is that the employee does not become a shareholder in the company, but is placed in a monetary position through contractual agreements as if he or she were directly involved. He therefore has no shareholder rights (in particular no voting rights). However, they receive "profit distributions" and any exit proceeds in the same way as a shareholder under company law.

Example: You conclude a VSOP agreement with your employee. After five years of service, he is entitled to five percent of the shares as a virtual participation. If the shareholders now decide on a distribution of 1,000,000 euros, the employee receives 50,000 euros.

All regulations for true participations (in particular Sections 17, 19a, 20 EStG) do not apply. Virtual profit distributions are deductible operating expenses at the level of the Company (Sec. 4 (4) EStG). The employee receives wages that are taxable upon receipt in accordance with Secs. 19 (1) No. 1, 11 (1) Sentence 1 EStG.

VSOPs require only a contract with the employee; all transactions under company law are omitted. The VSOP agreement is an addition to the existing employment contract, so that the "distributions" themselves are comparable to pure bonuses. The "real shares" in the corporation remain with the existing shareholders.

Therefore, virtual participation usually offers the following advantages:

• No complex procedures under company law
• No outflow of liquidity upon allocation of the virtual shareholding
• no need to go to a notary
• No taxation on allocation, but only on exit, therefore can be used in all company phases
• Flexible commitment of beneficiaries through vesting arrangements
• Immediately and individually applicable
• no hidden costs, no material risk of loss of value
• No dry-income problem, as there is a direct liquidity advantage

Taxation of virtual participation (VSOP)

The profits resulting from a VSOP are reflected in the payroll. The inflow principle of Sec. 11 (1) EStG applies. The decisive factor for accounting (Sec. 7 (4) Sentence 1 KStG) is when the entitlement arises. At this point, the employer can claim the operating expense deduction. In the case of the employee, it is the receipt of the distribution in the account that is decisive. 

Thereafter, beneficiaries pay tax on their VSOP income as part of their normal income tax assessment.

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