The founding of a startup is typically a turbulent process. An existing idea has to be transformed into a business model, the team has to be assembled and investors have to be found for the financing. The focus in this phase is on driving the project forward and the practical implementation of the business model - less on contracts and tax optimization. However, strong contracts and forward-looking tax planning are a must for every startup in the medium and long term - especially if it is successful! The VISCHER Startup Desks's three-part series Focus on Taxes is dedicated to the tax aspects that have to be considered for a successful startup from the point of view of investors and founders, employees and the company:
- Focus on Taxes - Investors and Founders: Tax-free Capital Gains
- Focus on taxes - employees: Participation in the success of the startup
- Focus on taxes - company: Setup and operation of the startup
Capital gain as compensation for startup risk
A startup often requires a lot of capital in the initial phase, especially in the life science sector. Solid contracts with investors create the basis for raising capital via financing rounds or loans. Investors, in turn, depend on the founders and key people to remain motivated during the startup phase, i.e. during the entire investment cycle of 6 to 10 years. During the startup phase, usually only small salaries can be paid to the founders and employees. Since no profits are generated in this phase, no dividend can be distributed either. Founders and employees therefore receive shares of the company. Hence, the focus of the founders, investors and employees involved is often on the exit, i.e. selling the startup to a third party or going public. With the sale of their shares in the startup, they can realize a profit, which compensates them for the low salary and the entrepreneurial risk assumed. In the (positive) difference between the selling price of their shares and the price they paid for them (e.g. when issuing shares on formation or on a financing round), the shareholders realize a capital gain at the time of exit.
No taxation of private capital gains in Switzerland
Shareholders who are resident in Switzerland at the time of the sale of their shares generally do not pay tax on this capital gain. Most countries, on the other hand, tax capital gains in the same way as they tax other income, but at a lower tax rate: e.g. France (30%), Italy (26%), Austria (28%), Germany (28%) or the USA (0 to 40.8%). In contrast, Switzerland does not tax capital gains realized by natural persons at all, but only if the following conditions are met:
Holding of shares as private property. The shareholders must hold the shares in the startup company as private assets at the time of sale. This is the case, for example, if a founder pays in the company's initial capital from private funds, employees participate in a financing round at the market price or the same price as the independent investors in the startup, or generally independent third parties (investors) participate in the startup as part of their private asset management. Caution is required, however, if employees receive the shares from their employer at less than fair value or at a formula value (for the tax consequences in connection with employee stock ownership plans, see Focus on Taxes - employees participation in the success of the startup).
No professional securities trading. A capital gain achieved within the framework of self-employment is not tax-free. It must therefore be ensured that the tax administration does not classify the sale of shares as an independent activity in itself. Only those capital gains that result from the simple management of one's own private assets or from an accidental opportunity are considered tax-free capital gains. A profit from an activity carried out for profit can lead to the assumption of self-employment and taxation of capital gains (professional securities dealer). However, professional securities trading can be excluded if the following tax-recognised Safe Haven criteria are taken into account:
- Compliance with a minimum holding period of six months;
- Few annual securities transactions;
- Capital gains are not needed to finance livelihood;
- Financing of securities from private funds;
- Derivative financial instruments are only used for hedging purposes.
If not all Safe Haven criteria can be met, this does not automatically lead to taxation of capital gains. In such a case, it must be assessed on the basis of all circumstances whether or not securities are traded commercially. The tax authorities in Switzerland are generally reluctant to tax capital gains under the title of professional securities dealer.
No self-employment. As a matter of principle, care should be taken to ensure that shares are held as private assets. Capital gains made in the course of self-employment are always subject to income tax. In addition to income taxes, social security contributions (AVH/IV etc.) of approx. 10% are owed on profits from self-employment (e.g. professional securities dealer).
Be careful with mixed contracts. Mixed contracts are contracts that link the sale of shares in a company (often the majority of the shares in the company) to other conditions such as a non-competition clause or continued cooperation in the company. It should be noted that only the proceeds directly related to the sale of the shares are tax-free. Compensation for a non-competition clause or for continued work in the company is taxable as income. In the case of mixed contracts, it must therefore be ensured that the purchase price for the shares in the contract corresponds to the market value and is clearly separated from the other parts of compensation. To ensure that the tax authorities do not qualify part of the capital gains as taxable capital gains, it must be ensured that the selling employees continue to receive compensation in line with market conditions, particularly when continuing to work for the company.
Beware of retained earnings. Companies which have already realized profits in previous years and have not distributed them, have accumulated retained earnings in addition to the share capital and the capital contributions of the shareholders. If at least 20% of the shares in such a company are sold from the private assets into the business assets of a natural person or legal entity, this may result in the taxation of future distributions from these retained earnings existing at the time of the sale at the level of the selling shareholders (so-called indirect partial liquidation). However, this can be avoided with forward-looking tax planning and contract drafting.
Caution when transferring to self-controlled company. Even the total profit exceeding the share capital including capital reserves may be taxed if private shareholders sell a holding of 5% or more in a corporation to a partnership company or a legal entity in which they individually or collectively hold at least 50% of the capital. From an economic point of view, such a transfer does not constitute a sale, but rather a pure reallocation of assets (so-called transposition). As of 1st January 2020, when the corporate tax reform passed this year comes into effect, all such asset shifts, including those of less than 5%, will be taxed.
... don't put all your eggs in one basket
Shareholders who comply with the above conditions will realize a tax-free capital gain if they sell their shares to third parties in the course of an IPO or sale of a business. Despite this tax advantage, it does not always make sense, from the point of view of risk diversification, to steadily increase its holding in the company.
In addition to the chance of a capital gain, there is also always the risk of a capital loss. Often, employees or collaborating founders also have to waive part of their salary and advances or loans granted to the company in the event of a loss of capital. These private capital losses cannot be claimed for tax purposes, since such profits are not taxed either. For this reason, it must always be considered whether the chance of a possible tax-free capital gain exceeds the additional risk of an equally possible capital loss.
Professional contracts are necessary
In order to avoid an unpleasant surprise when selling the shares, watertight contracts and careful clarifications are essential:
Clear separation of private and business assets. It cannot be emphasized enough that care must be taken to keep the shares in private assets. This has to be ensured separately for each participant. To be on the safe side, this question can be dealt with in advance by the cantonal tax administration in a so-called tax ruling. This can be useful, for example, if investors additionally advise the company within the framework of self-employment. Even if shares are held as business assets, correct accounting is important so that a later capital gain can retraced by the tax authorities.
Professional contracts between founders and investors. With a shareholders' agreement, the quorum of the startup can be ensured. This prevents that one shareholder alone could block a sale of the startup or sell his shares to any third party without the consent of the other shareholders.
Comprehensive sales contract for the sale (exit) of the startup. As shown, the capital gain from the sale of the shares is tax-free only as long as it is not related to any further compensation to the selling shareholder or to any indirect partial liquidation or transposition. If, for example, the founders are to continue to work for the company after the sale of their shares or if they have committed themselves to a non-competition clause (see mixed contracts above), it must be ensured that the taxable income from these services is clearly distinguished in the sales contract from the proceeds from the sale of the shares. This question can also be discussed with the cantonal tax administration. It is equally important that in the event of a sale to a legal entity, the sales contract contains a so-called indirect partial liquidation clause where necessary, in order to protect the seller from unpleasant tax bills.
Only careful planning enables tax-free capital gains
Professionally written contracts, a careful evaluation of the tax situation of all shareholders - both Swiss and foreign - and, where appropriate, the prior obtaining of tax rulings prevent unpleasant surprises when selling shares in a startup. They also support the smooth operation of the startup and are in the interest of investors as well as founders and employees.
For further questions regarding the structuring of startups, please contact our tax law team or our startup desk.