A startup company faces a number of structuring decisions that can have material consequences on its tax treatment. In particular, the tax implications of entity classification decisions and equity compensation arrangements can have a major impact on the startup’s success down the road.

The decision of whether to form a startup as a C-corporation, S-corporation, partnership, or limited liability company (LLC) comes with important tax implications. The choice of entity classification for tax purposes can impact whether a startup faces two levels of taxation of its income. C-corporations are taxed at both the entity level as well as the stockholder level. In other words, it is subject to taxation at the entity level when income is earned and taxation at the stockholder level when income is distributed. Despite the double taxation, C-corporations are the most common corporate form for startups because of their flexibility. C-corporations can issue multiple classes of stock and can have an unlimited number of owners.

S-corporations and partnerships are classified for tax purposes as pass-through entities, also known as disregarded entities. Unlike C-corporations, they avoid taxation at the entity level. However, venture capital and other startup investors find these corporate forms less favorable because they are subject to more structural and management limitations. Limited liability companies can be classified as disregarded entities, C-corporations, S-corporations, or partnerships for U.S. federal income tax purposes. The default rule for single-member LLCs is that they are treated as disregarded entities for tax purposes. The default rule for multiple-member LLCs is that they are treated as partnerships for tax purposes.

The choices made concerning the forms of equity compensation issued to employees can also have major long-term consequences for a startup. Equity compensation can come in a variety of forms, including restricted stock, incentive stock options (ISOs), non-qualified stock options (NQSOs), restricted stock units (RSUs), phantom stock, and stock appreciation rights (SARs). While they all share a common purpose of motivating and incentivizing employees to work toward building a successful startup, it is important to understand the unique tax implications of the different forms of equity awards.

Restricted stock is a grant to employees of actual stock. The restricted stock comes with customary stock ownership rights including voting and dividend rights. However, the stock is subject to restrictions until the stock vests. For instance, the shares are non-transferable until the vesting date. Vesting can be time-based or performance-based. Performance-based vesting is typically contingent on the startup meeting certain financial metrics, such as revenue targets. Restricted stock awards are commonly awarded to founders and employees in early-stage startups when the valuation of the stock is low.

Stock options provide employees with the right, but not the obligation, to buy shares at a specified exercise price in the future. Stock options are usually subject to time-based vesting. The classification of stock options as ISOs or NQSOs carries distinct tax consequences. Overall, ISOs come with more favorable tax treatment. NQSOs generally are taxed at ordinary income tax rates whereas ISOs are taxed at the lower capital gains tax rates. Stock option awards are commonly awarded to employees of startups once they have hit a high-growth phase and therefore the valuation of the stock is rising.

RSUs represent a promise of shares in the future, provided that certain vesting conditions are satisfied. An employee granted RSUs does not actually own the underlying shares of the company until the RSUs vest. However, some companies may elect to pay so-called “dividend equivalents”. This means the company will pay the value of the dividends that have accrued between the grant date and the vesting date. RSUs are more commonly awarded to employees of established, mature companies.

Equity awards of phantom stock allow employees to benefit from the appreciation in the startup’s stock price overtime. On the grant date, an account is credited with hypothetical or “phantom” shares. On the vesting date, the employee receives the full value of the shares plus any dividends paid during the vesting the period. Phantom stock awards may be settled in cash or stock.

Equity compensation in the form of SARs similarly allow employees to benefit from upside in the startup’s stock price. Unlike phantom stock awards, however, SARs only provide the employee with a cash or stock payment equivalent to the appreciation in the value of the stock during the vesting period.