Navigating the Tax Complexity of Secondary Stock Sales

Author: Jonathan Ham, Partner

December 2025 – For founders and employees of privately owned companies, oftentimes their first chance for liquidity is through a “secondary sale” of a portion of their shares. The tax implications of these sales can be very dramatic, and the outcome is heavily dependent on the facts and circumstances surrounding the sale.  When contemplating these secondary sales, it is imperative that the seller avoids the potential pitfalls that could ultimately prevent capital gain treatment on the sale of the shares. This article discusses the various factors that dictate the tax treatment associated with these secondary sales and how to preserve capital gain treatment without subjecting any portion of the sale to ordinary income treatment.

Tax Treatment of Secondary Sales – Considerations for Founders, Employees, and Investors

In recent years, sales of private company stock to both new investors and existing investors has become commonplace for founders, employees, and existing investors. As with most things that become more prevalent over time, the increase in these “secondary sales” is directly tied to the necessity and utility of these sales for all parties involved. Oftentimes a secondary sale can be driven by any (or a combination) of the following:

1. To maintain their cap table (i.e. existing ownership structure and corresponding ownership percentages)
2. To not dilute existing shareholders
3. To offer liquidity to existing shareholders (founders, employees, or otherwise)
4. To offer additional shares to new or existing shareholders
5. To offer shares to strategic investors
6. To meet certain minimum investment or ownership requirements for new or existing shareholders

These secondary sales come in a number of variations and scenarios. Historically, secondary sales often came about at the time of a new round of financing. As part of the round of financing, the investors participating in the round would purchase shares from the existing shareholders (which was often limited to a certain percentage of the investors existing shareholdings).  Generally speaking, the investors participating in the rounds were venture funds or similarly structured investment vehicles.  In recent years, this has been changing as there has been significant demand for private company securities coming from “retail” investors. Because of this demand, a number of marketplaces and companies specializing in brokering private company stock sales has now opened up the market for these retail investors who previously had no access to these companies’ cap tables given that they had no connection to the company or access to the venture funds investing in these companies. With these markets in place, secondary sales have become even more commonplace and the tax issues surrounding these sales often come to the forefront of an existing shareholder’s decision-making process when it does come time to decide whether to sell.

What It Means from a Tax Perspective

In general, when a taxpayer sells shares of stock, the gain on the sale of the stock is characterized as capital gain. If the stock was held for more than one year at the time of the sale, the gain is considered to be a long-term capital gain which is subject to preferential tax rates for federal (and some state) income tax purposes.  In a secondary sale, the stock is sold at a price determined by any number of factors including:

1. The price is determined by the round of financing that is being done at the same time that the secondary is being offered
2. The price is determined based on a discount to the preferred shares at a current or recent round of financing due to the preferences available to the preferred stock as compared to the common stock
3. The price is determined by the marketplace brokering the transaction and varies by recent sales and availability of shares available in the market

Generally speaking, the price of shares sold in secondaries is significantly higher than the company’s Section 409A value (which is the value that the company uses for issuance of their stock options, restricted stock, etc.).  The premium that is paid above the Section 409A value has been subject to much discussion in recent years from a tax perspective. In fact, this is often the first issue that is brought to the attention of a shareholder when considering whether to sell shares in a secondary sale. The question is whether all of the gain on the sale of the shares will be considered capital gain or whether a portion of the gain (specifically related to the premium paid above the Section 409A price) will be considered compensatory (and therefore subject to the highest federal and state income tax rates). If a portion is compensatory, this could lead to a number of other issues in addition to the shareholder potentially opting not to participate in the secondary sale at all.

The Law

To date, the tax guidance surrounding this issue has predominantly been guided by case law which has touched on various fact patterns specific to those taxpayers, of which, none are directly on point with this particular issue. The genesis of the question of whether a portion of the secondary proceeds could be considered compensatory is tied to a lengthy history of court cases centered around companies conferring assets or other items of value to employees or other service providers outside of their normal compensation structure.  The outcome of these cases generally sides with the IRS in asserting that property received by employees and other service providers is generally considered compensation. Given this history, the concern is that redemptions (i.e. re-purchases) of stock by the company at prices greater than the company’s Section 409A value could be considered compensation. Additionally, there is concern from some practitioners that the IRS could assert that an investment (i.e. purchase of shares) by an outside investor could be recharacterized by the IRS as an equity contribution to the company from the investor followed by a subsequent compensatory payment from the company to the employee or service provider. The case law for this particular concern is very limited, but it is important to consider and analyze your fact pattern and understand which of the following factors may be important when determining if there is potentially a compensatory element to your secondary sale. The following considerations should be reviewed and understood prior to selling:

1. Was the stock sold to the company (i.e. a redemption or re-purchase)
2. Does the company intend to declare any part of the transaction as compensatory and subject it to wage and withholding requirements?
3. Does the company intend to claim a deduction for any value of the shares treated as compensatory?
5. Was the stock sold to any existing investors?
6. Was the stock sold to any new investors?
7. Are all shareholders able to sell a portion of their shares, or is it limited to specific employees?
8. Are all shareholders selling their shares at the same price?
9. If all shareholders are not selling at the same price, how is the price being determined? Is the price being negotiated separately by each respective seller?




Ancillary Issues



It is beyond the scope of this article, but it should be noted that there are a number of ancillary issues that should be analyzed and reviewed by the applicable parties when undertaking a secondary sale. The following is a non-exhaustive list of items that should be considered:

1. Dividend versus capital gain treatment when redeeming
2. Converting from common stock to preferred stock as part of the secondary
3. Exercising stock options or selling shares resulting from stock options in the secondary sale
4. Qualified Small Business Stock (QSBS) gain exclusion under Section 1202
5. Wage and withholding issues for the company
6. GAAP deduction issues and reporting for the company



Oftentimes there is a path to full capital gain treatment for shareholders when selling in a secondary. As with most tax planning, there are always a number of items that are unique and specific to an individual’s situation. It is important to understand your fact pattern and the potential risks and pitfalls to avoid prior to selling and to seek tax advice when appropriate.

If you are considering a secondary sale—or expect one to be on the horizon—engaging a tax advisor early can help identify potential issues, evaluate alternatives, and position the transaction to achieve the most favorable outcome. Proactive planning and thoughtful structuring can make a meaningful difference in both the tax result and overall success of the transaction.

 



About the Author Jonathan Ham, Partner
Income Tax Planning and Consulting / LinkedIn / E-mail

Jonathan Ham is a partner in the Tax practice at Frank, Rimerman + Co. He works with high net worth individuals, venture funds, and closely held corporations and partnerships. Jonathan’s expertise includes gift and estate planning, charitable planning, stock option planning, qualified small business stock planning, entity structuring, state and foreign tax compliance, residency issues, various forms of trusts (GRATs, DGTs, CRTs, CLTs, ILITs), and family partnership structures.




IRS Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

The material appearing in this communication is for informational purposes only and should not be construed as legal, accounting, tax, or investment advice or opinion provided by Frank, Rimerman + Co. LLP or its subsidiaries or affiliates. This information is not intended to create, and receipt does not constitute, a legal relationship, including, but not limited to, an accountant-client relationship. Although these materials have been prepared by professionals, the user should not substitute these materials for professional services and should seek advice from an independent advisor before acting on any information presented. Frank, Rimerman + Co. LLP and its subsidiaries or affiliates assume no obligation to provide notification of changes in tax laws or other factors that could affect the information provided.