Let’s spend a little bit of time now talking about equity incentives and employee compensation. As I said earlier, oftentimes startup companies that are bootstrapped and trying to raise investment capital don’t have a war chest of money available to pay the best and brightest new employees market rate salaries. And oftentimes startups will bridge that gap by offering equity incentives to employees to incentivize them to work hard on behalf of the business. So let’s talk a little bit about the differences between a corporation or a limited liability company in that regard.
Corporations that plan to use equity incentives, for example, stock options, to attract and retain talent often prefer to operate as C corporations. Why? C corporations can offer what are known as incentive stock options to employees, and incentive stock options allow employees to defer tax on the equity compensation that they receive until they ultimately sell the underlying stock that is subject to the stock options. That’s a very important advantage that C corporations have as a startup company. C corporations can offer certain fringe benefits to employees, for example, health insurance, qualified education costs, term life insurance, employer-provided vehicles, public transportation passes. And in doing that, all those can be tax deductible to the company and also tax free to the employee.
Although S corporations can grant stock options, they can only be granted to a U.S. citizen or a resident alien. So if you as a startup company have an employee that’s a non-U.S. citizen, you can’t issue stock options as an S corporation to that individual. Oftentimes that really curtails the likelihood that an S corporation is going to be the entity of choice for most startup companies.
Another way that S corporations are typically less flexible than C corporations is with regard to the fringe benefits that I just talked about. An S corporation must either report the benefits as taxable compensation for the employees or, conversely, an S corporation has to forfeit the fringe benefit deduction available to the company. So again that’s an important distinction between a C corporation and an S corporation.
We’ll switch now to a limited liability company. While an LLC can of course reward its employees by offering the employees membership interest in the LLC, the equity compensation process is relatively awkward and may be more unattractive to employees than the stock option in a corporation. It’s a little more complicated. Equity incentives require a lot more involvement from tax advisers and accountants. LLCs are not able to offer certain forms of equity compensation that are available to corporations, such as incentive stock options that again have that tax advantage benefits that a lot of the startup company employees have come to know and love.
In total, there’s a lot of advantages as a C corporation in terms of equity compensation incentives that S corporations and LLCs simply just don’t have.