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.