Premium or paycheck? Tax treatment of secondary sales above FMV

Editor: Jessica L. Jeane, J.D.

As private companies remain private for longer and equity compensation becomes a cornerstone of employee incentive structures, secondary sales of private stock are increasingly common. These transactions often involve shares being sold at a premium over their Sec. 409A fair market value (FMV), raising a critical tax question: Is the premium capital gain or compensation?

The answer has significant implications for both taxpayers and companies. If the premium is treated as compensation, it is subject to ordinary–income tax rates and potentially payroll taxes; on the upside, the company receives a tax deduction equal to the employees’ gain. If it qualifies as a capital transaction, the seller may benefit from preferential long–term capital gains rates, but there is no deduction for the company. Unfortunately, the IRS has not issued definitive guidance on this issue, leaving tax professionals to navigate a complex facts–and–circumstances analysis.

This item explores the key factors that influence the tax characterization of premiums in secondary sales and offers practical guidance for structuring transactions to support capital gain treatment.

The legal framework: Sec. 83 and beyond

There is no specific IRS regulation that directly addresses the tax treatment of a premium over FMV in secondary sales. Instead, the IRS relies on Sec. 83, which governs the taxation of property transferred in connection with the performance of services, along with case law and administrative guidance.

Under Sec. 83, if property is transferred “in connection with the performance of services,” the excess of the FMV over the amount paid is treated as compensation income. However, if the transfer is not tied to services, such as a bona fide investment transaction, the gain may be treated as capital.

Because the IRS applies a facts–and–circumstances approach, tax professionals must carefully evaluate each transaction to determine the appropriate tax treatment.

Key factors in the IRS’s analysis

The IRS considers a variety of factors when determining whether a premium should be treated as compensation or capital gain. These include:

FMV vs. purchase price: The IRS generally defines FMV as the price at which property would change hands between a willing buyer and a willing seller, without compulsion to buy or sell and with both having reasonable knowledge of the relevant facts. When a secondary sale occurs at a price significantly above FMV as determined under Sec. 409A, the IRS may scrutinize the transaction to determine whether the reported FMV was accurate or whether other, non-arm’s-length factors influenced the valuation.

However, if the transaction reflects a genuine arm’s–length sale between unrelated parties, the premium paid may be interpreted as reflecting the buyer’s forward–looking valuation of the business, based on expected growth or strategic value, rather than as disguised compensation or a transfer of value. As such, the excess over FMV, while notable, may be subject to capital gain treatment if the seller is transferring a capital asset. Subsequently, the sale reflects a bona fide market valuation rather than a disguised form of ordinary income.

Example 1: A strategic investor offers to purchase shares at 2.5 times the FMV determined under Sec. 409A. The investor justifies the price based on a trailing 12–month revenue multiple.

Purpose of the transaction: The IRS will examine the purpose of the transaction and the intent of the parties. If the primary purpose is to compensate employees or service providers, the premium may be treated as compensation. Conversely, if the transaction was structured to facilitate a strategic investment or liquidity event, it may be treated as a capital transaction.

Key indicators of compensatory intent include:

• Tying the sale to employment milestones (e.g., promotions or raises);
• Offering premiums only to current employees; and
• Coordinating the sale with changes in compensation or equity grants.

In contrast, if the transaction is initiated by an investor seeking to increase ownership or gain strategic advantages and the seller is not receiving any concurrent compensation, the facts may support capital gain treatment.

Example 2: A company seeking to incentivize its employees structures a secondary sale with a new investor specifically for that purpose. Instead of issuing new treasury stock to complete the investment, the company allows employees to sell their existing shares and benefit from the premium. In this scenario, the premium received by employees would most likely be treated as compensation.

Identity of the purchaser: In the case the shares are purchased directly by the company (employer) or by a current significant investor, generally, the IRS will classify the premium as compensation. A significant investor is considered an investor holding an interest in excess of 5%. However, if the investor is acting independently or there is a new investor purchasing shares, this may support a noncompensatory interpretation.

Example 3: When a strategic investor, who owns more than 5% of a company, makes an additional investment, the IRS may scrutinize the transaction. However, if the investor has no other relationship with the seller and the seller is not the company but the individual shareholder, the facts may still support capital gain treatment, depending on the overall circumstances.

Identity of the participants: The inclusion of nonemployee shareholders tends to support noncompensatory treatment, particularly when participation in the transaction is not tied to the performance of services. However, when a transaction is limited to current or former employees or service providers, the IRS may be more inclined to scrutinize whether any portion of the premium reflects payment for past or ongoing services, especially if the sale coincides with employment-related events such as promotions, terminations, or performance milestones.

Unlike transactions involving passive or purely financial investors, which more clearly support capital gain treatment, a limited seller pool consisting solely of employees and service providers may raise questions about whether the premium is tied to compensatory arrangements. That said, in cases where the shares were originally acquired at FMV; held over time; and sold in an arm’s–length transaction with a third party, without any concurrent changes to compensation, equity grants, or employment terms, the facts support noncompensatory treatment.

Company involvement: The degree of company involvement is a critical factor. Most often, if the company is the purchaser of the shares, the premium will be viewed as compensation. Similarly, if the company negotiates the price, identifies participants, or facilitates the transaction, the IRS may view the premium as compensation.

In contrast, if the transaction is initiated and negotiated independently by the investor and the company’s role is limited to administrative processing, this may support capital transaction characterization.

Example 4: The investor approaches the shareholder directly, and the company is informed only after the transaction has been agreed upon. The company’s involvement is limited to administrative support, such as canceling and issuing new share certificates. These facts support a noncompensatory characterization of the transaction.

Frequency of secondary sales: Regular or recurring secondary sales, especially those tied to employment milestones, may be viewed as compensatory liquidity programs. If a company is in the habit of facilitating semi-regular secondary sales, such as on an annual basis, the likelihood of those transactions being treated as compensatory will be significant. Infrequent one-off transactions are less likely to be recharacterized as compensation. Companies should avoid establishing a pattern of facilitating secondary sales for employees unless they are prepared to treat premiums as compensation.

Accounting treatment: While not determinative, the company’s financial reporting can influence the IRS’s view. If the premium is booked as compensation expense, it may undermine a capital gain position. The company should document the reasons for the discrepancy.

Common pitfalls in secondary sale transactions

Even when the facts appear to support capital gain treatment, several common missteps can increase the risk of IRS scrutiny or recharacterization of the premium as compensation. Practitioners should be aware of these pitfalls and proactively guide clients to avoid them:

Inadequate documentation of valuation: Failing to document how the purchase price was determined, especially when it significantly exceeds the FMV under Sec. 409A, can raise red flags. The IRS may assume the premium reflects compensation unless the buyer can substantiate a bona fide investment rationale.

Company overinvolvement: When the company plays a central role in negotiating the transaction, selecting participants, or setting the price, the IRS may view the transaction as a disguised compensation program. This is especially likely if the company has a history of facilitating similar transactions.

Timing with employment events: Transactions that coincide with employment-related events, such as promotions, raises, or new equity grants, may be viewed as compensation, even if the parties claim otherwise.

Lack of holding period or FMV purchase history: If the seller acquired the shares at a discount or did not hold them for a meaningful period, the IRS may argue that the gain reflects compensation rather than appreciation of a capital asset.

Selective participation: Allowing only current employees and/or service providers to participate in a premium-priced secondary sale can suggest a compensatory motive, particularly if the selection criteria are opaque or tied to performance.

Frequent secondary sales: If the company regularly facilitates secondary sales, especially on a predictable schedule, the IRS may be more likely to view the premium as compensation rather than as a return on investment.

Case study: Applying the framework

Let’s apply these principles to a hypothetical transaction.

Background: The secondary sale has the following characteristics:

• Purchase price: The price is ١.٥ times FMV as determined under Sec. ٤٠٩A, supported by a calculation based on company revenue.
• Purpose: The investor is seeking to increase its investment in the company to align its portfolio with current investment strategy.
• Investor: The investor currently owns a ١٠٪ interest.
• Sellers: The transaction is open to all shareholders, including current employees.
• Company role: The investor approaches the company and negotiates the purchase price; the company also makes the decision on who can participate in the secondary sale.
• Frequency: Other sales have been on an infrequent, irregular basis. Every few years, the company will have a secondary sale to facilitate new investments.
• Accounting treatment: The company decided to account for this expense as compensation expense.
• Seller status: An executive involved retains control and key rights; the former service provider has not rendered services for a meaningful period.

Analysis: The transaction appears to be conducted at arm’s length and is strategically motivated. Participation is open to all current shareholders, and secondary sales occur infrequently.

However, because the investment is being made by a current strategic investor and the company played a role in facilitating the transaction, including negotiating the price, the IRS may still view the transaction as compensatory in nature, particularly with respect to current and former employees and service providers.

Analysis and planning can help

As secondary sales become more prevalent in the private markets, the line between capital gain and compensation is increasingly blurred. While the IRS offers no bright–line rule, a careful analysis of the facts and proactive planning can help ensure favorable tax treatment.

Tax professionals play a critical role in guiding clients through these nuanced transactions. By understanding the IRS’s key considerations, avoiding common pitfalls, and documenting the transaction thoroughly, advisers can help clients structure secondary sales that withstand scrutiny and achieve the intended tax outcomes.

In a landscape where liquidity events are rare and valuations are volatile, the ability to distinguish a premium from a paycheck is more important than ever. With thoughtful planning and a facts–first approach, capital gain treatment is not only possible but also defensible.

Editor

Jessica L. Jeane, J.D., is director of tax policy, national tax, with Baker Tilly in McLean, Va.

For additional information about these items, contact Jeane at Jessica.Jeane@bakertilly.com.

Contributors are members of or associated with Baker Tilly.

Baker Tilly US, LLP, and Baker Tilly Advisory Group, LP, and its subsidiary entities provide professional services through an alternative practice structure in accordance with the AICPA Code of Professional Conduct and applicable laws, regulations, and professional standards. Baker Tilly US, LLP, is a licensed independent CPA firm that provides attest services to clients. Baker Tilly Advisory Group, LP, and its subsidiary entities provide tax and business advisory services to their clients. Baker Tilly Advisory Group, LP, and its subsidiary entities are not licensed CPA firms.