In a previous blog post, we talked about how C-suite executives are increasing their use of the secondary market to liquidate private shares in order to gain access to cash. We expect this trend to continue as companies stay private longer and create a pent up demand for liquidity.
PwC’s recent paper titled, Private company liquidity: CEO and CFO considerations: A guide to secondary transactions, provides a wealth of information about the intricacies involved in secondary sales. Because this market is more opaque than the equity markets, sales of shares in a secondary market introduce unique challenges that are not well understood. In particular, understanding the tax considerations can be challenging for employees accessing this market.
Capital or compensatory?
If the sale price exceeds the current 409A valuation, the difference may be either capital or ordinary income in nature. The answer may depend on a variety of facts and circumstances, and there is no easy test to make this determination. Both scenarios carry implications:
Capital: If the gain is determined to be capital in nature, the difference between the sale price and the valuation will generally will be treated as a capital gain. The employee will pay long-term or short-term capital gains tax depending on how long the shares were held. However, if the shares were purchased through the exercise of an incentive stock option (ISO) and are sold either within two years from the date of the ISO grant or one year from the date of exercise of the ISO, generally any gain up to the excess of the fair market value of the shares on the date of exercise over the exercise price will be treated as ordinary income and subject to Federal income tax reporting (although not Federal employment taxes or Federal income tax withholding).
Compensatory: If the gain is determined to be compensatory in nature, the difference between the sale price and the current 409A valuation will be ordinary (W-2) income to the employee.
There may be other issues. For example, if a loan was used to facilitate the stock purchase, this documentation should be examined to confirm that the stock purchase was in substance a purchase rather than an option to purchase.
Secondary sales are an opportunity for private company employees to generate cash before the company goes public. Read our full report, or contact us to learn more. You can also read about valuation considerations in our recent post, Three tips for valuations related to secondary sales.
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