Employee participation programs are an important instrument for motivating employees of startups. Actually, startups often grant phantom shares (= virtual shares) to their employees. These virtual shares are like an additional payment claim based on certain parameters (e.g proceeds from the sales of shares by the shareholders). The employees have no legal or contractual shareholder rights. From a tax point of view these payments are treated like bonus-payments.

Subsequently the case may arise that employees change from a virtual employee participation programme to an equity share programme. In that case a tax-optimal structure has to be found in order to avoid a taxable “dry income”.


What exactly is “dry income”?

In the course of the conversion of the employee participation programme from a virtual employee participation programme to a share participation programme, “dry income” may occur. This could be the case with an underpriced or free of charge granting of a shareholding. Such a non-cash benefit (market value of the shareholding granted less any purchase price) is generally subject to the progressive income tax tariff for the employee (basically up to 50%). This means that at the time the shareholding is granted without cash inflow, income tax has to be paid, although investments in startups are often exposed to a corresponding impairment risk at this time.


Options for avoiding “dry income” in the course of a change from phantom shares to equity shares

The following structuring options could be considered in the course of changing the type of employee participation programme in order to avoid a taxable “dry income” (in this context a case-by-case analysis is advisable):

  • Negative liquidation preference

In general, liquidation preferences regulate how and in which order the earnings from so-called liquidity events (e.g. sale of shares, liquidation and distributions) are distributed, i.e. which shareholder is served first before the other shareholders receive a share. Liquidation preferences therefore generally lead to a distribution of proceeds to the shareholders which deviates from the participation structure (= non-linear distribution of proceeds from a contractual perspective). From a contractual point of view, such liquidation preferences represent agreements under the law of obligations on an alinear distribution of proceeds.

Negative liquidation preferences represent a subordinated participation of a shareholder in the distribution of proceeds. Employees with shares, that are tainted with such negative liquidation preference participate in the distribution of proceeds only if the proceeds exceed the amount of the negative charge. If this threshold is not reached, only the remaining shareholders will participate in the proceeds. The buyer of such shares has to agree to the non-linear distribution, otherwise the current shareholder won’t agree to the transfer of the shares. As compensation the buyer might pay a lower purchase price, which takes into account the negative liquidation preference.

The objective of an employee participation programme using a negative liquidation preference is to render the shares to be transferred under the programme economically worthless. Due to the agreed negative liquidation preference, the shares do not participate in the past performance of the startup, but only in future increases in the value of the startup. By agreeing on a negative liquidation preference, a non-cash benefit can be avoided with regard to an increase in value that has occurred by the time the shares are granted (difference between the market value of the shares at the time of granting and the consideration paid in the form of the nominal value). However, the opportunity for a future increase in value at the time of granting of the share is not included.

  • Loan structure

Alternatively, the granting of shares in the course of changing the type of employee participation programme can also be considered by means of a loan structure. In this context in a first step the shares are acquired by the employee at the current value in return for a loan. The loan bears interest at arm’s length and is repayable in the course of a triggering event (e.g. qualified exit).

Through this structuring there is no taxation at the time of the acquisition of the shares. The taxable income is triggered later on in the course of the sale of the shareholding by the employee (taxed with 27,5%).

  • Granting of shares with subsequent partial disposal for tax payment

One further option would be that the shares are granted underpriced or free of charge to the employees. The difference between the reduced purchase price and the arm’s length purchase price leads to a taxable non-cash benefit for the employee (basically taxed at up to 50%).

In order to be able to settle the resulting tax burden, part of the shares granted will be sold by the employee. The sale of shares is subject to a tax rate of 27.5%.



The granting of shares in the course of changing the type of employee participation programme from phantom shares to equity shares could trigger taxable “dry income”. In order to avoid such a taxable dry income different structuring alternatives are available, which need to be analysed on a case-by-case basis in advance to the implementation.



Christoph Puchner, Managing Partner and Tax Advisor &
Bianca Weigelhofer, Senior Assistant from ECOVIS Austria, one of the leading tax consultants in Austria in the startup sector.