September 22, 2023

How to grant startup equity to employees: LLCs vs. C-corps

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Attracting top-notch employees to a startup often entails offering equity alongside traditional compensation and benefits.

The way equity is issued depends on whether your startup is structured as an LLC or a C-corp. Let’s break it down:

Equity issuance for C-corps

Issuing equity is much simpler for C-corps relative to LLCs. You can grant restricted shares or stock options to early-stage employees, and the tax implications are fairly straightforward compared to those associated with LLCs. Here’s how it works:

  1. Share authorization: Corporations typically authorize ten million shares during the incorporation process. The majority of these are issued to founders, while the remainder are reserved for employees and advisors.
  2. Share purchase: Employees can only receive shares or options with an exercise price set at the fair market value at the time of purchase.
  3. Taxation post-purchase: The tax implications vary depending on how long the shares are held and when they are sold:
  • If shares or options are purchased when they are issued, there is no taxable event at the time of exercise.
  • If shares are sold within one year of purchase, the proceeds are taxed as regular income.
  • If shares are held for more than a year before being sold, the proceeds are taxed as long-term capital gains.
  • Shares held for over five years may qualify for the Qualified Small Business Stock (QSBS) exemption, which allows the employee to deduct 50% to 100% of the profits from their personal taxes.

Equity issuance for LLCs

Issuing equity in an LLC is more complex, primarily due to IRS regulations. Under these rules, W-2 employees of an LLC cannot hold equity. Thus, alternative methods of compensation must be devised.

LLCs have three primary methods for issuing equity to employees:

  1. Unit/membership interests: These are like stocks in a C-corp, as they come with voting rights. However, these are subject to taxation at the time of issuance if the fair market value of the interest isn't paid by the recipient. Generally, these are only granted during the early stages of the LLC.
  2. Profits interests: As the value of the LLC grows, profits interests become more attractive. They work similarly to stock options in a C-corp, providing the potential for benefiting from increases in equity value occurring after the grant date. If issued correctly, they can actually be received tax-free.
  3. Unit appreciation rights (UARs) or "phantom equity": This method is often used when an LLC wants to provide equity-like compensation to non-director employees while still treating them as standard W-2 employees. UARs do not offer actual equity or voting rights but rather provide a future cash payment—in a manner similar to a bonus—when specific future benchmarks are achieved.

Administering equity for employees in an LLC requires careful planning and may necessitate guidance from a tax expert. We recommend incorporating as a C-corp if you’re planning to issue equity to employees.

Why investors prefer C-corps for equity investments

On top of streamlining equity issuance for employees, C-corps also generally attract more investors due to their straightforward equity structure. Here's why:

Simplicity of share ownership: C-corps issue shares of stock, which represent ownership in the company. These shares are easy to transfer and consistently track ownership percentages. This simplicity makes managing investments easier for investors and can reduce legal and administrative friction.

Preferred shares: Investors often seek preferred shares, which LLCs are unable to issue. Preferred shares provide additional rights, such as dividends and liquidation preferences, that offer more security and potential upside for investors.

No pass-through taxation: C-corps have a double taxation structure—the corporate earnings are taxed, and then the individual dividends are taxed. This differs from LLCs' pass-through taxation, where company profits directly impact owners' personal taxes. As investors commonly prefer to separate their investment activity from personal tax situations, they often lean towards C-corps.

Familiarity: Most institutional investors, venture capitalists, and angel investors are accustomed to dealing with C-corps. This level of familiarity can streamline negotiations and reduce potential barriers to investment related to structure or legal considerations.

Equity issuance can be complex for LLCs, involving various options like unit interests, profits interests, and unit appreciation rights, each with different tax implications. In contrast, C-corps have a simpler route to incentives, primarily through issuing restricted shares or stock options.

Based on these complexities, we recommend startups opt for the C-corp structure if equity forms part of their compensation strategy.

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