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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

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This story appears in the March 2010 issue of Start Up.

Q: I'm planning to start a 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 (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 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 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.

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