So often, as well as the founders taking little or no cash out of the business as salary in its early days, the first (brave!) employees also end up having to share this pain.
To help ease this, it is common for employees to be offered shares in the company in lieu of salary (in full or in part). This seems like a sensible option, as the first employees they are treated like sort of quasi-founders, and by taking a small slice of the equity they have the potential to share in the upside of equity ownership if all goes well in exiting further down the line.
This can therefore work well commercially, however, it can cause a headache from a tax perspective….
The UK tax rules related to shares issued or transferred to employees are unfortunately tightly drawn. This results in shares passed to employees being treated for tax as if they were received at full market value – even if no cash changed hands – and therefore as ‘earnings’.
So, say I reward you with 500 ordinary shares in my early stage start up company for the hard work and dedication you’ve put in so far and for accepting a reduced salary, HM Revenue & Customs (HMRC) would treat these shares as employee related income subject to income tax (and possibly even National Insurance). Any employment related tax would be due on the market value of the shares at the date of issue or transfer less any amount paid (if any). The logic behind this is that had the company had cash and paid a salary instead then this would have been subject to tax via PAYE in the normal way so there should be no difference…
But so many start up and early stage companies do not think of this – why should they?
In very early stage companies this may be less of an issue but in situations where there has been external investment or where there is valuable proprietary intellectual property (IP) or even where the founders have a track record of success and there is significant ‘hope value’ or likelihood of success (and therefore value) then extreme care is required.
Complex rules like these, quite frankly, should not be inflicted on new and emerging companies, however, they can and do bite so it’s better to be forewarned (and armed) than to risk stumbling into this headache later down the line which could ultimately disrupt investment or exit opportunities – or at least result in a distracting tax investigation!