Employee equity participation is an important tool for start-ups, growth companies, and private equity structures to retain executives and key employees over the long term. Particularly relevant in this context are so-called Hurdle Shares – equity interests that are designed to allow employees to participate economically only in future increases in the company’s value. The Bavarian tax authorities recently addressed this topic in a guidance letter dated May 28, 2026, providing important insights into the tax treatment of such structures.
The good news upfront: The tax authorities’ guidance provides greater legal certainty and is expected to significantly promote the practical use of Hurdle Shares. According to the Bavarian tax authorities, agreeing on a so-called negative liquidation preference does not automatically mean that the allocation of shares or subsequent proceeds from the participation must be taxed as employment income. Rather, the decisive factor remains whether the participation constitutes a genuine equity interest under corporate law or whether, from an economic perspective, it merely represents compensation for services performed.
What are Hurdle Shares?
With Hurdle Shares, employees receive genuine equity interests in a company that are subject to a special distribution mechanism. The objective is to ensure that employees do not participate in the company’s existing value, but only in future increases in value. This approach is intended, on the one hand, to avoid a taxable transfer of value at the time the shares are granted and, on the other hand, to allow employees to benefit from future value appreciation.
From a technical perspective, this is typically achieved through a so-called negative liquidation preference. Put simply, this means that employees only receive an economic benefit from dividends, sale proceeds, or liquidation proceeds once a certain threshold has been exceeded. Up to that threshold, the economic entitlement to the proceeds remains with the other shareholders.
A typical scenario: The employee receives shares at nominal value, while the actual value of the company is significantly higher. To prevent the employee from immediately participating in the company’s existing value – and therefore receiving a substantial taxable benefit – a negative liquidation preference is agreed upon. This reduces the economic value of the employee’s equity interest accordingly.
Avoiding wage tax on employee equity with a negative liquidation preference
The first key question already arises when the shares are granted: Does the employee receive a taxable benefit in kind?
According to the guidance issued by the Bavarian tax authorities, employment income arises upon the grant of an equity interest only if the shares are transferred to the employee at a discount. This is generally not the case if a negative liquidation preference has been agreed upon. The reason is that the negative liquidation preference reduces the fair market value of the employee shares.
This point is crucial in practice. If the equity interest, due to the negative liquidation preference, is economically worth only the purchase price paid by the employee, there is no transfer at below fair market value. Consequently, no taxable employment benefit arises at the time the shares are granted.
For companies, this means that the tax effectiveness of the structure depends on proper valuation and documentation. The agreed purchase price, the fair market value of the equity interest, and the impact of the negative liquidation preference must be economically consistent with one another.
Later gains from Hurdle Shares: Employment income or capital income?
No less important in practice is the second question: How are later proceeds from the equity interest treated for tax purposes?
According to the tax authorities’ guidance, proceeds from Hurdle Shares – such as dividends or gains from the sale of the shares – must either be classified and taxed as employment income or as compensation arising from a special legal relationship independent of the employment relationship. While employment income is taxed at the individual income tax rate (which is generally higher), dividends received by a capital investor are subject only to the flat withholding tax rate; the same applies to potential proceeds from the subsequent sale of the shares.
Would you like to receive such news directly to your mailbox every two months? Subscribe to our newsletter Private Clients Update – Assets | Foundations | Succession.
The tax authorities make clear that the mere agreement of a negative liquidation preference does not by itself turn later gains into employment income. The decisive factor is whether additional circumstances exist that establish a connection to the employee’s individual employment relationship.
The guidance therefore confirms a principle that is highly relevant in practice: Employee equity interests are not automatically treated as employment income for tax purposes simply because they are granted to employees.
Tax pitfalls in employee equity participation: These structures require attention
The guidance identifies several scenarios in which the tax authorities are likely to take a closer look. Employment income may become relevant, in particular, if the equity interest is not structured economically like a genuine ownership interest.
The following situations are particularly critical:
- The employee does not obtain beneficial ownership of the shares.
- The equity interest is not legally validly established or is not actually implemented in accordance with the agreed terms.
- The employee receives proceeds exceeding those to which they are entitled under the corporate law arrangements.
- The equity interest is not transferred at market value, for example because the liquidation preference is set too low.
- The equity interest has no independent economic substance because proceeds are only provided if the employee continues to perform services for the company.
The last point is particularly important in practice. If an employee only participates in proceeds as long as they continue to work for the company, this may indicate that the arrangement does not constitute a genuine equity interest. By contrast, if the employee remains entitled to the proceeds even without performing services – for example, in the event of illness – this generally supports the conclusion under the guidance that the equity interest has its own independent economic substance.
Another interesting point is that, according to the guidance, the termination of the employee’s equity participation upon termination of the employment relationship does not necessarily prevent the participation from being considered independent. This is particularly relevant for vesting, leaver, and repurchase provisions in equity participation programs.
How to structure Hurdle Shares in a tax-efficient way: Key considerations
The guidance is a positive signal for structuring practices. Hurdle Shares remain an attractive instrument for allowing employees and management to participate in future increases in value without granting them a share in the company’s existing value.
However, companies should ensure that their equity participation programs are not only “tax-efficient” in principle, but also carefully structured from a legal and economic perspective. The following points are particularly important:
Proper implementation under corporate caw
The equity participation must be legally validly established and actually implemented in accordance with the agreed terms.
Transparent and defensible valuation
The fair market value of the equity interest and the impact of the negative liquidation preference should be properly documented.
Market-based terms
The grant, repurchase, and sale of the equity interest should take place on arm’s-length terms and at market value.
Independent economic substance
The equity interest should not merely constitute a disguised bonus payment. Employees should receive a genuine legal position that can be distinguished from their employment relationship.
Coordination of tax, corporate, and employment law
Employee equity arrangements regularly involve multiple areas of law. In addition to wage and income tax considerations, corporate law, employment law, and, where applicable, social security implications must also be taken into account.
Greater certainty for companies, investors and founders
The guidance issued by the Bavarian tax authorities provides welcome clarity: Hurdle Shares do not become employment income solely because they include a negative liquidation preference. If the equity participation is properly structured, valued, and implemented, subsequent proceeds can generally be treated as income from an independent equity investment.
At the same time, the guidance also shows which aspects the tax authorities are likely to scrutinize in the future. Employee equity arrangements must have genuine economic substance and must be intended as real equity participation.
For companies, investors, and founders, this means that Hurdle Shares can be a powerful tool for retaining employees – but they should be structured properly from both a legal and tax perspective from the outset.
WINHELLER advises on employee equity participation and Hurdle Shares in Germany
WINHELLER supports companies, shareholders, and investors in the legally compliant structuring of employee equity participation programs – ranging from traditional equity models and virtual participation plans to crypto token programs, Hurdle Shares, management equity arrangements, and participation programs for start-up and private equity structures.
We review the tax implications, develop suitable corporate law structures, and assist with the contractual implementation of such programs. Please feel free to contact us if you are planning to introduce, review, or optimize an employee equity participation program from a tax perspective.
Our attorneys and tax advisors will be happy to support you!
