Avoiding a Trap for the Unwary: Gains from Secondary Sales Treated as Compensation

October 6, 2022

Founders and other employees of private companies commonly employ sales of stock in the secondary market as a means of accessing cash prior to an offering or exit. Such sales are typically structured as a direct purchase of stock by a third-party investor or as a stock buyback by the company. Many founders face an unwelcome surprise when a portion of the sale proceeds are treated as compensation for services subject to tax as ordinary income as opposed to capital gains.

The possibility that sale proceeds will be treated as compensation arises whenever the purchase price per share in a secondary transaction exceeds other indications of fair market value of the common stock being sold, such as the company’s option price or a recent 409A valuation. The theory is that the company, in allowing the founder to sell common stock for a price greater than its fair market value, is providing a benefit to the founder which is compensatory in nature.

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