Taxation of Employee Stock Options

Today, stock options are part of the "standard repertoire" in the compensation practice of large companies, particularly in the employment contracts of managing directors, board members, and other top executives. They give the employee the right to purchase a certain number of the company's shares at a previously set price (the purchase price) after the expiration of a retention period.

As a rule, stock options granted on the basis of respective agreements are considered income on which the employee must pay taxes. In this respect, the income "flows in" not when the stock option is granted, but only when the option is exercised and the stocks are booked on the employee's securities deposit (the "inflow" time). The amount of the taxable income is determined on the basis of the difference between market value at the time of inflow and the purchase price agreed upon in the option agreement.

Depending on the development of the stock price, there might be a significant increase in value up until the time of exercise, resulting in a corresponding tax burden. The question for the employee is whether the tax burden can be minimized by means of an appropriate arrangement, such as bringing forward the inflow relevant in terms of taxes to a point in time when the value of the stock option is low and the actual increase in value of the stocks prior to the time of exercise is no longer covered by the employee's income tax and/or wage tax.

Advanced Inflow Time

The German Federal Finance Court (Bundesfinanzhof ; BFH) decided in its judgment dated September 18, 2012 (VI R 90/10) that the noncash benefit of a stock option flows to the employee also in the case of a transfer to a corporation belonging to him or her, even if no adequate consideration has been agreed upon (an amount known as the "concealed equity contribution"). Decisive to the time of inflow is the employee's "utilization" of the benefit allocated by the employer, i.e., its economic incorporation into the employee's property.

If, as is usually the case, the employee exercises the option him- or herself, the noncash benefit flows in at the time the stocks are booked on the securities deposit. This does not apply, however, if the employee has previously disposed of the option.

In the opinion of the BFH, this is the case if the employee transfers the options by means of a concealed equity contribution to his or her limited-liability company (GmbH ). Thus, the inflow of the noncash benefit in this case is advanced to the time of transfer of the options. The employee therefore receives only the value of the option and/or the stock at this point in time. If, after this concealed equity contribution, there is another increase in the value of the stock and the corporation exercises the option at the time of exercise, then the further increase in value remains untaxed for the time being. The hidden reserves are subject to taxation only if the stocks are sold by the corporation. Such capital gains (and dividends) are, as a matter of principle, 95 percent exempted from the corporation tax and the trade tax. When the tax exemption is taken into account, taxes accrue in the amount of approximately 1.6 percent of the capital gain. If the corporation distributes the capital gain to the shareholder/employee, for private assets a flat-rate tax amounting to 25 percent plus the solidarity surcharge and, if applicable, church tax accrue. Even in the case of a full distribution, the total tax burden thus amounts to less than 30 percent on the gains from the stock option; if the employee had exercised the option directly, income tax (or, if applicable, "wealth tax" (Reichensteuer )) of up to 45 percent plus the solidarity surcharge and church tax would have accrued.

According to the BFH, such tax arrangements generally do not constitute an abuse of the law, even if the arrangements lead to lower tax burdens.

Tax Planning in Connection With Employee Stock Options

The BFH's judgment leaves room for individual tax planning in connection with employee stock options, particularly in the case of managing directors, board members, and other top executives with relatively high income and a high percentage in variable remuneration in the form of stock options.

Imagine the following scenario:

Managing Director X establishes a limited-liability company (GmbH) for his private asset management. X is the beneficiary of a stock-option plan provided by his employer, and in May 2013 he receives the (transferable) option to purchase 1,000 shares from the U.S. parent company at an exercise price of €10 per share. At the time the option is granted, the price is €18 per share. The earliest date for exercising the option is May 31, 2015.

On August 15, 2013, X transfers the options to his limited liability company by means of a concealed equity contribution. On this day, the stock of the parent company is listed at €16 per share. On May 31, 2015, the quotation of the shares has risen to €32 per share. The limited-liability company purchases 1,000 shares at the exercise price of €10 per share.

What is the solution?

At the time of transfer of the stock option, X was supposed to receive a noncash benefit in the amount of €6,000 (€16,000 [the quotation of the shares] minus €10,000 [the exercise price]), which is taxable.

At the time of exercise of the option by the limited-liability company, X does not receive any (further) noncash benefit. For the limited-liability company, the acquisition is a transaction that does not affect the net income. Subsequent gains from dividends or capital gains of up to 95 percent should be tax-free.

In such an arrangement, it is necessary to consider not just the circumstances of the individual case, but also the fact that capital gains and dividends would not be exempt from taxes at a rate of 95 percent for the limited-liability company if the stocks were purchased by the corporation with the object of reselling the same on short notice. According to the German Tax Act 2013, this arrangement should be restricted to credit institutions and financial-services institutions, but due to the current political landscape, the German parliament has not yet adopted the act, despite the fact that this particular amendment was not viewed as controversial by any of the political parties.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.