From the May 2008 issue of Startups

Question: I've started a successful company and invested about $100,000 of my own money into it. I want to hire an operations manager and give him 30 percent of the stock in my company as an incentive, but he doesn't have any cash to contribute to the company--only his labor. What's the best way to legally do this?

Answer: People who become owners of a startup without putting up any of their own money as capital contribute what is known as "sweat equity." You can give this person stock, but he'll get a nasty surprise at tax time. If your company currently has a value of at least $100,000, by giving him 30 percent of your stock, you're giving him $30,000 in compensation, and he'll have to pay taxes at ordinary income rates on the full amount this year. Sadly, the IRS doesn't accept stock as payment for taxes--he'll have to come up with the cash. You have a few other options:

  1. Issue the stock in installments as he "earns his way in" (e.g., $1,000 worth of stock for each month he works for your company). He'll still have to pay taxes, but the liability is spread out over a longer period, making it more affordable for him.
  2. Give him the stock, then give him a year-end bonus equal to the tax liability he will incur on the stock grant (this is called a "gross up payment," and is itself subject to tax).
  3. Give him an option to purchase the stock at today's price after he's worked for you for a year or two. This is the preferred method, as he'll incur no tax liability on the option. (Although he may incur it later on, when the option is exercised.) Also, giving him options rather than shares gives you an opportunity to evaluate his performance before you make him a full partner in your company.