Are the Proceeds from a Secondary Sale Taxed as Compensation or Capital Gains?

There has been a recent uptick in partial liquidity events referred to as a “Secondary Sales”. A secondary sale is when a company consummates a round of financing and, in conjunction with that financing, employee-shareholders of the company engage in a secondary sale of their stock.

There are different ways that a secondary sale of shares may be structured. Typically, a new investor will invest money directly into a company, generally in exchange for preferred stock, and the company will use some or all of the investment dollars to redeem existing shareholders. The new investors usually acquire a series of preferred stock that has different terms from the existing common and preferred stockholders. Another scenario involves a cross-sale whereby the new investor participating in the round of financing purchases the shares directly from the selling shareholders.

The transaction price for these sales have typically been pegged to the preferred share price in the round of financing occurring. Generally the seller of the shares is a founder or early employee and the shares they are selling are common stock. Emerging Growth companies generally have annual valuations prepared to determine the fair market value (FMV) of the common stock for the purposes of ensuring their deferred compensation programs comply with IRC section 409A. These valuations generally indicate that there is a disparity between the FMV of the common stock being sold and the sales price based on the secondary sale. This could lead to the presumption or conclusion that the common shares were sold/redeemed at a premium above the common stock value. This premium may indicate that the transaction was in fact designed to be a reward or benefit of employment rather than a sale of stock between two market participants, thus a component of the premium could be deemed to be compensatory.

Whether a redemption or cross-sale transaction, the secondary sale transaction highlights the question of the tax treatment of the proceeds. The newly-issued preferred stock generally has economic features such as a liquidation preference, dividend rights, conversation rights, etc., that seemingly make it far more valuable than the common stock. On the other hand, in many cases, the participants may view the redemption/sale price for the common stock (at the preferred stock price) as properly representing its true FMV. This is especially true in the case where the preferred shareholders believe that they will ultimately convert their shares (mandatorily or voluntarily) into common stock in the future in connection with an exit transaction which, as a result, would level the FMV of common and preferred.

The discussion of whether part or all of the proceeds received by the employee-shareholder are treated as compensation or capital gain is somewhat subjective. This is generally a very sensitive and important issue for both the selling employee-shareholders and the company. In a redemption transaction, if the payment is compensation, the company receives a deduction and generally has a withholding obligation. On the other hand, if the payment is for redemption of stock treated as a capital gain, the company does not receive a deduction. For the employee-shareholder, compensation treatment usually will result in a significantly higher tax burden on the transaction proceeds, because compensation is taxed at federal income tax rates up to 37% and is also subject to employment taxes. The long term capital gains rate reaches a high of 23.8%, so depending on the shareholder’s tax basis, a significant difference can occur. In addition, a shareholder may also be eligible for a favorable Section 1202, Qualified Small Business Stock exclusion which may also be a motivating factor for individuals to take the position that the transaction is capital rather than compensatory.

There are several factors that are relevant in determining whether sales proceeds may be characterized in whole or in part as compensation. Such a determination is generally based upon an objective view of the facts. The following is a list of some factors to consider in making such determinations:

  • Fair Market Value: significant weight is given to evidence of FMV in determining the character of payments. In a transaction involving stock that is not regularly traded, FMV may be determined in a range. Arms-length transactions of the same class of securities with shareholders not performing services may establish the FMV in particular cases. In some instances, a 409A valuation is available which is indicative of FMV. However, FMV refers generally to “the price that would be agreed on between a willing buyer and a willing seller, with neither being required to act, and both having reasonable knowledge of the relevant facts.” Therefore, there may be instances where the 409A valuation differs from the selling price.
  • Intent: the overall intent of the parties should be considered and the payment terms of the contract should be reviewed. For example, the company may not want to dilute existing shareholders and therefore payment is anticipated to be in the form of compensation.
  • The Investor: whether the investor was a significant owner prior to the transaction and could influence the FMV of the transaction, or was an unrelated third party willing to pay a premium in an otherwise closed market should be considered. In many cases in a secondary sale, a third party investor does not have significant ownership prior to the transaction and had no significant influence or control.
  • Employee-Nonemployee Shareholders Same Treatment: payment terms applying equally to employee and non-employee shareholders may indicate a lack of compensatory intent.
  • Market Created: in many instances, the secondary sale is a closed transaction amongst only a few parties. It may be a “one-off transaction” where the parties agree to the FMV, which as mentioned above, could differ from the 409A valuation. If, however, there are a series of secondary sales, this could be an indicator that the company has created a market for the stock. In this instance, the 409A would tend to lead to a closer FMV and a premium paid could be viewed as compensation.
  • Reporting: the parties’ reporting to the IRS is also a factor. Consider the manner in which each of the parties reports the transaction to the IRS, and consider binding the parties to reporting it in a consistent manner.
  • Financial Statement Treatment: while this article focuses on the tax treatment of payments, there are accounting considerations as well. It is helpful for the tax treatment to be consistent with the financial statements; however, there may be valid reasons for a departure.
  • Compensation Deduction More/Less Favorable: consider the tax profile of the parties. In certain instances, the company’s deduction outweighs the tax paid by the selling employee-shareholder, and the company can choose to gross-up the employee if it desires. The new tax rates will affect these determinations because the maximum corporate federal tax rate is now 21%, and the maximum individual tax rate is 37%. Also, many start-up companies have significant net operating losses that can be used to shelter taxable income.

In contrast to redemptions, the tax consequences of a cross-sale of stock by existing stockholders to new investors tend to be more straightforward. However, cross-sale transactions are also not entirely free from tax uncertainty. There still can be a question about whether some of the purchase price payable to employee-shareholders represents compensation. Intuitively, it would seem that if no payments are made by company to its employees, then no portion of the sale price could be treated as compensation. Moreover, participants often note that a price negotiated by unrelated buyers and sellers should be respected as FMV. On the other hand, where the facts indicate that there is some compensatory element to the agreed price, the proceeds could also be viewed as compensatory.

Given the lack of definitive guidance and the nuanced factual differences in the various transactions, each transaction should be analyzed separately given its specific facts and circumstances. Sometimes even minor differences can yield different tax results, and the IRS or other taxing authority can always challenge the chosen tax treatment. In addition, it is important for companies to consider the implications of these transactions within the context of their annual valuations which are completed in order to comply with section 409A. The company should ensure that the valuations contemplate any impact these transactions have on the FMV of the common stock.

Authors: Christopher M. DeMayo, CPA, MBA, Partner | [email protected] and Zsia Rosmarin, CPA, MS, Partner | [email protected]

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