LLCs taxed as partnerships are lousy choices for an early stage tech company that wants to follow granting traditional path stock options and raising money from Angels and VCs.
Granting stock equivalent options in a LLC is complex and costly from a legal and accounting fees perspective. That leaves you with S choice corporation or C corporation. Therefore, most angel investors do not want to invest in pass through companies and receive a Form K 1″ from a company they invested in. You should take it into account. This rules out S corporations.
Under the federal income tax law if you acquire stock in a C corporation with less than in gain can be completely excluded from federal income tax. In a startup early days, And so it’s common for founders to not pay themselves any cash compensation. This approach is sometimes also applied to other service providers, who receive just stock option compensation.
Despite this prevalence practice in the early days, as things progress it can lead to situations that put the company and its founders in a tough spot.
Example A minority co founder, who has not been paid any cash compensation, isn’t working out and is let go.
He or she might sue the company and the other founders personally for failing to pay the minimum wage, Therefore if this co founder feels aggrieved. With the potential to grow into a costly lawsuit, this situation would be a thorn in any side startup, the minority co founder may face an uphill battle to prove his/her claim. You can avoid this entire scenario by simply paying the individual at least the minimum wage in cash. Example You classify a service provider as an independent contractor, and you do not pay them cash. It is instead, you pay them in vesting equity. Their work is unsatisfactory so you terminate them, the person works for a while. Nevertheless, their equity is unvested, and so it all reverts to the company. As long as you didn’t pay them anything for it, this person may not only sue you for failure to compensate them. To add insult to injury, they might also assert that they own the IP they created while working for you.
For founders acting as corporate officers, So it’s generally difficult to escape employee status and the minimum wage and overtime requirements. Under the federal income tax law, an officer of a corporation is defined as a statutory employee. Basically, we’re looking at the applicable rules to Seattlearea based startups, as long as ashington and Seattle minimum wage levels are higher than the federal standard. Usually, the risk with not paying your employee cofounders at least the minimum wage is that they might sue you personally if things don’t work out. Washington state has an unlawful wage statute ) that imposes personal liability for twice the wages amount unlawfully rebated or withheld on corporate directors, officers and investor representatives on the board. This is one reason investors usually want to know if a company has severance plans in place before they invest. As a result, failure to pay severance when a company runs out of cash is another potential source of troubles for directors and company officers.
Now let me ask you something. Wait, you might say, how can some famous CEOs pay themselves