What Happens if My Company Does Not Qualify for the Startup ESS Scheme?

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Table of Contents

• Startup ESS Tax Concessions 
• Premium Priced Option Plan
• Limited Recourse Loan Plan
• Partly Paid Share Plan
• Key Takeaways

As a startup owner, you may wish to incentivise your employees with equity. To do so, you should find a plan that minimises your employees’ tax consequences. Likewise, you want to minimise the amount that your employees must pay upfront for that equity. Although the startup ESS scheme addresses these needs, only startups who meet certain eligibility criteria can access these rules. This article sets out some alternatives to the ESS scheme that your startup may consider if it does not qualify. 

This article is Part 2 of Alternatives to Startup ESS Tax Concessions. You can read Part 1 here.

Startup ESS Tax Concessions 

One of the most common ways startups and early-stage companies will offer their staff equity is using an option plan or share plan. These schemes are compliant with the Australian Taxation Office’s startup tax concession rules. 

Your startup must first meet certain eligibility criteria before it can use an option plan or share plan. If eligible, your startup may also rely on certain valuation methodologies. These are known as the ‘safe-harbour valuation methodologies.’ The result is that your employees can pay a low price for their options or shares. Likewise, your employees will only be taxed when you make a financial gain from your equity interest (usually when selling that interest).

You can read more about the ESS tax concessions rules in our Employee Share Schemes guide. 

However, startups can only rely on these rules if they meet the relevant eligibility criteria. It may be the case that your startup is not eligible because it fails to meet one or more of the requirements. For example, your company may not qualify because it was incorporated more than ten years ago. As such, your company may have to consider alternatives to the ESS scheme discussed below.

Premium Priced Option Plan

A premium priced option plan involves the company issuing options with an exercise price. The price is usually sufficiently above the market value of the underlying shares. This will result in the options having no intrinsic market value. Hene, the value of the options for tax purposes is nil.

Your tax advisor can help you determine the appropriate exercise price following the relevant tax rules to obtain a nil valuation for the options. 

One issue is that the 12 month holding period to access the capital gains tax (CGT) discount restarts when you exercise options. Hence, employees may not want to have a long vesting period which delays their ability to exercise their options.

You will need to consider the potential exercise prices under a premium priced option plan. Ask yourself whether such prices are financially feasible for your employees.

Limited Recourse Loan Plan

Under a limited recourse loan plan, you provide employees with a limited recourse loan to acquire shares at their market value. You can apply any dividends which your employees pay on those shares against the outstanding loan balance.

If a liquidity event occurs (for example, an IPO or a trade sale), or if the employee ceases employment, the employee must either:

• forfeit the shares; or
• fully repay the outstanding loan balance (in which case, they can retain the shares).

Suppose the employee is an existing shareholder. You will need to consider that private companies’ loans to their shareholders may be treated as a dividend for income tax purposes. You will also need to consider whether the loan to the employee will give rise to fringe benefit tax issues.

A key consideration is that your employees obtain all their shares upfront under a limited recourse loan plan. This is unlike an options plan. As such, be aware that your employees will have full legal ownership of their shares. Further, they will be entitled to exercise their share rights (subject to the terms of the company’s constitution or shareholders agreement).

Partly Paid Share Plan

A partly paid share plan involves your startup or company issuing shares to an employee at the shares’ market value. However, the shares are partially paid. Hence, your employees do not need to pay the full value upfront).

The employee is liable to your company for the unpaid balance on the shares. Any dividends paid on the shares can be applied against the outstanding amounts on the shares.

As with the limited recourse loan plan, under a partly paid share plan, the employees obtain all their shares upfront. Therefore, they will have full legal ownership of their shares and be entitled to exercise their share rights. Again, this is subject to the terms of your company’s constitution or shareholders agreement.

Key Takeaways

Some alternatives to the ESS scheme are premium priced option plans, limited recourse loan plans and partly paid share plans. Suppose you intend to issue equity to employees using a plan which does not rely on the startup tax concessional rules. In that case, you must obtain tax advice because different equity plans will have different consequences for income tax, CGT and fringe benefit tax. These rules are complex. Ensure you understand the different implications of these plans on your company before proceeding with any.

If you would like to discuss startup option or share plans, contact LegalVision’s startup lawyers on 1300 544 755 or fill out the form on this page.