Employee participation provides tax benefits
Employee participation options enable employees to participate directly in their employer’s company through shares, profit participation bonuses or shares in cooperatives or limited liability companies. Indirect shareholdings via employee limited partnerships are also a common approach. This strengthens the employees’ loyalty to the company along with their commitment and motivation.
At the same time, employee share ownership is also a popular means of attracting qualified employees. This is because the participation provides interesting tax options. If the shares are granted at a reduced price – i.e. below their value at the time they are granted – or even free of charge, this benefit is taxable as wages. At the same time, the law allows concessions under certain conditions, by deferring income tax until the sale (§ 19a of the Income Tax Act (EStG)) and granting an allowance (§ 3 No. 39 of the Income Tax Act (EStG)), which has amounted to 2,000 euros since the beginning of 2024.
However, even if the participation is not granted at a reduced rate but at the full market price, the taxation of dividends and capital gains remains highly attractive provided that they are taxed as capital gains. Since 2019, capital gains have only been subject to a 25% flat-rate withholding tax, which is generally much lower than the income tax rate.
Federal Fiscal Court ruled that the increase in value of company participations when exchanged for shares does not constitute wages
The case before the Federal Fiscal Court dated back to 2006 and, thus, prior to the introduction of the flat-rate withholding tax for capital gains. At that time, capital gains were even completely tax-free under certain conditions.
A company had offered company shares to managers at favorable terms in connection with a planned IPO. One employee gratefully accepted the offer and purchased shares in his employer’s company for 25,000 euros at a low market value. The value of the shares subsequently exploded: Following a highly successful IPO, the man then sold his shares for a total of approximately 3 million euros.
However, his joy did not last long as the tax office classified the capital gain as taxable wages. It comes as no surprise that the man objected and ultimately took his case all the way to the Federal Fiscal Court.
No taxes at all on gains from the exchange of shares
The Federal Fiscal Court ruled that the capital gain was not taxable as wages. In the case in dispute, this meant that the man was not required to pay any tax at all. Today, he would have to pay tax on capital gains at the reduced flat-rate withholding tax rate.
The increase in value of the company participation which the employee had acquired did not represent wages but rather a source of income independent of wages. Consequently, the Federal Fiscal Court made several important statements:
The money would have only represented taxable wages if the man had received an excess price compared to outside investors when selling the employee shares.
Furthermore, neither a discounted purchase price nor the typical vesting regulations indicate that subsequent income should be classified as wages. Common vesting practices link the entitlement to the yields with the continuation of the employment relationship for a specified period of time.
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Summary of the key facts:
- Profits from the sale of employee shares are not classified as wages for tax purposes.
- Capital gains subject to more preferable taxation as investment income.
- Employees’ option of acquiring company shares at a reduced price as well as vesting regulations do not indicate that capital gains should be treated as wages.
