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.