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:
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.