This is the seventh installment in our “Smart Financial Moves” series, exploring essential financial strategies for business owners looking to build wealth efficiently. In Chapter 6, we covered Estate and Family Planning. This week, I focus on Equity Compensation.
As I work with growing business owners (those who are scaling their companies and navigating increasingly complex financial decisions), equity compensation becomes a powerful yet complex part of their financial picture.
Understanding the legal structures, tax implications, and strategic planning required can make the difference between maximizing wealth and facing costly mistakes.
Table of Contents
Separate Personal and Business Finances
One of the most common and risky mistakes I see business owners make is blending personal and business finances. The risks are significant and costly.
Legal problems represent the primary concern. Piercing corporate veils and exposing personal assets becomes a real threat when finances are commingled. The legal protections that business entities provide can be completely compromised.
Tax issues follow closely behind. Mixed finances could trigger audits and some deductions may be denied. This creates IRS scrutiny that raises red flags, potentially affecting you in future years even if an audit isn’t immediately triggered.
Business growth challenges emerge when you need capital. It’s hard to raise or sell the business if you have too much commingling because a potential purchaser might feel like the optics aren’t good, and it may be hard to unwind this stuff.
Cash flow confusion compounds everything. When you don’t know where money is going, you can’t really make smart decisions for either personal or business finances.
Practical Steps for Financial Separation
I recommend several practical steps to every business owner I work with. Segregated accounts are essential: separate business and personal bank accounts and credit cards completely. Rather than using the business as a piggy bank, set up regular guaranteed payments for LLC partnerships or structured payroll.
The Small Business Reality
However, the reality in the small business world is challenging. Unless you have significant scale, you often need to act as a personal guarantor and personally apply for credit cards. American Express, in particular, bases creditworthiness on the individual applying for the card in the small business world.
The reality is it’s not even business debt but personal debt, and it does commingle to that extent, opening up liability for an owner even if used exclusively for business.
Additional Protection Measures
For any loans between personal and business accounts, make sure they have formal terms as opposed to a friendly loan. Choose the right entity structure too. Sole proprietorships are the least advisable business structure. Better to use LLCs, S-Corps, or C-Corps for protection and tax benefits.
Choosing the Right Business Entity Structure
All three common structures (LLC, S-Corp, and C-Corp) provide limited liability that shields personal assets from business debts as long as you keep things properly separated.
LLCs: Flexibility and Simplicity
LLCs offer flexibility and simplicity. Probably the most viable for most businesses, they provide pass-through taxation where profits are taxed on the personal return.
They’re simple, flexible, and easy to form. For single-member LLCs, income rolls through your individual tax return. Multi-member LLCs generate K-1s that go to the partners.
However, if you’re self-employed in an LLC, self-employment taxes could be higher because you’re the only owner-operator.
S-Corp Election: Tax Optimization
S-Corp election provides tax optimization opportunities. It’s an election status rather than a separate entity type. The key advantage: it allows you to pay yourself what’s considered to be a reasonable salary while taking additional profits as distributions, and that avoids some portion of self-employment tax.
I always warn though: You’ve got to pay yourself something called a fair W-2, and the IRS does watch this. It’s something the IRS has been clamping down on. S-Corps are also limited to 100 U.S. shareholders with no ability for foreign individuals to own.
C-Corps: Growth and Capital Raising
C-Corps enable growth and capital raising but come with double taxation. They pay corporate tax, which is 21 percent federal. When profits are distributed as dividends, they’re taxed again at the individual rates, creating disadvantageous double taxation.
But C-Corps allow for basically unlimited growth, foreign investors, and different types of tranches and classes of stock. They’re great for startups for raising capital and publicly traded vehicles.
Choosing Your Structure: A Framework
My framework for choosing depends on your goals. Want to raise capital? Probably a C Corp. Want more flexible ownership? C-Corps allow broad ownership characteristics. Minimizing self-employment taxes? Possibly an S Corp. Want to reinvest in the business? C-Corps can make sense for leaving money in the company.
LLC is probably the best vehicle, the most flexible and simple. S-Corps if you want to optimize tax. C-Corps obviously with an eye towards raising capital and long-term reinvestment.
Understanding Equity Compensation Types
For those receiving equity compensation, understanding the tax implications is crucial for maximizing value.
Incentive Stock Options (ISOs)
Incentive Stock Options (ISOs) are granted to buy the company stock at a set price (the strike price). If the stock goes up, you can exercise and potentially get favorable treatment. Key benefits include no ordinary income tax if held properly and can qualify for long-term capital gains. You don’t get taxed when they’re granted, and there’s no regular tax at exercise.
However, the spread (the fair market value minus the strike price) is considered income for AMT purposes. To get the best treatment, you must hold shares for two years from the grant and one year from exercise. Selling early creates a disqualifying disposition where the spread is taxed at ordinary income.
Restricted Stock Units (RSUs)
Restricted Stock Units (RSUs) require no upfront cash and are valuable, even if the price only moderately appreciates. However, they’re taxed at ordinary income as soon as the shares vest based on the fair market value at the time of that vest.
You generally want to set aside cash for tax because the withholding probably won’t cover the full liability. Later gains or losses after vesting are treated as capital gains and losses.
Employee Stock Purchase Plans (ESPPs)
Employee Stock Purchase Plans (ESPPs) let employees buy stock at a discount, usually something like 5% to 15% via payroll deduction. They may include a look-back, so you can look back and buy the stock at the lowest price over that period.
The discount essentially is an instant gain. For optimal tax treatment, shares should be held for over two years from the grant and one year from purchase. Selling immediately to lock in the discount triggers ordinary income tax.
Preparing for Liquidity Events
Advanced planning is everything when preparing for potential IPOs or acquisitions.
Pre-Event Preparation
For pre-event preparation, I work with advisors and CPAs to understand your equity holdings, your vesting schedules, any sort of potential dilution, and what’s your cost basis. Run scenario-based analysis to estimate sale price, timing, equity treatment, and estimating ordinary income versus capital gains.
Consider the QSBS, which is Qualified Small Business Stock Exclusion. If you’re at risk for an AMT, calculate it and plan around it. Ensure you have all your documentation on hand: ownership records, anything on the legal side.
Strategic Planning Considerations
Strategic planning involves considering gifting or transferring shares because it’s easier to do so before binding deals are in motion. This can freeze estate values, and QSBS shares transferred early sometimes retain their tax-exempt status. Work with estate attorneys to explore different trust structures, spousal limited access trusts, things like that.
Post-Liquidity Planning
Think about your post-liquidity goals and lifestyle needs. What’s your enough number? How much do you need to feel secure? Model out your cash flow projections and sketch out a plan to invest the proceeds. Consider whether you want to start a foundation or fund generational wealth.
You don’t necessarily want to let the tax tail wag the dog, and remember that stock concentration is dangerous. Assess your cash flow situation versus tax risk. Get ahead of any of these things because they can be costly. Build liquidity and make sure you can cover taxes. Rely on your CPA and run some of the analyses.
The key is advanced planning rather than reacting after the fact, ensuring you maximize your equity compensation while minimizing unnecessary risks and tax burdens.
Check out other chapters in my Smart Financial Moves Series here.