Can you do it? Yes. But let’s start with some background info.
One thing that many people do not realize is that the S corporation is simply a tax designation that founders may make upon incorporating their business. From a state perspective, the entity is either a corporation or a limited liability company (or maybe a partnership), but from the IRS perspective, the entity is a C corporation, a partnership, or an S corp.
S corporations provide a unique blend of the benefits of C corporations and LLCs. Like LLCs, S corporations enjoy flow through taxation. This means that (like a partnership) an S corporation’s shareholders are taxed at the individual level on the profits of the business, rather than paying income tax at the corporate level. Like C corporations, S corporations have shareholders and a board of directors, but unlike C corporations, they are limited to 100 shareholders, they can have only a single class of stock, and their shareholders must be individuals who are U.S. citizens or permanent residents. Therefore, partnerships, LLCs, corporations and other entities cannot be shareholders of S corporations (with a few minor exceptions).
For those that may not know, stock options provide holders the right to purchase a predetermined number of shares at a preset price during a specific window of time. They are frequently used as part of the compensation package for startup companies because a company can give an employee some upside in a tax advantaged way without giving up any voting power.
Almost all venture-backed businesses are taxed as C corporations (learn more here), and many venture-backed companies issue stock options as part of the compensation package for key employees. So most people know that C corporations can issue stock options. But before businesses are venture-backed sometimes it can be beneficial to the founders to have the company be taxed differently. So, if the founders (with the advice of their tax advisor) elect to have the company taxed as an S corp, can the company still issue stock options to key employees?
Thankfully, the answer is yes, provided that the stock option grants do not violate (or lead the company down the path toward violating) the additional restrictions that come along with S corporation tax status. Holders of stock options are not actually shareholders until the options are exercised (they have no voting rights, they do not share in dividends, and therefore have no tax liability w/r/t the company’s profits), so issuing stock options to individuals who would be unable to hold stock in an S corp does not technically violate the S corp restrictions, but it does put the company in a position to lose S corp status up on execution of the options. S corporations can issue both incentive stock options and non-qualified stock options to employees, consultants, advisors and other service providers.
Additional Resources:
- Venture Financing Tips Video Series
- Super-Simple Entity Formation Checklist
- Selecting a Business Entity Blog
Please note – the lawyers at Fourscore Business Law are experienced in business matters of many kinds, which give us the opportunity to be involved in tax discussions on a regular basis. However, we are not CPAs or “tax” lawyers. We have many great contacts and refer our clients to them when needed. Please do not take the summary set forth in this article as tax or business planning advice!
Based in the Research Triangle region of North Carolina, Fourscore Business Law serves entrepreneurs and businesses in Raleigh, Durham, Chapel Hill, Wilmington, Charlotte and throughout the Southeast. We also represent venture capital funds and other investors who invest in companies located in New York, Silicon Valley and everywhere between.The idea of delivering maximum impact in a simple and succinct manner is what we’re calling the Fourscore Principle. And that is what Fourscore Business Law is based on. Our clients operate in a broad range of industries including tech, IoT, consumer products, B2B services and more. Questions? Shoot us an email or give us a call at (919) 307-5356. Your first call is on us.
