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Don't Let Sweat Equity Create 'Phantom Income'

How to set up an LLC without creating taxable income for your sweat-equity partner

Q: I'm planning to start a business with a longtime friend who has just been downsized from a large corporation and needs a job. I would provide $50,000 in startup cash, and he would basically do all the work. We would form a limited liability company (LLC) for the business and split profits and losses 50/50. Are there any legal or tax issues we need to think about?

A: There shouldn't be, but, sadly, there are. The problem is that our tax code places a value on capital (the money you put into the business) but not labor or "sweat equity" (the future services your partner will perform for the business). If you put $50,000 into this company and give your partner a 50 percent interest in the LLC, the IRS will value his interest at $50,000. Your partner will be required to pay taxes on that "phantom income," and he won't be happy about that.

There are three ways you may be able to set up this LLC without creating taxable phantom income for your sweat-equity partner.

Option 1: You would put your $50,000 into the company, and your partner would give a promissory note (basically an I.O.U.) to the company promising to pay $50,000 in capital, plus interest, over the next couple of years. As your partner works for the company, a portion of his cash compensation would be applied to pay down the note until his $50,000 has been paid in full. The note payments would be taxable to your partner but would be spread out over a period of time so as to lessen the pain--hopefully.

Option 2: You would put your $50,000 into the company as the sole LLC member and give your partner-to-be options to purchase equity that vest over time (for example, 5 percent every six months) at a price of $1,000 for each 1 percent purchased. Your partner would have to pay for his equity, but presumably he would be earning enough to cover the price, and there would be no taxable phantom income. You would also have some protection in case he finds a full-time corporate job and decides to quit the LLC.

Option 3: You and your partner would contribute a small amount (e.g., $10 each) to the LLC in exchange for a 50 percent equity stake. You would then loan the $50,000 to the LLC, with interest. The loan would be payable in full in five years, but could be prepaid at any earlier time out of the LLC's profits (if the two partners agree). You and your partner would be 50/50 owners of the LLC from day one, and you would be guaranteed a return on your investment.

Whatever you decide, make sure a good accountant or business lawyer helps you with the paperwork.

Cliff Ennico is a syndicated columnist and author of several books on small business, including Small Business Survival Guide and The eBay Business Answer Book. This column is no substitute for legal, tax or financial advice, which can be furnished only by a qualified professional licensed in your state.

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This article was originally published in the March 2010 print edition of Entrepreneur's StartUps with the headline: Don't Let Sweat Equity Create 'Phantom Income'.

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