Key Takeaways:

  • S corporations can issue stock options but must comply with single class stock rules.
  • They cannot issue both common and preferred stock like C corporations.
  • LLCs offer greater ownership flexibility and allow special allocations of profits/losses.
  • S corps are more favorable for companies seeking venture capital or public offerings.
  • Equity-based compensation in S corps, like incentive stock options (ISOs), must be carefully structured to avoid jeopardizing S corp status.
  • “What is corp option” refers to stock options allowing individuals to acquire shares in a corporation under certain terms, which S corps can provide with restrictions.

S corp stock options are limited, as these corporations are not allowed to issue common or preferred stock. S corporations also must be careful about how many stocks they are issuing, as having too many shareholders can cause the loss of the S corporation tax status.

S Corporation vs. LLC

If the founders of your startup company plan to be active in the businesses, including funding initial losses and deducting those losses from their personal tax returns, the two most beneficial business structures are a limited liability company (LLC) or an S corporation.

Choosing between these two entity types, however, can depend on several issues, including how the founders of your company wish to allocate losses. With an S corporation, for example, special allocations are not allowed. If there is no need for a special allocation of losses, then forming an S corporation is usually the best choice.

S corporations provide a variety of benefits that aren't accessible with an LLC. For example, S corporations are allowed to participate in tax-free organizations such as stock swaps and are also allowed to use stock option plans. LLCs, on the other hand, cannot participate in tax-free organizations and will also have trouble finding a suitable equivalent for stock option plans. Other benefits of S corporations include:

  • The ability to easily convert to a C corporation by accepting venture capital funding.
  • Reduction of the overall tax burden associated with hiring employees.
  • Simple equity sales and initial public offerings.
  • Easy-to-understand corporate structure.

While forming an S corporation is the better option for most businesses, limited liability companies are not without their benefits. For example, LLCs provide much more flexible ownership options and are also permitted special allocations.

Defining Corporate Options and How They Work

A corporate option typically refers to the right granted to an individual—often an employee, advisor, or contractor—to purchase shares of a corporation’s stock at a predetermined price within a specified period. These are often part of compensation packages and are intended to incentivize long-term commitment and performance.

In the context of what is corp option, S corporations can grant stock options, but they must take care not to violate IRS rules surrounding equity structure. Unlike C corporations, which may offer multiple classes of stock and more flexible vesting arrangements, S corporations must maintain a single class of stock and adhere to the shareholder limit of 100. Any rights tied to stock options must not create a second class of stock, or the S corporation risks termination of its tax status.

Options are typically classified as:

  • Incentive Stock Options (ISOs): Tax-advantaged options for employees, with deferral of tax until sale and potential for long-term capital gains treatment.
  • Non-Qualified Stock Options (NSOs): More flexible but taxed at the time of exercise.

Whether you operate an S corp or LLC, issuing equity in the form of options requires legal precision. The equity incentive must align with your corporate structure to ensure compliance and support long-term growth objectives.

S Corporations and Incentive Stock Options

An S corporation is formed by making a special tax election with the Internal Revenue Service (IRS). Essentially, the main reason to form an S corporation is to be taxed differently than a traditional C corporation.

With an S corporation, your business will not be taxed on corporate income. Your corporation's income will be passed on to shareholders and reported on their personal returns. Because of the ability to avoid double taxation, S corporations are required to follow strict rules for maintaining their status. For instance, S corporations can have no more than 100 shareholders and are only allowed to issue a single stock class.

The purpose of the single class stock rules of a corporation is to guarantee that every stock a corporation issues provides the same rights to proceeds resulting from a liquidation or distribution. This is different from a C corporation, where different classes of stocks can be used to provide different rights.

S corporations cannot issue common and preferred stocks, which is allowed of C corporations. If an S corporation follows the single class of stock rules, however, they can issue stock options that function similarly to incentive stock options.

When a corporation wants to adopt incentive stock option (ISO) plans, it must first receive approval from its shareholders and Board of Directors. By complying with the rules of the ISO plan, company employees are able to acquire stock shares. Holding incentive stock options allows employees to delay being taxed on their shares until they are actually sold.

If an S corporation is considering adopting an ISO plan, it must be very careful about abiding by the single class of stock rules. Most importantly, the S corporation needs to be certain that implementing an ISO plan will not increase its shareholders to more than 100. Additionally, the shares offered through the ISO plan need to be identical to those issued to shareholders.

S corporations should be very cautious when offering incentive stock options. If an ISO plan is implemented incorrectly, it could result in the loss of S-corporation status, which may mean paying retroactive taxes on corporate income.

A corporation's issued shares are not required to equal the amount of total authorized shares. Corporations are allowed to have both outstanding and issued shares. In terms of issued shares, there are three important factors:

  • Who owns the shares.
  • If the owners of the issued shares are the majority shareholders.
  • The voting rights of shareholders.

Remember, S corporations can only have one class stock, meaning all shareholders have the exact same voting rights.

Compliance Considerations for Stock Option Plans

Implementing a stock option plan within an S corporation structure requires detailed planning to maintain eligibility for S corp taxation. Here are essential compliance issues to address:

  • Stock Class Restrictions: All outstanding shares must confer identical rights to distribution and liquidation proceeds. Options cannot create preferred rights.
  • Written Agreements: Clearly documented option agreements should include terms of vesting, strike price, and treatment upon termination.
  • Valuation and Strike Price: Options must be priced at fair market value at the time of the grant to avoid unintended tax consequences.
  • Transfer Restrictions: Options and resulting shares must only be issued to eligible shareholders—generally U.S. citizens or resident individuals.

S corporations must also be cautious about exceeding the 100-shareholder limit through option exercises. For example, granting options to multiple contractors who later exercise their rights could inadvertently push the shareholder count beyond the threshold.

Additionally, issuing equity to non-individuals such as partnerships or corporations can also revoke S corp status. The corporation must monitor eligibility at all stages of the stock option lifecycle.

Best Practices for Structuring S Corp Equity Compensation

To make the most of stock options while preserving the benefits of S corporation status, consider these best practices:

  1. Cap Table Planning: Maintain a detailed capitalization table to track authorized shares, issued shares, and reserved options.
  2. Use a Legal Entity Management Tool: To simplify compliance and equity tracking, consider using legal platforms that track ownership and restrictions.
  3. Grant Options Strategically: Grant options with clear vesting schedules to reduce turnover risks and align with business goals.
  4. Educate Option Holders: Ensure recipients understand how options work in an S corporation, especially tax implications and liquidity limitations.
  5. Seek Legal and Tax Counsel: Given the high stakes of non-compliance, professional guidance is essential for drafting equity plans and option grants.

Remember, even though S corps have restrictions, they still offer a strong framework for incentivizing team members through ownership—so long as plans are carefully implemented.

If you need help navigating corporate stock option planning, you can find experienced attorneys on UpCounsel to assist with your equity structure and compliance needs.

Frequently Asked Questions

What is corp option in an S corp? A corp option refers to a stock option granted by a corporation, allowing the holder to purchase shares under certain conditions. In an S corp, these must align with single class stock rules to maintain tax status.

Can S corporations issue incentive stock options? Yes, but they must structure them carefully to ensure all stock retains identical rights and avoid creating a second class of stock.

How do S corp options differ from C corp options? C corps can offer more flexible equity options, including multiple stock classes and convertible instruments, while S corps are restricted to one class of stock and up to 100 shareholders.

What are the risks of issuing stock options in an S corp? Improperly structured options could violate IRS requirements and lead to the loss of S corp status, resulting in corporate taxation.

Can non-U.S. residents hold stock options in an S corp?No. Only eligible shareholders—generally U.S. citizens or resident individuals—can hold stock or options in an S corp.

If you need help with S corp stock options, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.