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.
An alternative to trading services for equity is to trade services for a share in future profits. While the case law is currently in flux, the prevailing view is that the IRS does not consider a share in future profits in exchange for the performance of services as taxable. This is a very complicated accounting and tax issue that requires consultation with a tax expert. There are other alternatives such as the investment partner loaning the sweat equity partner money for the initial capital contribution or forming the company with nominal capital contributions with the investment partner loaning money to the company to provide operating funds. The company could also be set up so that the sweat equity partner’s interest vests over a longer period of time to reduce the impact of the “phantom” tax.
Unfortunately, while the “sweat equity” model is ideal from a practical standpoint for many start-up businesses, it comes at the cost of increased investment in time, energy and money. Companies must take great care in how they structure their business and work closely with their accountant and attorney to ensure that all members’ goals are met.