How to Issue Startup Equity to Employees: LLCs and C Corporations
Many startups try to incentivize employees by offering them equity in the company as part of their compensation packages. Since startups often can’t compete on salary with bigger companies, they are able to retain top talent by offering generous stock options to early employees. The choice of entity type — LLC vs C-corp — for your startup comes with consequences for how you can issue equity to employees at your company.
Let’s look at the process of issuing equity to employees in an LLC and a C Corporation. In general, it is vastly more complex to issue equity to employees in an LLC, as compared to a C corporation. This is one of the many reasons that startups choose to incorporate as a C Corporation instead of an LLC — the most important is that investors simply prefer to invest in C Corporations.
Different forms of equity in LLCs and their tax treatment under IRS rules
Issuing equity to founders and employees in an LLC can be very complex to navigate for a startup.
One major complicating factor with granting equity in an LLC is that W-2 employees of an LLC cannot hold equity in that LLC under Internal Revenue Service (IRS) rules. This means that if you want to grant shares to employees in your LLC, you will have to get creative with how you pay them since they cannot remain on payroll as employees. LLCs must issue a K-1 on an annual basis to all shareholders of the company (essentially, they are “partners” in the LLC for tax purposes) and the company cannot deduct employment taxes like it does for W-2 employees.
There are 3 different ways for an LLC to grant equity to employees: unit / membership interests, profits interests, and unit appreciation rights (shadow equity). Each type of equity interest is taxed differently by the IRS.
Unit / Membership Interests
Unit / membership interests are the LLC equivalent of stock. They come with voting rights and they are taxable at the time of grant if the shareholder does not pay “fair market value” for the units. Typically, unit/ membership interests are only granted very early in the life of the LLC.
As the value of the LLC increases, companies will switch to profits interests, which are sort of like an LLC equivalent for stock options. Profits interests entitle holders to the appreciation in value of their equity after the grant date, and if issued properly, they can be tax-free to receive.
Returns from both units and profits interests are both taxed as capital gains by the IRS. While units typically have voting rights in an LLC, companies often structure profits interests to restrict voting rights.
Unit Appreciation Rights
LLCs will often switch to unit appreciation rights (UAR) or so-called “phantom equity” when the companies want to issue equity-like compensation to non-director employees, but wish to continue treating them as W-2 employees. Unit appreciation rights do not come with voting rights and, technically, they are not really equity at all. Instead, unit appreciation rights entitle the recipient to a cash payment, kind of like a bonus, when a future milestone is reached, such as a company acquisition or liquidity event. The UAR contract will typically codify a value of the equity at the time of the grant, and the holder’s future bonus payout will increase proportionately with the increase in value of the company since the date of the grant.
If issued properly by the LLC, UAR grants are not taxable on the grant date. While this can dramatically simplify tax filings for the recipients (they don’t have to switch to receiving income as partners in the company, and can remain W-2 employees), the downside is that any profits from the UARs will be treated as ordinary income by the IRS and are not eligible for treatment as capital gains.
With LLCs, issuing equity for employees can be rather complex and require the advice of tax specialists to do it right.
Issuing equity to employees in a C Corporation
In strong contrast to the complexity of issuing equity in LLCs, issuing equity to employees in a C Corporation is relatively cut and dry. At early stage startups, employees receive either restricted shares (common shares with a restrictive sales legend) or stock options (essentially, an option to purchase common shares in the company at a future date). The tax implications for employees are fairly straightforward.
- Employees can only be issued shares or options with an exercise price set to the fair market value by the company.
- If the employee buys the shares or options when they are issued, there is no taxable event at the time of exercise since there is no spread between the exercise price and the fair market value of the shares.
- If the employee holds shares for less than 1 year before selling the shares, then the sale of the shares will be taxed as income.
- If the employee holds shares for more than a year before selling the shares, then the sale of the shares will be taxed as long term capital gains.
- Shares held for more than 5 years can before sale are potentially eligible for the Qualified Small Business Stock (QSBS) exemption, meaning 50%-100% of the profits can be deducted from the employee’s personal taxes
Since equity compensation is such a critical part of recruiting and retaining key employees at startups, many startups choose to incorporate as a C Corporation to simplify granting shares and options to employees.
If you incorporate your company with Capbase, we make it easy for you to issue shares and options to employees as part of their equity compensation packages. When an employee signs their contracts, your cap table and document room will be automatically updated in our software.
- Many startups prefer C Corporations over LLCs because it is easier to compensate employees with equity by granting shares or options in a C corporation
- There are 3 different ways of granting equity to employees in an LLC: membership interests / units, profits interests, and unit appreciation rights
- Each way of giving equity in an LLC has a different tax treatment under IRS rules
- Shares in corporations held more than a year will be taxed as long term capital gains when sold
- Early employees and founders who hold shares in a startup for more than 5 years may be able to write off up to 100% of the profits from selling the shares if the startup qualifies for the QSBS exemption