November 19, 2024

Choice of Entity

When deciding whether to form a startup company as a C corporation, S corporation, partnership, or limited liability company (LLC), there are important tax considerations. For example, a C corporation's income is taxed at both the entity level and again at the stockholder level when profits are distributed (i.e., "double taxation"). Despite this, the corporate tax rate (21%) is relatively low compared to recent historical levels, so startups who prioritize reinvestment over profit distributions can benefit greatly from the current low rate environment. Moreover, qualifying C corporation shareholders can potentially take advantage of the benefits of Section 1202 by excluding a considerable portion of the gain recognized on a subsequent sale.  

In contrast, S corporations, partnerships and LLCs (taxed as partnerships or disregarded entities) are "pass-through" entities for tax purposes, meaning they are not taxed at the entity level. Instead, profits and losses are passed through to the individual owners, who report them on their personal tax returns (which are therefore subject to a higher applicable tax rate). While a pass-through structure avoids double taxation, it can be less appealing in other ways. For example, S corporations are limited in the number and type of shareholders. S corporations are also limited to a single class of stock, making it difficult to structure various equity compensation and/or profit distribution arrangements. Partnerships are considerably more flexible in the number and types of equity arrangements and can provide for elaborate profit distribution schemes (i.e., distribution waterfalls), but their owners are typically subject to self-employment tax on their distributive share of income.

Note that LLCs can be classified in various ways for U.S. federal income tax purposes: as disregarded entities, C corporations, S corporations, or partnerships. For single-member LLCs, the default classification is as a disregarded entity, while multiple-member LLCs are generally treated as partnerships for tax purposes. While there is a trend among tax practitioners to elect S corporation status for LLCs, this invites more problems than solutions and is generally not recommended.

Equity Compensation Arrangements

The type of equity compensation offered to employees also has important tax implications that can affect a startup's future. Equity compensation can take many forms, including restricted stock, incentive stock options (ISOs), non-qualified stock options (NQSOs), restricted stock units (RSUs), phantom stock and stock appreciation rights (SARs). While all these methods aim to incentivize employees to contribute to the company's growth, each has distinct tax consequences.

Restricted stock refers to grants of actual stock with certain restrictions, such as transfer limitations until the shares vest. Vesting can be based on time or performance (including remaining employed with the company), with the latter often tied to financial targets like revenue goals. Restricted stock is common in early-stage startups when stock value is low and is frequently awarded to founders and early employees.

Stock options give employees the right to purchase shares at a specified price in the future, typically subject to time-based vesting. The tax treatment of stock options depends on whether they are classified as ISOs or NQSOs. ISOs are taxed more favorably (typically subject to capital gains tax rates) and have more rules governing their issuance and subsequent disposition. Meanwhile, NQSOs are simpler to craft and more commonly issued, but are taxed as ordinary income.

RSUs represent a promise to deliver shares at a future date, contingent on the fulfillment of certain vesting conditions. Unlike restricted stock, the employee does not own the shares until they vest, though some companies may provide "dividend equivalents" (i.e., payments that correspond to dividends that accrue during the vesting period). RSUs are commonly employed by more established companies.

Phantom stock grants employees the benefits of stock price appreciation without actual ownership of shares. The employee's account is credited with hypothetical shares, and upon vesting, the employee receives the value of those shares (settled in cash or stock), including any dividends paid during the vesting period. Phantom stock awards are generally not considered a second class of stock, and therefore may be the only option for S corporations looking to offer equity incentives to key employees. Similar to phantom stock, SARs allow employees to benefit from the increase in stock value over time. However, SARs provide a cash or stock payment based on the appreciation of the stock during the vesting period, rather than granting ownership of the stock itself.

Conclusion

When starting a new venture, the choice of entity directly affects the tax profile of the company and its owners, as well as its options for future equity awards. Each choice should be carefully considered at the outset based on the goals of the startup.