Compensation-related tax risks when cashing out employee shareholders

Executive summary

For many privately owned companies, an investment by a private equity fund (PEF) or venture capital (VC) provides an opportunity for liquidity to founders and other employee-shareholders. In many cases, the PEF or VC invests via a new class of preferred stock, while the employee-shareholders hold common stock. Often the employee-shareholders sell their common shares to the PE, VC or the company at the same price per share as the price of the new preferred investment, which might be at a higher value than the value ascribed to the common shares in the company’s section 409A valuation. The sale of stock at a price in excess of a 409A valuation can create risk that the shareholder must treat a portion of the sale proceeds as compensation, subject to higher tax rates, and that the company is subject to payroll tax withholding on that portion.   

Compensation-related tax risks when cashing out employee shareholders

For minority shareholders of privately held companies, opportunities to monetize a portion of their investment are infrequent. However, one situation where a monetization event sometimes occurs, is in conjunction with a new PEF or VC investment. The new investment might provide the company with sufficient reserves to finance a buyback. Alternatively, the PEF or VC might acquire shares directly from the existing shareholders. A shareholder’s sale of stock to a third-party investor or to the corporation via a stock buy-back or redemption typically generates capital gain treatment.¹

Due to the broad application of section 61, when a seller of stock is also an employee or service provider, a portion of the sale proceeds received by that seller may represent compensation if the sale proceeds exceeds the fair market value of the stock sold. Section 61(a) includes compensation for services, “from whatever source derived” as gross income. This can include payments an employee-shareholder receives in excess of the fair market value of the property (e.g., corporate stock) they sell.²   

The following example describes a relatively common transaction involving a PEF investment into an operating C corporation and a corresponding liquidity event for certain shareholders.

XYZ Corp is a privately held corporation with a mix of small investors, founders, and employee-shareholders. PEF and XYZ have negotiated for an investment by PEF of $100M into XYZ for 10 million shares of Series A preferred stock at $10/share. The Series A preferred includes a liquidation preference of the original $100 million invested plus a cumulative dividend of 10% per year if declared. If not declared, the cumulative dividend is added to the liquidation preference. The Series A is also convertible into common stock on a 1:1 basis.

Prior to the investment, XYZ’s only outstanding equity is common stock and options to acquire common stock. XYZ recently had a valuation performed to satisfy section 409A requirements, which provided a value of $5/share for its common stock. In connection with the investment, XYZ has offered to redeem up to $20 million of existing common stock at the same $10/share PEF is paying for the Series A preferred. 

In this fact-pattern, because the employee-shareholders receives purchase consideration in excess of the  $5/share 409A appraised share value, the excess may perhaps constitute compensation. However, because isolated share sales in excess or below a section 409A valuation occur frequently, additional pertinent facts and circumstances must be examined when assessing the risk of compensation income. Although no single factor is controlling, factors requiring analysis include:³  

1. Whether the share sale was open to shareholders that are not service providers, and if so, how many took part. (Non-service providers taking part on the same terms as the employee-shareholders is a factor supporting capital treatment and not compensation.) 
2. Whether any negotiations took place directly between the PEF and the selling employee-shareholders. (Direct negotiations between the PEF and selling employee-shareholders is a factor supporting capital treatment and not compensation.)
3. The amount of time that elapsed between the 409A appraisal date and the share sale. (The more time that elapses, the less weight to place on the appraised value.)
4. Whether the shares were acquired by the PEF or by the company. 
5. If acquired by the PEF, whether the impetus for the sale by the employee-shareholders is that PEF wanted to acquire more shares than the company was willing to issue. For example, suppose XYZ only offered $80 million to PEF, which required PEF to acquire the remaining $20 million of shares they wished to acquire from the employee-shareholders. Because the impetus for the $20 million sale was PEF’s desire to acquire the shares, the fact-pattern more closely resembles a transaction generating capital treatment and not compensation.  
6. If acquired by the PEF, whether the shares acquired by the PEF were subsequently recapitalized into the Series A preferred pursuant to a plan at the time of the acquisition. (A prearranged recapitalization of the common shares acquired by PEF from the employee-shareholders into Series A preferred is a factor indicating compensation and not capital treatment.) 

In addition to the above, a company should consider the financial statement reporting of the transaction. The rules surrounding the financial statement determination of compensation under this fact pattern is beyond the scope of this discussion, and financial statement reporting is not controlling for tax reporting, but if financial reporting treats the transaction as partially compensatory, it is a factor that the company should consider.  

The tax risk highlighted here can affect the company, not merely the employee-shareholder. It is tempting to suggest that the risk is only to the shareholder, as the company would forego a compensation deduction and overstate rather than understate taxable income. However, the risk highlighted here is not simply an income tax consideration, as the company is responsible for various payroll tax withholding requirements for employee compensation. The company’s failure to make required payroll tax withholding payments could result in the imposition of penalties and interest. Depending upon the facts, a company can incur harsh tax liabilities based on the compensatory amounts received by the shareholder.⁴

Summary

Transactions (including the acquisition and disposition of corporate stock) involving service providers who are parties to the transaction require scrutiny. The IRS and courts have applied the rules of section 61 broadly to treat payments to service providers as compensation. In such a case, the nature of the service provider/recipient relationship is key. As with many areas of the tax law, a taxpayer’s specific facts and circumstances will ultimately determine the issue. Notably as discussed above, factors such as the inclusion of non-employee shareholders taking part in the sale or redemption, and separately negotiated sales to third party investors often lessen the compensatory risk.  Consult a tax advisor when faced with issues such as those discussed in this article.

¹This assumes that the buyback is not essentially equivalent to a dividend, pursuant to section 302.

²See, e.g., Brinkley v. Comm’r., 808 F.3d 657 (5th Cir. 2015) (difference between claimed capital gain and the actual value of the sold stock was taxable as compensation); Azar Nut Co. v. Comm’r, 94 T.C. 455, 460 (1990), aff’d, 931 F.2d 314 (5th Cir. 1991) (employer purchasing property from an employee had paid a “premium or additional amount in excess of the fair market value,” and the premium constituted compensation).

³See, e.g., Coven v. Comm’r, 66 T.C. 295 (1976) (Tax Court performed substance over form analysis and determined that payments were sale consideration and not compensation); Treister v. Comm’r, 51 T.C.M. 418 (1986) (Tax Court performed a fact-based analysis, distinguished Coven, and concluded that the taxpayer’s receipt of payments in excess of the value of the stock he sold was compensation for his consulting services).

⁴See section 6672 (civil penalties equal to the amount of tax not collected); section 7202 (criminal penalties for willful failure).