By Joe Wallin and Dan Wright of Clark Nuber
Is it more complex to make a compensatory equity grant from an LLC (taxed as a partnership) than from a corporation?
Granting service providers an equity interest in an LLC is much more complex than granting an equity interest in a corporation. Here are just a few of the reasons:
- Once an employee receives equity in an LLC, the employee can no longer be considered an employee for federal income tax purposes. Instead, for federal income tax purposes, they have to be treated as “partners.” (They can still be employees for state law purposes.) This means that instead of having income and employment taxes withheld from their paychecks and receiving a Form W-2, they will instead have to make quarterly tax deposits themselves as a self-employed person, pay self-employment taxes, and receive a Form K1 from the company.
Employees who receive an equity grant in a corporation, in contrast, continue to retain employee status and receive a W-2 reporting their salary/withholding information.
W-2 reporting (v. Schedule K1 reporting) is generally easier to understand.
- Usually when a company wants to grant an equity award to a service provider, it doesn’t want the equity award recipient to owe tax upon the receipt of the award. To do this in either an LLC or a corporation, it is necessary to value the equity to be awarded (and in the corporation context grant a stock option at FMV). However, in an LLC, there is really no corollary to granting a FMV stock option. Unless the recipient of the award pays FMV for the award, it is necessary to take the additional steps to ensure that the equity award qualifies as a “profits interest.”
- A “profits interest” is defined in Rev. Proc. 93-27 and 2001-43 to mean an interest that entitles the holder to only a share of the future profits of a company. When the LLC holds assets that have appreciated before the equity grant, in order to grant a profits interest to the recipient, adjustments need to be made on the books of the LLC to reflect the pre-equity grant appreciation in the capital accounts of the existing members. This is often referred to as a “book-up”. The federal tax accounting required to “book up” the capital accounts can be complex. Frequent capital account “book-up” adjustments resulting from compensatory grants can make this difficult for the members to understand and expensive to track, especially if the value of the equity fluctuates significantly between equity grants. Corporations do not have to track capital accounts.
Suppose Moe, Larry and Curly own an LLC together. They have been working on the LLC’s business for several years. They believe the business is worth $1 Million. Moe, Larry and Curly’s capital accounts, for tax purposes, aggregate to $100,000. Their capital accounts don’t aggregate to $1M because the company has unrealized (unbooked) appreciation in its assets of $900,000. The LLC wants to grant a 10% equity interest to Noob. The fundamental question is – do Moe, Larry and Curly want to give Noob 10% of the current $1M value – a $100,000 equity award. Or do they want to give Noob a 10% share of appreciation in the business from $1M and up?
Usually Moe, Larry and Curly want to give the Noob just a share in future appreciation in the business above and beyond $1M. To do this in the LLC context, they have to book up their capital accounts to aggregate $1M. This is not necessary in the corporate context.
When favorable circumstances exist, electing to organize a business as an LLC can produce significant tax and legal advantages. However, when it comes to administering equity grants, one should carefully consider the costs and benefits of the additional tax, legal and accounting complexities associated with granting LLC equity interests. Administering a stock option and/or a restricted stock plan in a C corporation context is likely to be much simpler.
I am the founder of a company. If I formed my startup as an S corporation, can I convert it to a C corporation before the end of this year and still get 1202 status for my founder stock?
Section 1202 stock is entitled to a special tax break if held for five years. If acquired between 9/27/10 and 12/31/13 – the break is 100% (subject to a generous cap).*
No. “Qualified small business stock” means stock in a C corporation, if “at the date of issuance, such corporation is a ‘qualified small business.’” A “qualified small business” means a C corporation.
What this means is that if you initially formed your company as an S corporation and you terminate your S election before the end of this year, your founder shares will not qualify for the 1202 stock benefit (because you will have not received them when the company was a C corporation).
If you convert to a C corporation, subsequent investors may obtain the 1202 benefit, however. The reason for this? Because IRC Section 1202 (c)(1) says: “as of the date of issuance, such corporation is a qualified small business.” But shares received while the company was an S corporation cannot qualify.
The answer is different if you are currently an LLC and you incorporate. If you incorporate an LLC, your founder shares can qualify for the Section 1202 benefit.
* For more information on Section 1202 generally, please see this blog post: startuplawblog.com/section-1202-qualified-small-business-stock
Suppose you’ve decided that you want to form your new business as a corporation (not an LLC), and you are trying to figure out if it should be an S Corp or a C Corp. How do you decide? Flip a coin? Arm wrestle your co-founder? Rely upon your lawyer’s or CPA’s advice? The following is a high level summary of some of the more important federal income tax and non-tax considerations involved in choosing between doing business as an entity taxed for federal income tax purposes as:
- a C corporation (C Corp) vs.
- an S corporation (S Corp); and
I generally don’t recommend a coin toss as the method of deciding. Hopefully, the pros and cons listed below will help you.
C CORPORATION ADVANTAGES/S CORPORATION DISADVANTAGES
- Traditional Venture Capital Investments Can Be Made – C corporations can issue convertible preferred stock, the typical vehicle for a venture capital and angel investment. S corporations may have a single class of stock only and therefore cannot issue preferred stock.
- Retention of Earnings/Reinvestment of Capital – Because a C corporation’s income does not flow or pass-through to its shareholders, C corporations are not subject to pressure from their shareholders to distribute cash to cover their shareholders’ share of the taxes payable on account of taxable income that passes through to them. An S corporation’s pass-through taxation may make conservation and reinvestment of operating capital difficult because S corporations typically must distribute cash to enable shareholders to pay the taxes on their pro rata portion of the S corporation’s income (S corporation shareholders are taxed on the income of the corporation regardless of whether any cash is distributed to them).
- No Single Class of Stock Restriction – S corporations can only have one economic class of stock; thus, S corporations cannot issue preferred stock. This restriction can arise unexpectedly, and must be considered whenever issuing equity, including stock options or warrants. (S corporations can, by the way, issue voting and non-voting stock, as long as the stock is economically the same class.)
- Flexibility of Ownership – 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 100 shareholders, generally cannot have non-individual shareholders, and cannot have foreign shareholders (all shareholders must be U.S. residents or citizens).
- Eligibility for Qualified Small Business Stock Benefits – 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, such as the 50% gain exclusion for gain on the sale of qualified stock held for more than five (5) years (for an effective capital gains rate of 14%) and the ability to roll over gain on the sale of qualified stock into other qualified stock. Currently, for C corporations acquired before the end of 2013, this exclusion is 100% (subject to a generous cap).
- More Certainty in Tax Status – A C corporation’s tax status is more certain than an S corporation’s; e.g., a C corporation does not have to file an election to obtain its tax status. S corporations must meet certain criteria to elect S corporation status; must elect S corporation status; and then not “bust” that status by violating one of the eligibility criteria.
- Avoidance of Shareholder State Income Tax Problems – Shareholders of an S corporation may be subject to income taxes in states in which the S corporation does business.
S CORPORATION ADVANTAGES/C CORPORATION DISADVANTAGES
- Single Level of Tax – S corporations are pass-through entities: their income is subject to only one level of tax at the shareholder level. A C corporation’s income is taxable at the corporate level and distributions of earnings and profits to shareholders (i.e., dividends) that have already been taxed at the C corporation level are also taxable to the shareholders (i.e., the dividends are effectively taxed twice). This rule is also generally applicable on liquidation of the entity.
- Pass-Through of Losses – Generally losses, deductions, credits and other tax benefit items pass-through to a S corporation’s shareholders and may offset other income on their individual tax returns. These returns are subject to passive activity loss limitation rules, at risk limitation rules, basis limitation rules, and other applicable limitations. A C corporation’s losses do not pass through to its shareholders.