“Sweat equity” allows individuals with little or no capital to obtain ownership in a business, usually a partnership or California Limited Liability Company (“LLC”), by trading labor for equity. It allows individuals with financial capital to partner with others who have expertise in a particular field for the purpose of starting a business together.
It is important however for individuals wishing to engage in a sweat equity arrangement to be cognizant of the tax implications associated with the transaction. Essentially, the sweat equity partner is earning money that she then exchanges for an ownership interest in the company. Because the IRS taxes income and defines income as both cash and non-cash compensation, a sweat equity partner’s compensation, in the form of ownership in the company, is subject to taxation. Sweat equity is subject to income and payroll taxes when: (1) it is issued in connection with the performance of services; and (2) the person receiving the equity pays less than the fair market value for the equity obtained.
Sweat equity is not immediately taxable if it is subject to a substantial risk of forfeiture. Sweat equity is subject to a substantial risk of forfeiture when the partner’s ownership in the equity is conditioned on future performance of services (e.g. the partner must work for the LLC for five years before her interest vests) or is contingent on the occurrence of a condition related to the transfer (e.g. the partner must attain a certain rank in the company). When the sweat equity is no longer subject to the substantial risk of forfeiture, it is considered vested and therefore subject to taxation.
Once it is established whether sweat equity is subject to taxation,
the rate at which it is taxed is next determined. The rate of taxation
on sweat equity is based on the value of ownership interest in the
company provided to the recipient. The IRS generally calculates the
value of an ownership interest to be what the owner would receive if the company liquidated all of its assets. For example, if a company is
worth $1,000,000, a ten percent ownership interest is valued at
$100,000, which is the value that would be used for taxation purposes.
Taxing sweat equity creates a problem, however, when the partner has
no money with which to pay the tax on her ownership interest. Remember
that the sweat equity partner isn’t getting paid cash for her services.
She is being paid with equity. From her perspective, she is being
taxed on phantom income. One way to avoid this problem is to allow the
sweat equity partner to purchase her interest in the company on loan
instead of being given an equity interest directly for her services.
For example, the business would loan the sweat equity partner $100,000
which she would use to purchase the ownership interest in the company.
The sweat equity partner would then repay the loan slowly over time with her share of the company’s future profits.
Sweat equity arrangements have significant tax implications which, if handled improperly, can result in serious tax consequences. Prior to
entering into a sweat equity transaction, it is best to consult a San Diego Business Attorney.