Navigating Entity Formation, Incentive Compensation, and Ownership Compliance

Understanding Entity Types for Your U.S. Startup: Making the Right Choice

When embarking on the journey of forming a startup, one of the most crucial decisions you will make at the start is choosing the type of legal entity for your business. This decision may have far-reaching implications, particularly in areas of fundraising, taxation, and compliance. The three most common types of entities in the U.S. are Limited Liability Companies (LLCs), S Corporations (S Corps), and C Corporations (C Corps). Each has distinct features and implications for your business.

Although we will briefly discuss some considerations related to entity formation (this is not legal advice!), this discussion will remain at a very high level. Ultimately, this decision should be based on a careful assessment of your business goals, the nature of your activities, your financial situation, and your long-term plans.

This article is for informational purposes only and does not constitute legal or tax advice.

Limited Liability Companies (LLCs)

LLCs are often preferred for smaller startups and businesses looking for simplicity and flexibility. If you’re seeking minimal formalities and flexible tax options, an LLC might be a good choice.

Key Considerations:

Tax Flexibility: LLCs offer pass-through taxation, meaning the company itself doesn’t pay taxes. Instead, profits and losses are passed through to the owners’ personal tax returns.

Ownership and Compliance: LLCs provide a high degree of flexibility in ownership and management structures without many of the formalities required for corporations.

Future Fundraising: While LLCs are flexible, they are less attractive for venture capitalists and investors who generally prefer C Corps for equity investment due to structural and tax considerations. Although many of the common fundraising instruments (e.g., SAFEs, convertible notes) can be used by LLCs, standard agreements may have to be restructured to be appropriately applied to an LLC.

Furthermore, startups often attract talent by offering stock options or equity. In C Corps, issuing stock options is straightforward, but LLCs don’t have stock; they have membership interests, which can be more complex to allocate and value. This complexity can be a deterrent for potential employees and investors.

Ultimately, LLCs can be a great option for those who are looking for operating simplicity or flexibility in structuring the ownership interests. This is especially true for those not expecting to raise sizable amounts of capital in the future from professional investors.

S Corporations (S Corps)

Choose an S Corp provides pass-through taxation but with a more formal structure than an LLC; only U.S. citizens or residents can be shareholders.

Key Considerations:

Tax Advantages: Like LLCs, S Corps offer pass-through taxation, avoiding double taxation. Furthermore, founders/owners can pay themselves reasonable salaries for the work they do, resulting in employment taxes on only this amount and not on remaining profits that are distributed to founders/owners (compared to LLCs, where all profits are subject to self-employment taxes).

Ownership Restrictions: S Corps have restrictions on the number and type of shareholders they can have (up to 100, and individuals, certain trusts, and estates only). Shareholders must be U.S. citizens or residents. Another restriction on S Corps is that they can issue only one class of shares.

Future Fundraising: S Corps can be limiting for future fundraising, as many investors and venture capitalists. The single class of stock limitation may be the most severe to investors as the flexibility to offer different terms or preferences to different investors is a common practice in venture capital financing.

C Corporations (C Corps)

When to Choose: Opt for a C Corp if you plan to seek venture capital funding, go public, or want to offer employee stock options.

Key Considerations:

Tax Implications: C Corps are subject to corporate income tax. This can lead to double taxation (once at the corporate level and again at the shareholder level when dividends are distributed), but the tax benefits for reinvesting profits in the business are significant.

State of Incorporation: Many startups choose to incorporate in Delaware due to its well-established corporate law structure, even if they operate elsewhere.

Attracting Investors: C Corps are the most investor-friendly entity, particularly for venture capitalists and those looking to eventually go public. They allow for an unlimited number of shareholders and classes of stock.

In summary, your choice depends on your business size, ownership structure, tax considerations, and long-term goals, particularly regarding fundraising. It is often best to consult with legal and financial experts to make an informed decision that aligns with your startup’s strategic objectives.

A Note on Tax Planning: While many strategies to reduce a business owner’s tax liability—such as establishing solo or group 401(k) plans and creating family board positions—can be applied across various entity types, the choice of organizational structure plays a crucial role in tax planning. As a company grows, careful engineering of its organizational structure, in collaboration with an experienced tax and legal advisor, becomes increasingly important in helping business owners achieve their personal financial goals. The value of expert guidance in this area cannot be overstated; skilled advisors are instrumental in navigating the complexities of tax law and maximizing financial benefits.

Choosing the Right Entity Formation for Employee Ownership Options

It’s essential to address a key decision: selecting the right entity formation for offering employee ownership. Different structures–C Corporations, S Corporations, and Limited Liability Companies (LLCs)–influence your ability to distribute ownership to employees through stock options, Restricted Stock Units (RSUs), and other types of ownership.

C Corporations are often preferred for their ability to issue various types of stock, making them ideal for businesses planning to offer stock options or RSUs to employees. This flexibility is especially beneficial for startups aiming for external funding or an IPO. However, they come with double taxation and more regulatory requirements.

S Corporations, while offering similar benefits to C Corps in terms of liability protection, have restrictions on stock issuance, limiting the types of stock (single class of shares) that can be offered and to whom (U.S. citizens or residents and no more than 100 shareholders). Beyond these restrictions, there are also tax disadvantages for shareholder-employees of S Corporations (those who own at least 2% of the company)–for shareholder-employees, fringe benefits may be considered taxable income.

LLCs offer a different approach. They do not issue stock but can offer profit-sharing plans or membership interests (and options on the conveyance of membership interests). Although an LLC structure provides more flexibility in profit distribution, employee incentive plans and ownership is often clunkier and less familiar than with C Corps, often resulting in relatively less desirable outcomes for employees (and often less tax efficient for employees).

Qualified Small Business Stock (QSBS)

QSBS represents a major aspect of business investing and exit strategies, particularly for investors and founders involved in small businesses and startups. QSBS is governed by Section 1202 of the Internal Revenue Code, providing tax benefits to incentivize investments in small businesses.

Key Features of QSBS:

Capital Gains Exclusion: Investors can exclude up to 100% of the capital gains from the sale of QSBS held for more than five years, subject to certain limits.

Limit on Exclusion: The exclusion is limited to the greater of $10 million or 10 times the taxpayer’s basis in the stock (which, in theory could be nearly $50 million, resulting in a $500 million capital gains exclusion).

Eligibility Criteria: To qualify as QSBS, the stock must be in a C Corporation with gross assets of $50 million or less (at the time of stock issuance), and the corporation must meet active business requirements, using at least 80% of its assets in the operation of a qualified trade or business. Note, an LLC taxed as a C Corp may be eligible for the QSBS designation.

There are also a few key businesses that typically do not qualify for QSBS, including:

• Service Businesses: Businesses where the principal asset is the reputation or skill of one or more of its employees. This includes fields like law, health, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, and brokerage services.

• Banking, Insurance, Financing, Leasing, Investing, or Similar Businesses: These are businesses involved in banking, insurance, financing, leasing, investing, or similar activities.

• Farming Businesses: This includes businesses involved in agriculture, as well as the raising or harvesting of trees.

• Mining and Extraction Businesses: Companies involved in the extraction of natural resources, such as oil, gas, and minerals, are typically excluded.

• Hospitality Businesses: This can include hotels, motels, restaurants, and similar businesses where the primary service is providing accommodations or food to customers.

• Real Estate Businesses: Businesses involved in the development or holding of real estate. This includes real estate investment trusts (REITs) and other similar entities primarily engaged in real estate activities.

Relevance to Business Investing and Exits:

For Investors: The QSBS provision offers a substantial tax advantage, making investments in eligible small businesses more attractive. It can significantly increase the after-tax return on an investment if the business is successful.

For Founders and Employees: Founders and early employees who receive stock options may also benefit from the QSBS provision when they exercise their options and eventually sell their shares.

Some Important Dates

The percentage of capital gains exclusion for Qualified Small Business Stock (QSBS) under Section 1202 of the Internal Revenue Code can vary depending on the date when the stock was acquired. The exclusion rate is not always 100% and has changed over time:

1. Stock Acquired Before February 18, 2009: For QSBS acquired before this date, only 50% of the capital gains are eligible for exclusion. The remaining 50% is subject to regular capital gains tax, and a portion of the gain may be subject to the alternative minimum tax (AMT).

2. Stock Acquired Between February 18, 2009, and September 27, 2010: For stock acquired during this period, 75% of the capital gains can be excluded. The remaining 25% is subject to capital gains tax, and a reduced portion of the gain may be subject to AMT.

It’s important for investors, founders, and relevant stakeholders to stay informed about the latest developments in QSBS legislation. Potential rule changes, like those proposed back in 2021, could significantly impact tax planning and investment strategies related to small business investments. Professional advice from a tax expert is highly recommended to navigate these complexities and to leverage the QSBS benefits effectively.

Some more detailed information about QSBS can be found in this helpful article from Carta. Additionally, a great post by Miracle Mile Advisors here is helpful in explaining how a strategy known as “stacking” can effectively lead to an expansion of the capital gains exclusion limits.

Note on QBI Deduction: QSBS should not be confused with the Qualified Business Income (QBI) deduction, a key provision introduced by the Tax Cuts and Jobs Act of 2017, which allows owners of pass-through entities—such as sole proprietorships, partnerships, S corporations, certain trusts, estates, and LLCs depending on their tax classification—to deduct up to 20% of their qualified business income from their taxable income. It’s designed to reduce the tax burden on small business owners and self-employed individuals, making it a significant benefit for many taxpayers.

Eligible Entities: Sole proprietorships, partnerships, S corporations, some trusts and estates, and LLCs (based on their tax treatment).

Income Thresholds: The full deduction is available below specific income thresholds, which were $170,050 for single filers and $340,100 for married filing jointly in 2023, subject to annual inflation adjustments. Above these thresholds, the deduction faces limitations and phaseouts.

SSTB Limitations: High earners in specified service fields (e.g., law, health, consulting) may face limitations and can be ineligible for the deduction if their income exceeds the set thresholds. Limitations may depend on the total W-2 wages paid by the business.

Limitations for High-Income Earners: For those above the income thresholds, the deduction may be limited by the business’s wages paid and the property basis.

Sunset Provision: The QBI deduction is scheduled to sunset after December 31, 2025. Unless Congress extends or makes permanent this provision, the QBI deduction will no longer be available starting in 2026. This sunset date means that the tax benefits associated with the QBI deduction are temporary, and planning for the future tax landscape is essential for businesses and individuals taking advantage of this deduction.

Types of Employee Ownership and Incentive Compensation

When companies aim to attract, retain, and motivate employees, they often turn to various forms of employee ownership and incentive compensation programs. When done right, these mechanisms align the interests of the employees with the goals of the company and its shareholders. 

Here, we’ll delve into some of the most common forms of equity compensation and incentive schemes: Incentive Stock Options (ISOs), Non-qualified Stock Options (NSOs), Stock Appreciation Rights (SARs), Restricted Stock (RS), Restricted Stock Units (RSUs), and Performance Share Units (PSUs). Each has unique accounting (often subject to ASC 718) and tax implications, both for the company and the recipient.

But First, Let’s Talk Top-Hat Rules…

Top-hat rules come into play when dealing with certain non-qualified deferred compensation plans, which are specialized compensation arrangements designed to reward and retain key executives and highly compensated employees. 

What is a Non-Qualified Deferred Compensation Plan?

A non-qualified deferred compensation (NQDC) plan is a contractual arrangement between an employer and an employee that allows the employee to defer receiving a portion of their compensation until a later date. This deferral can apply to salary, bonuses, or other forms of compensation, and the plan is typically designed to provide additional retirement benefits or reward long-term service. 

These plans are “non-qualified” in the sense that they do not meet the stringent regulatory requirements set out for qualified retirement plans under ERISA and the Internal Revenue Code (e.g., funding, fiduciary responsibilities, nondiscrimination testing, contribution limits, and detailed reporting and disclosure requirements). This non-qualified status allows them to offer greater flexibility in plan design, participation, and funding, but at the cost of the tax advantages and protections that come with qualified plans. 

Unlike qualified plans where employer contributions are often tax deductible for the employer yet contributions are often tax-deferred for the participant until distribution, NQDC plans do not offer the same tax advantages unless structured under specific rules.

Unlike qualified plans, which must adhere to strict ERISA regulations, non-qualified deferred compensation plans can offer greater flexibility while being subject to fewer regulatory protections, especially if a “top-hat plan”. NQDC plans often take the form of SARs, RSUs, NSOs, or similar programs.

A top-hat plan is a particular type of NQDC plan that is only offered to a “select group of management or highly compensated” employees. Although this group is not defined, some advisors say that case law has suggested this group to be no more than ~15% of total employees. When these plans meet the criteria, they are exempt from the more rigorous requirements of ERISA, including those that affect many non-top-hat NQDC plans. Some of the benefits 

• Funding Rules: Unlike other NQDC plans that might need to adhere to certain funding rules, top-hat plans do not require assets to be set aside in a trust or a separate account. This means that the employer can keep the deferred compensation as part of the company’s general assets, providing more liquidity and flexibility in managing company finances.
• Nondiscrimination Rules and Contribution Limits (discussed further below: A top-hat plan by definition does not abide by ERISA’s nondiscrimination rules, which can be a huge benefit for incentive plans that are targeting a select group of employees. Similarly, most NQDC plans (including non-top-hat) do not have to abide by the contribution limits on qualified plans.
• Fiduciary Responsibilities: Top-hat plans are not subject to ERISA’s fiduciary duties, which means the plan administrator does not have the same legal obligations to act solely in the interest of plan participants. This reduces the legal and administrative burden on the employer and allows more flexibility in managing the plan.
• Reporting and Disclosure: Top-hat plans are exempt from many of the detailed reporting and disclosure requirements that apply to other ERISA-covered plans. While a top-hat plan must file a simple one-time statement with the Department of Labor, it is not subject to the annual Form 5500 filings or other comprehensive disclosures required for other plans. This reduces the administrative complexity and costs associated with maintaining the plan.

In practice, today it is uncommon to see NQDC plans that are not top-hat. However, they do exist and are generally reserved for situations where the employer seeks to extend deferred compensation benefits to a broader group of employees or where industry-specific factors necessitate their use.

Limitations of Qualified ERISA Plans for Incentive Programs

One point of clarity: qualified plans under ERISA, such as 401(k) plans or pension plans, are designed to provide retirement benefits to a broad base of employees and come with significant regulatory oversight to ensure fairness and nondiscrimination. While these plans offer tax advantages and strong protections for participants, they are limited in their use as incentive compensation tools for the following reasons:

• Nondiscrimination Requirements: Qualified plans must pass strict nondiscrimination tests to ensure that benefits do not disproportionately favor highly compensated employees. This requirement makes it difficult to use these plans for targeted executive compensation or incentive programs.
• Contribution Limits: Qualified plans have annual contribution limits that cap the amount that can be deferred or contributed on behalf of an employee. These limits may restrict the ability to offer meaningful incentives to key executives.
• Vesting and Participation Rules: Qualified plans often have mandatory vesting schedules and participation rules, which can limit the flexibility needed to design tailored incentive programs for top executives.

Due to these limitations, companies often turn to non-qualified deferred compensation plans for executive incentive programs. And by abiding by top-hat rules, employers can design compensation arrangements that align closely with their strategic goals while offering substantial rewards to their key leaders, without being constrained by the strict regulations governing qualified plans (and many of which apply to other NQDC plans).

Although the incentive compensation plans listed below are not exclusively top-hat or non-qualified deferred compensation (NQDC) plans, they are most commonly implemented as top-hat plans.

Incentive Stock Options (ISOs): Incentive Stock Options (ISOs) are a form of employee stock option offering favorable tax treatment, typically coming with terms that include a vesting schedule, an exercise price set at the grant date (often granted at the current fair market value), and options for liquidity upon certain events like a sale of the company or an initial public offering. 

Company Perspective:

• Accounting: Expense based on the fair value of the option at the grant date and recognized over the vesting period.
• Tax: No tax deduction at the time of grant or exercise. Further, if the employee holds the shares for the required period and sells them at a gain, the company misses out on a tax deduction.

Recipient Perspective:

• Tax: No tax at grant or exercise. Capital gains tax applies if shares are sold after holding them for at least 1 year past the exercise date and 2 years past the grant date. If these conditions are not met, the spread at exercise is taxed as ordinary income.

Non-Qualified Stock Options (NSOs): Non-Qualified Stock Options (NSOs) offer greater flexibility in terms of their structure and eligibility, allowing companies to extend them to a wider range of recipients, including employees, consultants, and board members, and to implement more creative structuring such as lower exercise prices than the fair market value at the grant date. This flexibility enables companies to tailor the options to meet diverse strategic goals and compensation needs, unlike Incentive Stock Options (ISOs), which are subject to stricter IRS regulations regarding eligibility, pricing, and tax benefits. However, they are often less tax efficient than ISOs for recipients.

Company Perspective:

• Accounting: Expense based on the fair value of the option at the grant date and recognized over the vesting period.
• Tax: Deduction equal to the amount of ordinary income recognized by the employee at the exercise date (see below).

Recipient Perspective:

• Tax: No tax at grant. Ordinary income tax on the spread at exercise (the amount the NSOs were discounted to fair market value at exercise). Capital gains tax applies to any further appreciation if the recipient holds the stock and sells it later.

Restricted Stock (RS): Restricted Stock refers to shares granted to an employee that are subject to vesting and restrictions on transferability until certain conditions. Unlike ISOs and NSOs, which grant an option to purchase stock at a future date, Restricted Stock is actual equity ownership awarded upfront, subject to vesting, without requiring the recipient to purchase the shares. Restricted Stock is sometimes used rather than ISOs or NSOs when the goal is to provide immediate equity ownership with a vested interest in the company’s success.

Company Perspective:

• Accounting: Expense based on the fair market value of the stock at the grant date and recognized over the vesting period.
• Tax: Deduction at the time of vesting equal to the amount recognized as income by the employee (see below).

Recipient Perspective:

• Tax: Ordinary income tax on the fair market value of the stock at vesting. Capital gains tax applies to any appreciation (over grant price) if the recipient holds the stock and sells it later.

Restricted Stock Units (RSUs): Restricted Stock Units (RSUs) are a form of stock-based compensation where employees are granted the right to receive shares of the company’s stock or the cash equivalent upon the vesting of these units, with no purchase required.

Company Perspective:

• Accounting: Expense typically based on the fair market value of the stock at the grant date and recognized over the vesting period. May differ for RSUs that are cash-settled.
• Tax: Deduction at the time of vesting/delivery equal to the amount recognized as income by the employee.

Recipient Perspective:

• Tax: No tax at grant. Ordinary income tax on the fair market value of the stock at vesting/delivery. Capital gains tax applies to any appreciation if the recipient holds the stock and sells it later.

Stock Appreciation Rights (SARs): Stock Appreciation Rights (SARs) are a form of employee incentive compensation that grants the right to receive a payment equal to the increase in the company’s stock price over a set period, and they can be settled either in cash, shares of the company, or a combination of both, depending on the plan’s specific terms.

Company Perspective:

• Accounting: Expense based on the fair value of the outstanding SARs units, creating a shifting deferred compensation liability as the company’s fair value shifts.
• Tax: Deduction equal to the payment made to the employee, which is treated as ordinary income to the employee.

Recipient Perspective:

• Tax: No tax at grant. Ordinary income tax on the payment received, which is equal to the appreciation of the stock.

Phantom Stock Units (PSUs): Phantom Stock Units are a form of deferred compensation that grants employees the right to receive a cash payment or shares equivalent to the value of a specified number of the company’s shares at a future date, effectively mirroring the appreciation of the company’s stock without conveying actual equity ownership.

Company Perspective:

• Accounting: Similar to SARs and RSUs, expense recognized over the vesting period based on the fair value of the phantom units, with adjustments for changes in their value.
• Tax: Deduction at the time of settlement equal to the cash or the value of shares provided to the employee, which corresponds to the amount recognized as income by the employee.

Recipient Perspective:

• Tax: No tax at grant. Ordinary income tax on the cash received or the fair market value of the shares at the time of settlement, with no capital gains tax implications unless settled in actual shares and held for a period after distribution.

A Note on Value Realization/Ownership Liquidity:

How do employees actually realize the value of their ownership in the company? That’s an important question for both the company and employees to ask. For public companies, the answer to this question is often much simpler, as there exists a public market where ownership can be sold. 

However, for private companies, the answer can be challenging. Some key considerations include:

Vesting Events: Before any ownership interest can be realized, equity awards often need to vest. Vesting is the process by which the employee earns the right to the equity, usually over a set period of time or upon achieving certain performance milestones. Once vested, the employee has the right to exercise stock options or may automatically receive shares in the case of RSUs.

Exercise of Stock Options: For stock options, realization occurs when the employee exercises their options after vesting — paying the exercise price to purchase shares at the previously agreed-upon price. After exercising, the employee owns the shares outright and can benefit from any appreciation in the company’s value.

Sale or Liquidity Events: The most common liquidity events that allow employees to realize the value of their equity include:

– Acquisition: If a private company is acquired by another company, employees may be able to sell their shares as part of the acquisition deal.

– Initial Public Offering (IPO): An IPO, where the company offers its shares to the public for the first time, provides an opportunity for employees to sell their vested shares on the open market.

– Secondary Market Transactions: Some private companies may facilitate or allow transactions on secondary markets, where employees can sell their vested shares to private investors or through company-managed buyback programs.

Direct Company Buybacks: Occasionally, private companies may choose to buy back shares from employees directly. This can offer a partial or full realization event for the employees outside of an acquisition or IPO.

Dividends: In some cases, private companies may issue dividends on shares, including those granted as part of equity compensation. While not a realization of the ownership interest in terms of selling the equity, dividends provide a direct financial benefit to the shareholders, including employees with vested shares.

Cash Settlement: For cash-settled units, liquidity is often more accessible to the holder. However, some plans will still require a “liquidity event” before cash-settled units can be exercised and paid out to employees.

A Note on Value Realization/Ownership Liquidity:

How do employees actually realize the value of their ownership in the company? That’s an important question for both the company and employees to ask. For public companies, the answer to this question is often much simpler, as there exists a public market where ownership can be sold. 

However, for private companies, the answer can be challenging. Some key considerations include:

• Vesting Events: Before any ownership interest can be realized, equity awards often need to vest. Vesting is the process by which the employee earns the right to the equity, usually over a set period of time or upon achieving certain performance milestones. Once vested, the employee has the right to exercise stock options or may automatically receive shares in the case of RSUs.

• Exercise of Stock Options: For stock options, realization occurs when the employee exercises their options after vesting — paying the exercise price to purchase shares at the previously agreed-upon price. After exercising, the employee owns the shares outright and can benefit from any appreciation in the company’s value.

• Sale or Liquidity Events: The most common liquidity events that allow employees to realize the value of their equity include:
  • Acquisition: If a private company is acquired by another company, employees may be able to sell their shares as part of the acquisition deal.
  • Initial Public Offering (IPO): An IPO, where the company offers its shares to the public for the first time, provides an opportunity for employees to sell their vested shares on the open market.
  • Secondary Market Transactions: Some private companies may facilitate or allow transactions on secondary markets, where employees can sell their vested shares to private investors or through company-managed buyback programs.

• Direct Company Buybacks: Occasionally, private companies may choose to buy back shares from employees directly. This can offer a partial or full realization event for the employees outside of an acquisition or IPO.

• Dividends: In some cases, private companies may issue dividends on shares, including those granted as part of equity compensation. While not a realization of the ownership interest in terms of selling the equity, dividends provide a direct financial benefit to the shareholders, including employees with vested shares.

• Cash Settlement: For cash-settled units, liquidity is often more accessible to the holder. However, some plans will still require a “liquidity event” before cash-settled units can be exercised and paid out to employees.

Stock Issuance and Incentive Compensation Compliance

Compliance in the issuance of stock and the implementation of incentive compensation plans is crucial for small businesses and startups for several reasons. Firstly, it ensures adherence to federal and state securities laws, preventing potential legal and financial penalties. Non-compliance can lead to severe consequences, including fines and legal action, which can be particularly damaging for smaller entities with limited resources. 

Secondly, proper compliance helps maintain the company’s credibility and attractiveness to investors, as it demonstrates a commitment to legal and ethical business practices. This is vital for startups seeking to raise capital and for small businesses looking to grow. 

Lastly, compliance ensures that incentive plans are fair and transparent, helping to motivate and retain employees while aligning their interests with the company’s goals. This fosters a positive work environment and contributes to the company’s overall success.

Below we very briefly explore some of the key regulations for businesses to be aware of. Compliance can be very complicated–businesses should consult a legal professional to better understand the application of these and related regulatory considerations.

83(b) Election

Rule 83(b) refers to a provision under the U.S. Internal Revenue Code that allows individuals who receive property (such as stock) in connection with the performance of services, but subject to vesting, to elect to be taxed on the property at the time of receipt rather than when it becomes vested. For founders and employees receiving restricted stock in startups, making an 83(b) election can be particularly significant.

When a founder receives restricted stock that is subject to vesting, the IRS normally taxes the stock as it vests, based on its fair market value at the time of vesting. However, by filing an 83(b) election within 30 days of receiving the restricted stock, the founder opts to be taxed on the total fair market value of the stock at the time of receipt, irrespective of the vesting terms.

This can be advantageous for founders in several ways:

• Lower Taxes: If the stock appreciates significantly in value over the vesting period, the founder or employee will have a much lower total tax burden. Instead of paying ordinary taxes on the share appreciation on the vesting date, he or she pays taxes on the grant date using the fair market value of shares at grant. In both instances, capital gains will be paid upon sale of the share—for shares subject to an 83(b) election, capital gains tax will be applied to the increase of share value over the grant price, whereas shares without the 83(b) election will result in capital gains tax being applied to the increase of share value over the price when shares are vested.

• Capital Gains Treatment: It starts the clock on the holding period for long-term capital gains treatment earlier. If the stock is held for more than one year from the date of the 83(b) election (and more than two years from the date of grant), any sale may qualify for more favorable long-term capital gains tax rates.

• Tax Certainty: It provides tax certainty at the time of the election, rather than uncertainty over what the tax burden will be as the stock vests and its value changes.

It’s important for stakeholders to carefully consider whether an 83(b) election is right for their specific situation, as the election is irrevocable and requires paying taxes upfront on stock that may never vest or could decrease in value.

Form 3921

Form 3921, “Exercise of an Incentive Stock Option Under Section 422(b),” is a tax form used in the United States to provide information about the exercise of an incentive stock option (ISO). It serves as an important document for both businesses and employees in the context of stock-based compensation. The IRS requires companies to furnish this form to employees (or former employees) who have exercised their ISOs during the tax year. Here’s a brief overview of its significance for both parties:

For Businesses:

• Compliance Requirement: Companies are obligated to file Form 3921 for each employee who exercises an incentive stock option during the tax year. This form must be provided to the employee and filed with the IRS, ensuring compliance with federal tax regulations.

• Reporting Details: The form captures key details about the ISO exercise, including the exercise date, the number of shares acquired, the exercise price per share, and the fair market value of the shares on the exercise date.

• Deadlines: There are specific deadlines by which Form 3921 must be furnished to the employee and filed with the IRS, typically early in the year following the year in which the ISO was exercised.

For Employees:

• Tax Planning Information: Receiving Form 3921 provides employees with essential information for preparing their tax returns. While ISOs offer favorable tax treatment under certain conditions (such as the possibility of qualifying for long-term capital gains tax rates), there are specific rules and holding period requirements to meet.

• AMT Consideration: The information on Form 3921 is crucial for determining the potential alternative minimum tax (AMT) implications. Exercising ISOs can trigger AMT liability, and the details on Form 3921 help in calculating the tentative minimum tax.

• Recordkeeping: For employees, keeping a copy of Form 3921 is important for their records. It helps track the basis of the stock acquired through an ISO exercise, which is necessary for calculating capital gains or losses upon eventual sale of the stock.

In essence, Form 3921 plays a critical role in ensuring both businesses and employees handle the tax implications of incentive stock options correctly, providing transparency and aiding in compliance with IRS regulations.

409A Valuation 

Section 409A of the IRC sets the rules for when and how deferred compensation can be paid to employees. It was designed to prevent employees from deferring income for tax purposes without strict controls. Non-compliance with Section 409A can result in significant tax penalties, so it is critical for employers and employees to structure deferred compensation arrangements carefully to ensure they meet these requirements. 

If stock options, SARs, or certain other deferred compensation plans have an exercise price below the fair market value at the time of grant (i.e., discounted options), or if they allow deferral of income beyond exercise (the section place significant restrictions on exercise and payments events of deferred compensation), they may be subject to Section 409A.

A 409A valuation is an assessment of the fair market value (FMV) of a private company’s common stock, typically by an independent third party who specializes in business appraisal (often costing about $2,000 to $15,000 per valuation report). It determines the price at which employees can purchase stock through equity compensation plans, such as stock options.

These valuations are conducted to ensure that stock options and related forms of employee ownership are issued at or above the FMV, to comply with Section 409A of the Internal Revenue Code. This prevents the company from offering stock options with artificially low exercise prices, which could be considered deferred compensation and subject to penalties and taxes. 

For instances that allow ownership to be conveyed at a grant price below fair market value, a 409A valuation may still be necessary/helpful to determine the amount of deferred compensation or to calculate the expense amount to recognize as units vest.

When applicable, 409A valuations are needed:

• At least once every 12 months: Regular updates are necessary to reflect the company’s current value.
• After a significant event: Such as a new funding round, major changes in the business model, or significant revenue growth, which could significantly affect the company’s valuation.

A Note on Sharing 409A Reports with Employees:

It is ultimately up to the discretion of the company to determine what 409A valuation details, if any, are shared with employees. However, the per share price will likely be provided to employees in certain filings that are required for their individual tax returns.

Many companies provide employees with ownership a short overview of the 409A valuation and how it has changed from prior years (and often highlighting key drivers of value creation). This transparency can help incentive compensation plans be more effective in motivating team members.

In situations where ownership interests are highly illiquid, such as in a private company where units can only be exercised during a liquidity event, employees should be mindful that 409A valuations often represent theoretical values. These valuations estimate the fair market value of the company’s stock for tax and accounting purposes but may not directly reflect the actual price that could be realized in a market transaction. Given the absence of a public trading market, the practical realization of these values is contingent upon specific events, such as a sale of the company or an IPO, which may not align with the estimated valuations.

Rule 701 

Rule 701 is a regulation issued by the U.S. Securities and Exchange Commission (SEC) under the Securities Act of 1933, designed to facilitate private companies in offering their securities as a form of compensation to employees, consultants, and advisors without needing to register the offerings with the SEC. This exemption is particularly useful for startups and private companies that wish to use equity compensation as a tool to attract, retain, and motivate their workforce.

Key Aspects of Rule 701:

• Eligibility: Rule 701 is available to non-public companies (private companies) for offers of securities as part of written compensation agreements to employees, directors, general partners, trustees, officers, or consultants and advisors who are natural persons and provide bona fide services to the company.

• Disclosure Requirements: The rule imposes disclosure requirements that escalate with the size of the offering. For offerings that exceed certain thresholds, the company must provide additional disclosures, including risk factors, copies of the compensation plan under which the offering is made, and financial statements.

• Offering Limits: Rule 701 sets limits on the value of securities that a company can offer or sell within a 12-month period. This limit is the greatest of $1 million, 15% of the issuer’s total assets, or 15% of the outstanding amount of the class of securities being offered, adjusted periodically for inflation.

• Safe Harbor: Compliance with Rule 701 provides a “safe harbor” exemption from the registration requirements of federal securities laws. It’s important for companies to ensure they meet all the conditions of Rule 701 to take advantage of this exemption.

• Recent Amendments and Updates: The SEC periodically reviews and may amend Rule 701 to reflect changes in the market, inflation adjustments, and to further facilitate the use of equity compensation by private companies. Companies should stay informed of any changes to ensure ongoing compliance.

Rule 701 enables private companies to leverage equity compensation as an effective tool for growth and development by simplifying the legal and regulatory process. It highlights the importance of compliance with specific conditions to benefit from the exemption and avoid potential legal and financial repercussions.

Staying compliant when it comes to incentive compensation is very important for businesses and their stakeholders. To help manage the often complex regulatory environment that surrounds equity issuances and employee ownership, software and services like Carta can help lower the burden of compliance.

Conclusion

In conclusion, the choice of entity formation and navigating equity compensation are critical steps for U.S. startups, impacting tax responsibilities, fundraising capabilities, and equity distribution to employees. Familiarity with key regulations, including the 83(b) election, Form 3921, 409A valuations, and Rule 701, is essential for compliance and strategic advantage.

Given the complexities involved, consulting with legal and financial experts is advisable to align decisions with the startup’s long-term objectives, ensuring a foundation for growth and success.

This article is for informational purposes only and does not constitute legal or tax advice.