Updated July 7, 2020:

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.

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.

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.