San Diego Business Lawyer Blog

Trading "sweat equity" for a share in ownership of a California Limited Liability Company (LLC) or Partnership is common these days particularly because the recession is forcing people out of the main stream work force and into creative forms of income generation.  Trading "sweat equity" is a practical way for financial investors and motivated human capital to combine forces to start and/or grow a new business.  Unfortunately, most people are unaware of the potential pitfalls and move forward without any thought to potential conflicts between partners or the tax consequences.

There is little doubt that new and growing businesses benefit from sweat equity.  The young business gets an infusion of much needed human capital and the sweat equity provider earns ownership.  It's a win-win situation for the fledgling LLC or Partnership.  However, business owners considering trading ownership for sweat equity need to be acutely aware of two important issues.  

First, it's critical that the economic relationship between the members or partners be clearly defined in the LLC's operating agreement or in the partnership agreement.  Otherwise, the business' future will be froth with peril.  The company must anticipate potential conflicts that would arise should for instance the sweat equity partner fail to perform as expected or either partner expose the company to liability.  A well drafted LLC operating agreement or partnership reduces the possibility of future conflict and/or litigation.  A partnership attorney will ensure that all eventualities are addressed.  

Second, the sweat equity partner (the person trading sweat for equity) is in effect earning dollars that she is trading for a percentage ownership in the business (her capital contribution).  This is a complex issue that has important tax implications.  In the simplest terms, the dollars earned are taxed when the ownership is vested and the tax will be based on the value of the percentage ownership in the LLC or Partnership at the time. For example, say the LLC was formed by a member who contributed $50,000 for 50% ownership and a sweat equity member who contributes one year's future services valued at $50,000 for 50% ownership.  The $50,000 is compensation for services and is considered taxable income.  This can have a sizeable impact on the sweat equity's tax burden.  Moreover, if the company never proves profitable, it's much like paying tax on phantom income. 

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The excitement that comes with starting your first business is most often tempered by the myriad of critical decisions you have to make.  New businesses are sprouting up all over San Diego, and a common question for young entrepreneurs is "How do I pay myself?"  The question is usually asked well after the new business is underway.  It is common for new business owners to forge ahead with the expectation that as soon as they see a profit, they'll simply pay themselves.  However, as they think more about "how much" and "how" to pay themselves, they begin to wonder just how to accomplish the task.  Do they withdraw profits for themselves?  If so, can they do this any time or must they wait until year's end?  Do they pay themselves a salary including the withdrawal of state and federal deductions?  What are the tax consequences?  What about my partner?  

The answer depends on your business' structure.  If you have formed a corporation, you would typically pay yourself as the corporation would pay any employee including the withdrawal of state and federal deductions.  You would also have the option of paying out dividends.  Determining what to pay and how to pay yourself requires careful consideration of the corporation's anticipated profits.  It makes little sense to pay yourself more than the corporation makes (whether via salary or dividends).  The decision becomes more complicated if you have multiple shareholders but your Articles of Incorporation and By-Laws should be set up to clearly address management compensation and dividends.  

As a sole proprietor, you pay yourself a draw from the company profits.  When and the amount you draw from the business has no tax implications.  You and the company are the same entity for tax purposes, and you pay yourself whatever you like.  However, the ability to pay yourself and whether paying yourself makes good business sense are two different things.  Withdrawing all of the company's revenues leaving the company unable to pay expenses is never a good idea.  It's also important to know that what you pay yourself is not an expense for tax purposes.  You don't get to write it off.  For a single member Limited Liability Company (LLC), you would pay yourself exactly the same way as you would for a sole proprietorship.  LLC's are considered pass through entities (as long as you did not elect to be taxed as a corporation) which means you are taxed the same as if you were a sole proprietor - you pay yourself a draw from the company profits.  

You also pay yourself a draw from company profits in partnerships and multi-member LLCs (that do not elect to be taxed as corporations), although as with corporations, paying yourself becomes more complicated because there are multiple owners.  In these circumstances, it is important to plan ahead and ensure that a well drafted partnership agreement or LLC operating agreement is executed.  Otherwise, partners and LLC members will struggle with how to divide up profits and this can be devastating to young and growing businesses.  

In the end, how much you pay yourself will be more important than how you pay yourself.  You will want to balance your personal needs with the needs of your business.  Whatever your financial goals, it remains important that you begin your new venture by carefully considering which business entity to choose, and this decision shouldn't be made without first consulting your accountant or tax attorney.

Organizing a workforce for your San Diego business presents formidable challenges.  One of those challenges is deciding whether to hire staff as independent contractors or as regular employees.  Obviously, there are fiscal advantages to hiring independent contractors.  For those workers classified as "employees", withholdings, payroll taxes, worker's compensation, and compliance with labor laws generally add about 18% to your payroll costs, and this is exclusive of employee benefits.  Hiring independent contractors is an appealing alternative, but it's not as simple as treating all workers as "independent contractors".  Federal and State law dictates whether a worker is an "independent contractor" or an "employee".  

When the time comes to hire staff, it is crucial that businesses ensure that workers are properly classified under Federal and State law.  Even large corporations have fallen victim to the assumption that classification of its workers as independent contractors was appropriate.  Microsoft Corporation, Hewlett-Packard, Time Warner, Allstate and FedEx have all borne the cost of litigation regarding the misclassification of workers.  Since 2007, estimates of settlements in worker misclassification cases approach one billion dollars.  Nonetheless, employers continue to opt for the "independent contractor" classification while treating staff as employees opening themselves to significant tax liabilities, interest and penalties.  

Part of the problem lies in the ambiguity in existing regulation lending to subjective determinations.  In California, the Employment Development Department offers the following guidelines for the definition of an "employee":  the employer has the right to discharge the worker at will; the work is usually done under supervision; the worker does not provide the tools, equipment, or place of work; the worker is paid based on time worked or piece rate; the worker has little or no meaningful discretion on how to do the job; and the worker does the same kind of work as that which is the principal production of the company.

Under these guidelines, it is easy for unwary employers to convince themselves that they are properly classifying workers as independent contractors.  This is often done through rose colored glasses without fully understanding the consequences of misclassification.  If the I.R.S. or state tax agency determines that a business' workers are misclassified as independent contractors, the business will be subject to back taxes, interest and penalties which can be significant.   In most cases, especially for smaller businesses, the issue of misclassification never arises.  Workers classified as "independent contractors" fear challenging their employer's determination. Nonetheless, employers that currently classify workers as independent contractors should reevaluate the classification, particularly as tax agencies are increasingly viewing the use of independent contractors with suspicion.  If there is any doubt, employers can seek the advice of a business attorney and/or file a Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Tax Withholding.

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