Cost-saving tax planning can be much more difficult to implement after your company is well-established and has reached the stage where an IPO, merger, or acquisition becomes a likely event.
Many of the insights below are ones that are understood well by second or third-time founders or startup veterans, who learned about these specific tax provisions from experience and are ready to implement them when they start their subsequent ventures.
Corporate tax planning considerations for startups: Structural decisions made by the company
Some of the first and most important decisions for founders are the foundational determinations of how the company is structured and how equity is issued:
Choose the right corporate entity
You’ll need to determine if you want the business to be organized as a partnership, LLC, S Corporation, or C Corporation. The first three options are pass-through entities, so profits and losses are distributed to the owners who are taxed on them.
While partnerships, LLCs, and S-corps must file informational returns with the IRS, they do not pay taxes on profits independently. However, each has more restrictions on ownership than a C Corp does. C Corps are taxed as independent entities, creating the potential for double taxation as the company is taxed on profits and shareholders are taxed on distributed profits.
If your exit strategy will also involve the sale of shares or an IPO, rather than an asset sale, organizing as a C Corp is often the preferred approach despite the risk of double taxation. Startups (typically) do not distribute dividends, as income is reinvested into the venture, so the biggest downside of a C Corp is not a major concern. Additionally, C Corps are consider “qualified small businesses” which can allow individual investors to take advantage of the Qualified Small Business Stock tax deduction, which we explain below.
Consider an early exercise option
Early employees of startups often receive stock options, which can be converted to stock by paying the exercise price. In cases where companies allow for early exercise and the share price is low enough that employees can afford to exercise their options quickly, this can also provide some substantial tax savings as well.
Early exercise of options will enable employees to hold their shares for long enough that they can be taxed at lower long-term capital gains rates. However, if they exercise early and don’t file the 83(b) for their individual taxes, the IRS won’t recognize ownership of the share until it’s been fully vested. More on this below.
|With early exercise and 83(b) election||Without early exercise|
|Number of NSOs issued||100,000||100,000|
|When options are exercised||At grant||At vesting (or later)|
|FMV per share at time of grant||$5.00||$5.00|
|FMV per share at time of vesting||$10.00||$10.00|
|Exercise price per share||$5.00||$5.00|
|Sale price per share||$15.00||$15.00|
|Total FMV of all shares at time of exercise||$500,000||$1,000,000|
|Total price paid for exercising all shares||$500,000||$500,000|
|Total proceeds from sale of shares||$1,500,000||$1,500,000|
|Taxes paid at exercise (35% ordinary income tax rate)||$0||$175,000|
|Taxes paid at sale (20% LT capital gains & 35% ST capital gains tax rates)||$200,000||$175,000|
|Total taxes paid||$200,000||$350,000|
Exercising options early could also enable founders and early employees to become eligible for the Qualified Small Business Exemption. More on this below. This exemption enables those who meet certain requirements, such as holding the stock for five years, to avoid federal taxes on up to $10 million in capital gains taxes.
Types of shares to offer: ISOs, NSOs, RSAs, RSUs
Startups must determine how best to issue stock shares to employees.
Restricted Stock Awards, or RSAs
RSAs are one of the simplest options to issue stock to employees. In this type of stock option, no stock pricing is required. The employer issues employees stock shares subject to restrictions that cannot be sold or transferred until certain conditions and requirements are met. The company transfers the shares at their current cash value. Unless an 83b election is timely filed, the fair market value of the stock on the vest date or the date when the employee has no substantial risk of forfeiture is considered taxable compensation income.
Restricted stock units, or RSUs
RSUs are similar to restricted stock awards, except that the employee does not receive the stock until certain conditions are met and requirements have been fulfilled. The consequence of this simplicity, however, is that income taxes apply to RSUs so employees lose the chance to potentially be taxed at a lower capital gains tax rate.
Non-qualified stock options, or NSOs
NSOs work differently from RSAs and RSUs. In this type of stock option, an employee granted NSOs will have to pay ordinary income taxes on the spread, which is the difference between the grant price and market price, upon exercise and when the stock is sold.
Incentive Stock Options, or ISOs
ISOs are different from RSAs and RSUs. This type of stock option is only taxed upon the sale of the stock, and the valuation requirements are less stringent. However, ISOs are subject to extensive restrictions on who they can be issued to, whether they are transferable, and how much stock can be exercised. ISOs can only be issued to employees, and the company issuing the ISO cannot take a tax deduction.
Individual tax planning for founders and employees
Employees, even though you may not have full control over structural company decisions that were made before you joined, there are a few things you can still do as an individual share/option-holder right when you join the company.
Founders, keep in mind that you are also technically an employee that needs to file a personal tax return, so the tips below do still apply to you as well.
If you have RSAs, or early exercised, file the 83(b) tax election
For many startups, the founding team is generally issued at least some RSAs in the company that vest slowly over time. The vesting of the shares is a taxable event with stockholders owing the IRS based on the value of their equity at the time of vesting.
To preempt this process and avoid taxation as shares vest, RSA holders can opt for an 83(b) tax election. This is a provision of the Internal Revenue Code that makes it possible for stockholders to be taxed on the fair market value of their shares at the time when those shares are granted rather than when they vest.
|83(b) election||Without an 83(b) election|
|Number of RSAs issued||100,000||100,000|
|Taxable event||At time of RSA grant||At time of RSA vesting|
|FMV per share at time of grant||$1.00||$1.00|
|FMV per share at time of vesting||$5.00||$5.00|
|FMV of all shares at time of taxable event||$100,000||$500,000|
|Taxes paid at taxable event (35% ordinary income tax rate)||$35,000||$175,000|
Even if you don’t hold RSAs, it’s highly recommended that NSO or ISO holders who took advantage of an early exercise option file an 83(b). Remember, if you early exercise and don’t file the 83(b) within 30 days of the issue date, the IRS won’t recognize ownership of the share until it’s been fully vested and you’ll be paying significantly higher taxes at that point.
Take advantage of the Qualified Small Business Stock Exclusion
Founders, investors, and employees holding significant amounts of shares can avoid paying capital gains taxes on the greater of $10 million or 10 times their cost basis if they meet certain requirements, including receiving shares from a domestic C corporation at a time when company assets are less than $50 million.
To take advantage of this exclusion, however, you must hold your stock for more than five years and must sell when the company is actively operating and using 80% of other assets for purposes other than investing for substantially all your holding period. If you can qualify for this exclusion, it can provide substantial tax savings so be strategic about how long you hold your company stock for.
More information: An Overview of the QSBS Exemption: Qualified Small Business Stock
Consult a financial and/or tax advisor for tax planning
Whether you are a founder or an early employee at a startup, it’s important that you understand the tax implications of decisions you make today regarding how your company is structured, how and when you’re taxed on stock shares, and when you exercise stock options.
The best approach for each decision may differ based on certain unique considerations (business model, industry, growth plans, personal financial situation, etc.) and an advisor experienced in working with startups and startup employees can offer a lot of interesting insights in to what’s common with other companies, and their recommendations for the tradeoffs you should consider in your particular situation.