As of 1 January 2024, a long-standing dream of startups is coming true: these companies can provide shares to their employees and executives tax-free. As a result, the ownership mindset and motivation of these individuals can be efficiently ensured without tax burdens.
The commitment and long-term motivation of executives and employees play a crucial role in the success and sustainability of a startup. One of the best ways to achieve this goal in early-stage companies is by granting shares to individuals who play a key role in the company's life, whether through immediate benefits or call options.
However, until now, this has been extremely cumbersome and expensive from a tax perspective. At the time the employees or executives acquired shares in the company, they had to declare the fair market value of the shares as employment income. Tax rules, especially those related to option programs, further complicated the situation. When exercising options, the market value of the acquired shares had to be assessed, leading to significant tax burdens at the time of exercising the option, especially if the company experienced real market growth and value increase. It's no wonder that due to tax disadvantages, very few opted for this motivational tool in Hungary even though it is a common tool internationally.
Tax Obstacles to be Eliminated from January
A tax law amendment recently approved and taking effect in January addresses the above problem. According to this amendment, employees and executives of "startup companies" can now acquire shares in the company tax-free. This tax exemption also applies to call options: acquiring shares through the exercise of a call option will be tax-free if the employee or executive received the call option at the time the company met the definition of a “startup company”.
Under the new regulation, "startup companies" are micro and small enterprises that have been registered for up to 5 years, are not listed on the stock exchange, have not distributed profits, and were not created through mergers or splits. The new provision specifically focuses on startups and assists companies in the early stages of their operations.
Furthermore, the condition for tax exemption is that the employee or executive must remain an owner of the startup for at least 3 years after acquiring shares. In the case of call options, this rule should be interpreted as requiring at least three years to elapse between the granting of the option and the sale of the acquired shares. If the right to exercise the option opens in a timely manner, the regulation provides a tax-effective solution for the classic case where the employees exercises their option just before an exit.
How should one be taxed?
As long as the employee does not sell the acquired shares, there is no tax payment obligation. Moreover, once the employee becomes a shareholder, he/she can receive part of his/her income as dividends, subject to only 15% tax.
If an individual sells his/her shares, the entire sales proceeds (less the acquisition cost of the shares) will be taxed as capital income, which is significantly more favorable than taxation of employment income.
If Someone Doesn't Qualify... ESOP May Still Be Available
If a company does not meet the requirements set out by the new rules, it does not have to give up the possibility of this motivational tool. Companies may establish an Employee Share Ownership Plan (ESOP), through which employees can gain income subject to capital gains tax. Moreover, ESOP may also be suitable for creating employees' interest in exit: if a sale occurs, key employees involved in the ESOP may also gain income with favorable tax treatment.