Highlighted in this post are 6 tax issues that most startups will encounter early in their life cycle. These are presented in summary form with links to other more detailed posts we’ve published on these topics for those who want to take a deeper dive. Needless to say, there are many other tax issues that a given startup will face, and so this list should not be seen as exhaustive on the subject of taxes, but rather a point of entry.
Entity Tax Structure
QSBS and Capital Gains Exclusion
83(b) Elections on Vesting Shares
409A Valuations for Stock Option Grants
Tax Treatment of Equity Compensation
Worker Classification and Payroll Taxes
Entity Tax Structure
Often the first and most significant tax issue startups will encounter is at formation. The type of entity chosen and its corresponding tax treatment can have far-reaching consequences.
Fortunately, for many startups, this choice is an easy one. Startups that plan to raise venture capital should, in most cases, incorporate as a Delaware C corporation. Venture capital funds often have to invest in C corporations for tax reasons related to their own investors (LPs), but they also tend to prefer C corporation because of familiarity with corporate law governing management, fiduciary duties, etc., as well as QSBS eligibility (more on this below). While it’s true that C corporations are subject to two levels of taxation, venture-track startups rarely feel the sting of this double taxation because profits, if any, tend to be reinvested in growth, rather than distributed as dividends to stockholders.
On the other hand, for startups that do not intend to raise venture capital, a C corporation may not be the right choice. If the startup plans to distribute profits to its owners, then a pass-through tax structure, such as an LLC taxed as a partnership or a corporation that’s made the S election, is often the preferred choice. With that said, a pass-through structure may provide short term tax efficiency, but if it comes at the expense of a potential long term tax benefit, like eligibility for QSBS treatment, a startup will need to weigh these factors before making a decision.
Complicating things further is the possibility of forming as one type of entity with the intent to convert to a different type of entity in the future. For example, a startup might strategically form as an LLC with the intent to convert to a C corporation at some future point. This is sometimes done in an effort to maximize the potential benefits of QSBS, which is explored more in the linked post below.
Related Post: The Startup Guide to Converting an LLC to a C-Corporation
By now, you’re probably wondering what QSBS is and why it’s important. In fact it’s so important in the entity formation context that we’ve given it its own section separate from entity formation. That’s where we’ll head next.
QSBS and Capital Gains Exclusion
Qualified small business stock (QSBS) is stock issued by a C corporation that’s eligible for a sizable exclusion from federal capital gains taxes, provided all requirements are met. The federal capital gains exclusion for QSBS is limited to the greater of either $10 million of gain or 10 times the amount of the stockholder’s basis in the stock. So, for example, a startup founder that sells QSBS for a $10 million gain would pay zero federal capital gains taxes on that gain.
As we can see, QSBS has the potential to provide major tax benefits to startup founders, investors, and other stockholders, and so this tends to be an area of focus for early stage startups and their investors. In fact, this is one of several key reasons why many startups tend to form as C corporations, given that only C corporations can issue QSBS.
However, forming as a C corporation is merely one of a handful of requirements for QSBS eligibility. Other requirements include the company having gross assets of $50 million or less when QSBS is issued, and the stockholder holding the shares continuously for at least 5 years before selling. Additional requirements for QSBS eligibility can be found in our more in-depth post on QSBS, which is linked below.
Related Post: QSBS: The Basics of Tax-Advantaged Startup Stock
For the typical startup that will need to form a C corporation anyway, QSBS is an added potential benefit, rather than a determining factor for their entity choice. On the other hand, for startups that are weighing the potential benefits of QSBS against the potential benefits of pass-through taxation, careful consideration should be given to the company’s and its owners’ eligibility for QSBS as well. There are a variety of requirements that must be met and so startups should not assume they will do so without conducting further inquiry.
Some adventurous startups will seek to further maximize the potential tax savings from QSBS by forming as an LLC and converting to a C corporation just prior to the company’s gross assets exceeding $50 million. If timed correctly, this strategy has the potential to increase the QSBS cap from $10 million to up to $500 million. For readers interested in learning more about this strategy, please refer to the heading “Conversion Pro-Tip for Maximizing QSBS” in the linked post below.
Related Post: The Startup Guide to Converting an LLC to a C-Corporation
83(b) Election for Vesting Shares
83(b) elections come into play when a startup grants shares on a vesting schedule. For example, when founders are issued shares at incorporation, it’s standard practice to subject these shares to a 4 year vesting schedule with a 1 year cliff. This means that if the founders leave the company before they are fully vested, then the company can repurchase the unvested shares.
There are important tax implications for startup founders with stock on a vesting schedule. Generally, restricted stock is taxed as ordinary income when it vests. That means that if the value of the restricted stock is increasing as the stock vests over the four year vesting period (which, if the company is successful, will be the case), then there can be a corresponding increase in taxes owed by the founder. However, the stock is illiquid at this point, meaning the founder could have a large tax bill but no way to pay it via the stock.
Fortunately, founders can avoid this scenario by making an 83(b) election. With the 83(b) election, the IRS allows restricted stock recipients to pay taxes on their stock at the time the shares are issued, instead of as they vest. Doing this may significantly reduce a founder’s tax bill if the value of the shares ends up having increased at the time of vesting. Of course, if the value of the stock does not increase or if a founder leaves the company before the stock vests, then an 83(b) election may not have the intended effect. More information on the 83(b) election can be found in the linked post below.
Related Post: 83(b) Election for Startup Founders
409A Valuations for Stock Option Grants
Startups rely on granting stock options to service providers, like employees and advisors, as compensation to supplement below market cash compensation. A stock option gives the holder an option to buy shares at a certain price (known as the “exercise price” or “strike price”). The lower the strike price, the more attractive the option. But there are rules for setting the strike price. The most important one comes from a provision of the tax code known as Section 409A.
The goal for startups is typically to structure stock options so that they’re exempt from the requirements of Section 409A for nonqualified deferred compensation. For startups, the best way to structure stock options to be exempt from Section 409A in most cases is to obtain what’s known as a 409A valuation. A 409A valuation determines the value of the startup’s common stock on a per share basis. This value can then be used to set the exercise price of a stock option.
If a startup fails to have a valid 409A valuation in place when granting stock options, it increases the risk that options will violate Section 409A. When this happens, the recipient of the grant bears the brunt of the potential tax consequences, including:
An additional 20% federal penalty tax
Acceleration of income tax recognition to the year of vesting, rather than the date the option is exercised
Possible late penalties and interest on the taxable amount
Possible late penalties and interest on failure to withhold taxes
To avoid these consequences, it’s important for startups to have a valid 409A valuation in place when granting options. That means not only getting an initial 409A valuation but also getting fresh 409A valuations after raising outside financing or any other “material event, and at least once every 12 months. Readers interested in learning more about 409A valuations can read more in the linked post below.
Related Post: What Startups Need to Know About 409A Valuations
Tax Treatment of Stock Options
We’re staying on the topic of stock options, but with a shift in focus to the tax considerations that option recipients face. While this may seem more relevant to optionees than to startups, founders need to understand this too as it will help inform their discussions with option recipients.
There are two core types of stock options: Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs). Only employees are eligible to receive ISOs, while NSOs can be granted to any type of service provider, including employees, contractors, advisors, and the like. The main reason why a startup would grant ISOs to an employee is that there is a potential tax benefit to the recipient of ISOs. However, this potential tax benefit comes with a host of requirements that must be met. There can also be hidden risks with ISOs.
Below is a table to help illustrate some of the key tax differences between ISOs and NSOs.
| ISOs | NSOs |
Tax at Grant | No tax (if granted at FMV) | No tax (if granted at FMV) |
Tax at Vesting | No tax (if granted at FMV) | No tax (if granted at FMV) |
Tax at Exercise | No ordinary income, capital gains, or employment tax. However, the difference between the FMV and exercise price is treated as income for purposes of calculating AMT–could result in AMT taxes. | The spread between FMV and exercise priced is taxed as ordinary income. Employment taxes. |
Tax at Sale | Sale price less exercise priced taxed as long-term capital gains, so long as held for 1 year past exercise and 2 year past grant date. | Sale price less FMV at exercise taxed as long-term capital gains if held for 1 year past exercise. |
As we can see from this table, ISOs have potential tax benefits over NSOs at two points: at exercise and at sale.
The potential tax benefit at exercise is that unlike NSOs, ISOs are not subject to ordinary income, capital gains, or employment taxes. The reason this benefit is only a “potential” one is that the alternative minimum tax (AMT) must also be considered for ISOs. For some optionees (particularly higher income earners) in certain situations ISOs may still have undesirable tax consequences at the time of exercise.
The potential tax benefit at sale with ISOs is to have more gains be subject to preferential long-term capital gains tax rates than NSOs. The example below helps illustrate this.
Example: Tom and Tina are both granted an option to purchase 100 shares at a $1 exercise price. Tina is an employee and is granted an ISO, while Tom is a contractor and is granted an NSO. Tina and Tom both exercise their option when the FMV of the shares is $5. Several years later, they both sell their shares for $7 per share.
Assuming Tina met both holding periods (more on this below) for her ISO, Tina would pay long-term capital gains rates on the difference between her exercise price ($1/share) and the sale price ($7/share). That means that for every share, Tina is paying long-term capital gains rates on the entire $6 spread between exercise price and sale price.
Tom, on the other hand, assuming he met the holding period, would pay long-term capital gains rates on the difference between the FMV of the shares when he exercised ($5/share) and the sale price ($7/share). Tom would have already paid ordinary income tax on the spread between the exercise price ($1/share) and the FMV of the shares when he exercised ($5/share). That means that for every share, Tom is effectively paying long-term capital gains rate on only $2 and ordinary income tax rates on the remaining $4.
This example suggests that ISOs always hold the tax advantage at sale. But that isn't necessarily the case. In order to realize the potential benefits at sale, ISO recipients must have held their shares for 1 year past exercise and for 2 years past the grant date. In practice, ISO recipients often don’t satisfy both of these holding periods.
What’s more there are a number of additional requirements for ISOs, which may make them less attractive to recipients depending on the circumstances. As a result, the question of whether to grant ISOs or NSOs does not always have a straightforward answer. Readers interested in learning more about taxes on ISOs and NSOs can read more in the linked post below.
Related Post: Startups and Stock Options: ISOs vs. NSOs
Worker Classification and Payroll Taxes
The final common tax issue startups encounter relates to worker classification. Specifically, whether to classify certain workers as employees or as contractors. One of the reasons why startups – especially early stage startups – often prefer to classify workers as contractors is to avoid having to pay payroll taxes (also known as FICA taxes or employment taxes).
Independent contractors are considered to be self-employed, and so businesses that use independent contractors don’t have to pay employment taxes for their contractors. Instead, contractors are required to pay self-employment taxes. In addition to lowering a business’ tax obligation, using independent contractors reduces burdens imposed by administrative obligations, regulatory compliance, and benefit programs.
This is a significant potential tax benefit to a startup because the employer portion of the Social Security tax is 6.2% of the employees’ covered wages (up to a wage base limit), and the Medicare tax imposed on employers is 1.45% of coverage wages (with no wage base limit).
But, of course, both federal and state agencies want to collect employment taxes from employers, as well as enforce employment law standards. This creates an incentive for federal and state state agencies—like the IRS and the Department of Labor (DOL), just to name a few—to aggressively police the line between employees and contractors. And they have an arsenal of enforcement mechanisms at their disposal, including imposing payment obligations of the following:
Unpaid employment taxes
Back pay, which may include overtime pay
The value of employee benefits
Civil (and, in rare circumstances, even criminal) penalties and interest for failing to pay workers’ compensation premiums or failing to file accurate unemployment tax reports
In view of the significant risks posed by misclassifying employees as contractors, startups should not be guided solely by the chance to save on payroll taxes when classifying workers. This can certainly be on the factors considered, but it should not be the guiding factor. To learn more about what other considerations should be taken into account (with a focus on Washington State), readers are encourage to check out the below linked post.
Related Post: Independent Contractors vs. Employees in Washington State
Takeaways
For startup founders, you don’t need to become an expert on the tax code. Your tax and legal counsel will be there to help you. But it does help to understand at least the basics for certain key topics, especially in the early days, so you can ask the right questions, engage at a higher level with your advisors, and help educate team members when questions arise.
