Navigating Tax Pitfalls in Employee Participation

The Employee Stock Ownership Plan encompasses various model variants for employee participation in the company's success. a distinction is made between true and untrue participation models.

The most common true participation models are as follows:

• Silent partnership
• Employee shares
• Allocation of shares
• Employee savings
• Profit participation rights
• Employee loans
• Debenture

The commonality among all these true models is that the employee is given the opportunity to acquire shares or ownership interests. Thus, they are directly or indirectly involved in the company's financial success. The differences lie within the rights and obligations that come with the acquisition. In some cases, in addition to acquiring shares, the employee also becomes a co-owner. Optional voting rights are possible, but in most cases, these are contractually excluded.

False participation models can be:

• Phantom stocks within a Virtual Share Program
• Stock Appreciation Rights
• Possibly co-investments

The main characteristic of the Phantom Stock model lies in the issuance of fictitious shares, the actual payout of which occurs later. The employee is thus not actually a shareholder but still receives their status. The payout amounts are determined by the performance of the stock. With Stock Appreciation Rights, the owner receives dividends accordingly. Co-investments can also be modeled as false participations by excluding the employee from acquiring actual ownership rights.

The Question of Taxation

The type of employee participation and the timing of profit distribution are crucial for calculating the taxes to be considered. Here is an overview of the basic qualifications:

True Employee Participations

From a tax perspective, the advantageous benefit that accrues to the employee from the discounted purchase price and the gain from the price increase of a share is decisive for the taxation of true employee participations. As a basic rule for calculating taxes on employee participations, the price difference between the share price and the actual market value of the share is used. The higher the difference, the higher the amount of taxes and social security contributions due. In this case, the result is considered as a social security taxable component of salary.

For the employer, employee participations are to be taxed as income from dependent employment. The purchase price of the shares is deducted. An exception is made for options on participation subject to a lock-up period and non-listed participations. Taxes are only due at the time of actual distribution.

False employee participations 

Phantom stocks and usually other forms of false employee participations are considered mere expectations until the actual profit distribution. At the present time, they do not generate any profit or provide the employee with other benefits, such as voting or participation rights that they could use. Therefore, taxes are only due upon distribution. A tax-free capital gain cannot be achieved from any of the false variants.

Lock-Up Periods

A lock-up period entails a six percent annual discount. This is added to the market value of the share for a maximum of ten years.

Start-Ups in Focus: Tax Issues and Solutions

For start-ups, ESOP models are often particularly interesting. The Phantom Stock variant, in particular, offers the chance to create a mutually beneficial situation through vesting. It does not immediately burden the young company financially and creates an attractive model for acquiring and retaining qualified professionals through the vesting phase. Thus, the start-up does not have to offer a high salary, which it usually cannot afford due to insufficiently high financial liquidity.

However, tax law does not always make it easy for founders to introduce a participation model. In calculating the income tax value of employee participation models, usually classic and simple methods are used depending on the situation. These are usually the value determined through financing rounds or the asset value method, or a formula valuation is used. The problem with these calculation models is that the earnings power, which is crucial for a start-up, is not taken into account at all. This ratio is often criticized. Unfortunately, there is still no new basis for alignment throughout Switzerland.

The Pioneer: Canton of Zurich

The Canton of Zurich has recognized the problem and developed its own valuation strategy for the wealth tax of start-ups as early as 2016. This strategy has a tiered valuation hierarchy. The asset value is only used as the basis of calculation within the first three years after the company's founding. In the fourth year, a mixed value is used, consisting of 2/3 asset value and 1/3 financing round value. In the fifth year, the values are reversed with 1/3 asset and 2/3 financing round value. In the following years, only the value of the financing rounds is taken into account.

An exception to this applies to the biotechnology and healthcare sectors. BioTech and MedTech start-ups are subject exclusively to the asset value as the basis of calculation in the first five years. In the sixth and seventh years, the calculation is made using 1/3 asset and 2/3 financing round value. From the eighth year onwards, only the value of the financing rounds is decisive.

Conclusion and Support Options

ESOP models offer opportunities and leave a lot of room for individually designed concepts for employee participation. However, the resulting tax consequences should not be underestimated. They are part of the heart of any employee participation plan, the development of which should be carried out with great care. Especially for start-up founders, clarification of all tax obligations when introducing an employee participation model should be the focus of attention.

Did you know that there have been lawyers and tax law specialists for several years now who have made it their mission to specifically support start-ups and SMEs in developing employee participation models? Their portfolio includes, for example, the creation of national and international participation plans or the review of already developed plans. They provide assistance with inquiries on all tax law matters and support you in court if necessary. Consultation with them is particularly recommended for start-up founders.

We at GetYourLawyer know how much time and effort searching for a suitable specialist lawyer can take. Therefore, we offer our support. By using our free contact form, you have the opportunity to easily and quickly receive quotes from lawyers and tax law specialists from your region.