Employee participation is an important tool for many growth companies to involve employees in future success without having to pay high salaries immediately. With guidance of 28 May 2026, the Bavarian State Tax Office ("BayLfSt") has taken a position on how employee participation arrangements with a negative liquidation preference, i.e. so-called Hurdle Shares, are to be classified for wage tax purposes. For the first time, the tax administration now provides clarity on when the grant of such shares gives rise to employment income and how later proceeds are to be treated for tax purposes.
Background
In addition to incentivising employees, tax considerations are a key driver in structuring employee participation programs: tax issues first arise when the participation is granted. A transfer of shares in the company to employees at a consideration below fair market value gives rise to fully taxable employment income, which must already be taxed at the time the participation is granted (the so-called dry-income). If proceeds from the participation are received at a later date, the question arises whether these proceeds are to be classified as employment income or as income from capital assets. The tax consequences can be significant, since income from capital assets is subject to a flat tax regime (Abgeltungsteuer) or the partial income method (Teileinkünfteverfahren), whereas employment income is taxed at the individual income tax rate.
What Are Hurdle Shares Anyway?
Hurdle Shares are shares in a company that carry a negative exit and liquidation preference. Unlike virtual participation programs (VSOPs), the holder of Hurdle Shares is a shareholder in the company. However, Hurdle Shares participate in all distributions from a company (current income, in particular dividends; sale proceeds; liquidation proceeds) if and to the extent a certain predefined participation threshold (the hurdle) has been reached. The proceeds attributable to the negative liquidation preference up to the point at which the hurdle is reached are allocated to the other shareholders. As a rule, the hurdle is based on the valuation at the time the Hurdle Shares are granted, meaning that the holders of Hurdle Shares participate only in future increases in the company's value, but not in value already existing at the time of grant.
Example:
An employee acquires a total of 100 shares in the company of his employer, A-GmbH, in year 1. The purchase price per share corresponds to the nominal value of EUR 1 per share. The fair market value of one share is EUR 2,000. In addition, a negative liquidation preference of EUR 1,999 per share is agreed.
In year 4, A-GmbH is sold to an investor. The purchase price amounts to EUR 5,000 per share.
Solution
The employee receives the following proceeds:
proceeds per share EUR 5,000
less exit preference EUR - 1,999
Sale proceeds per Hurdle Share EUR 3,001
For the 100 shares, the employee receives EUR 300,100.
This is precisely why the model is attractive for companies. It enables participation in further growth without employees having to fund the full current market value of a share. At the same time, this avoids the assumption of a high taxable benefit already at grant of the shares. If the contractual arrangements are structured correctly, the returns on the Hurdle Shares are regularly treated not as (fully taxable) employment income but as tax-favoured income from capital assets.
Tax Treatment Guidance of the BayLfSt
Tax Treatment of the Grant of Hurdle Shares
The guidance expressly states that employee participation only gives rise to employment income at the time of grant if it is transferred at a discount. For valuation purposes, the agreed negative liquidation preference must be taken into account because it reduces the fair market value of the shares. This is precisely the key tax lever of the model.
According to BayLfSt, the negative preference must be deducted when valuing the transferred shares. Since the nominal amount the employee usually has to pay for the Hurdle Shares at grant corresponds, due to the hurdle rule, to the fair market value of the shares (see example above), there is no discounted issue of shares. Accordingly, in the example, no taxable non-cash benefit arises.
In the past, there has always been uncertainty as to whether, and to what extent, a negative liquidation preference must be deducted in determining fair market value. With the guidance, the BayLfSt now expressly clarifies that the negative liquidation preference reduces the fair market value of the shares and must therefore be taken into account when assessing any discount.
Tax Treatment of Returns from Hurdle Shares
A second important clarification in the BayLfSt guidance concerns the tax treatment of proceeds from the participation. The guidance emphasizes that proceeds from employee participation can either be employment income (Sec. 19 German Income Tax Act (EStG)) or income from a separate legal relationship independent of the employment relationship (Secs. 17, 20 or 23 German Income Tax Act (EStG)), and that the agreement of a negative liquidation preference does not per se mean that proceeds from Hurdle Shares are to be treated as employment income. In line with current case law of the Federal Fiscal Court (BFH) (see, for example, BFH VI R 1/21, VIII R 13/23 and VIII R 14/23), the BayLfSt is of the view that a causal link to the individual employment relationship (and thus taxable employment income) exists only where further special circumstances are present. Such special circumstances may include, among others:
The employee does not have beneficial ownership of the Hurdle Shares (§ 39 para. 2 no. 1 Fiscal Code (AO)).
The participation is not validly established under civil law or is not actually implemented in accordance with the agreement.
The employee receives profit shares higher than those owed under company law.
The participation is not transferred at market price.
The participation has no independent economic substance, meaning there is no acquisition basis independent of the employment relationship. This may be the case, for example, if proceeds are provided only upon performance of work. By contrast, if the (participation) proceeds are also due even where no work is performed (e.g. in the event of illness), there will usually be independent economic substance. Termination of the participation upon termination of the employment relationship (leaver provisions), however, is not harmful for tax purposes.
Territorial Scope
Formally, the BayLfSt guidance binds only the Bavarian tax authorities. It is not evident from the guidance if and to what extent it has been substantively coordinated with the tax authorities of the other German federal states. Such clarification would be desirable from the taxpayers' perspective. In cases involving Hurdle Shares falling within the jurisdiction of the tax authorities of other federal states, however, the BayLfSt guidance can already be used at least as an argumentation aid.
Conclusion
The guidance issued by the BayLfSt provides Hurdle Shares with a marked increase in clarity regarding their tax treatment. It confirms that the negative liquidation preference must be taken into account in valuing the shares and therefore that the grant of Hurdle Shares does not automatically give rise to taxable employment income. Equally important is the statement that later proceeds are not to be treated as employment income merely because of the negative liquidation preference.
For companies, founders and employees, this is good news. The model can help to alleviate the dry-income problem at the start of employee participation and - if the model is structured correctly - opens up the possibility of receiving the proceeds as tax-privileged income from capital assets.
The clarity that now exists and the tax-favourable treatment of Hurdle Shares significantly increase the attractiveness of Hurdle Share models compared with virtual participation programs (VSOPs), which always lead to taxable employment income. The tax optimisation of exit proceeds, however, comes at a price: a Hurdle Share program is significantly more complex for the company than a purely virtual participation program.