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The identity of the grantees, the timing of the awards, and the size of the awards would all be at the discretion of the board, with no requirement for uniformity. Each grantee would receive an agreement, setting out the terms and conditions of his or her award. This memo is based on the assumption that the employer company is a C Corporation, but the tax, securities and accounting principles would apply to S Corporations as well.
However, S Corporations establishing equity compensation arrangements need to be mindful of the shareholder limit, and the requirement that the corporation have only one class of stock. Generally, a typical employee option to acquire common shares of an S Corporation has not been considered to be a separate class of stock. Phantom arrangements may be unattractive for S Corporations, not only because of the risk that the phantom arrangement could be deemed a separate class of stock, but also because of the potential difficulty of building a reserve to meet the eventual cash obligation.
The funds would be taxed to shareholders in the year they are earned and set aside by the corporation, but the corporation would not be able to take a deduction until the year of payment.
The exercise price must be not less than the fair market value of the stock on the date of grant. The right to exercise the option will typically vest over years, but vesting terms is determined solely at the discretion of the board. The term of an option is typically 10 years. A vested option could be exercised anytime during the year term while the grantee is employed, and for a limited period of time e. A form of option which is subject to certain volume limits and holding period requirements.
The employee receives special tax treatment. The company generally has no deduction available. Vesting conditions may be time-based or performance based. It is the most comprehensive practical and legal guide available, written to help investors and entrepreneurs avoid making expensive mistakes. Purchase the book to support the authors and the ad-free Holloway reading experience.
You get instant digital access, commentary and future updates, and a high-quality PDF download. This can be a more complex question than you might think. In general, for federal income tax purposes, there are three types of entities to choose from:. What primarily differentiates these business entities from one another is their federal income tax characteristics:.
C Corporation. A C Corporation is an entity that, in contrast to an S Corporation or an LLC taxed as a partnership, is subject to federal income tax and pays federal income taxes on its income. Its shareholders are not subject to tax unless the corporation pays amounts to them in the form of dividends, distributions, or salary. S Corporation. An S Corporation is not subject to federal income tax.
Investors generally prefer C corporations. If you plan to raise money from investors, then a C corporation is probably a better choice than an S corporation. They may not be eligible to invest in an S corporation. Thus, if you set yourself up as a C corporation, you will be in the form most investors expect and desire, and you will avoid having to convert from an S corporation or an LLC to a C corporation prior to a fund raise. Only C corporations can issue qualified small business stock.
C corporations can issue qualified small business stock. S corporations cannot issue qualified small business stock. Thus S corporation owners are ineligible for qualified small business stock benefits. This is a significant potential benefit to founders and one reason to not choose to form as an S corp.
Traditional venture capital investments can be made. C corporations can issue convertible preferred stock , the typical vehicle for a venture capital investment. S corporations cannot issue preferred stock. An S corporation can only have one class of economic stock; it can have voting and non-voting common stock , but the economic rights of the shares as opposed to the voting characteristics , have to be the same for all shares in an S corporation.
No one class of stock restriction. S corporations can only have one class of stock; S corporations cannot issue preferred stock , for example. But this restriction can arise in other situations unexpectedly, and must be considered whenever issuing equity, including stock options or warrants. Flexibility of ownership.
S corporations can issue both incentive stock options and non-qualified stock options to employees, consultants, advisors and other service. SPECIAL CONSIDERATIONS FOR S CORPORATIONS. number of shares reserved for issuance, the corporation granting options or the stock available for.
C corporations are not limited with respect to ownership participation. There is no limit on the type or number of shareholders a C corporation may have. S corporations , in contrast, can only have a limited number of shareholders, generally cannot have non-individual shareholders, and cannot have foreign shareholders all shareholders must be U. More certainty in tax status. For example, a C corporation does not have to file an election to obtain its tax status.
Single level of tax.
The book expense and the tax deduction would have been taken in the same year. That makes no sense. Share It. When the stock options are later exercised and produce a final value far above the earlier estimated book expense, corporations are happy to report that higher expense on their tax returns and thereby reduce their tax bills. As mentioned above, S corporations sponsoring ESOPs do not have to pay federal and usually state income tax on the percentage of their profits attributable to the ESOP. Amy Hanauer. Tax breaks for stock options were even larger in years before
S corporations are pass-through entities: their income is subject to only one level of tax, at the shareholder level. This rule is also generally applicable on liquidation of the entity. Pass-through of losses. Simplicity of structure. S corporations have a more easily understandable and simpler corporate structure than LLCs. S corporations can only have one class of stock—common stock—and their governing documents, articles, and bylaws are more familiar to most people in the business community than LLC operating agreements which are complex and cumbersome and rarely completely understood.
Traditional venture capital investments can be accepted. The issuance of convertible preferred stock by C corporations is the typical vehicle for venture capital investments. Venture capitalists typically will not invest in LLCs and may be precluded from doing so under their fund documents. Traditional equity compensation is available. C corporations can issue traditional stock options and incentive stock options. It is more complex for LLCs to issue the equivalent of stock options to their employees. Incentive stock options also are not available to LLCs.
Ability to participate in tax-free reorganizations. C corporations can participate in tax-free reorganizations under IRC Section Qualified small business stock benefits. LLCs cannot issue qualified small business stock. Self-employment taxes. Fringe benefits. C corporations have more favorable treatment of fringe benefits.
State income tax return filing requirements. Each member of the LLC may be required to file a tax return in multiple states. This is not the case with C corporations. The flexible nature of LLCs makes them more complex.
Partnership tax is also substantially more complex than C corporation tax. The relatively new nature of the LLC form and limited amount of case law make LLC transactions more complex and uncertain than their corporate counterparts. Tax rates. Individual income tax rates can be higher than the highest stated corporate tax rates. Administrative burdens. Partnership tax accounting is more complex than C corporation accounting. An LLC has to withhold taxes on certain types of income allocated to foreign persons, regardless of whether distributions are made.