What Entrepreneurs Call 'Sweat Equity' the IRS Calls 'Taxable'
Working without a salary for equity might feel like pitching in at your neighbor's barn raising but the government doesn't see it that way.
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Sweat equity is trading labor for equity or an interest in the company. What happens when you are paid your sweat equity? The answer is simple. Sweat equity is always taxable. We can blunt the tax burden a variety of ways but equity given in exchange for something with a dollar value is not sweat equity.
Entrepreneurs are usually confused when they hear that sweat equity is taxable. The IRS will see sweat equity as two separate transactions or events. The labor provided to the company is a single taxable transaction between the founder and the business. The entrepreneur will be taxed on the dollar value of the labor provided. The founder receiving equity is another transaction, where the founder pays the "dollar value of the labor" to receive equity in the company. The founder will pay taxes on the amount of income earned from the "labor provided" and receive equity instead of cash.
For example, Bob receives $100 dollars in sweat equity from ABC Corp. Bob is required to pay taxes on the value of sweat equity received ($100 dollars) as earned income. Bob pays taxes on the $100 dollars of income and gains the equity in the company worth $100 dollars. Bob's tax basis in the company is then $100 dollars.
Avoiding the tax burden from sweat equity depends primarily on the timing when equity is given and the form of incorporation. The major milestone is whether the equity is received before or after incorporating. Generally, it is easier to distribute equity in a company and avoid a tax liability before it is incorporated. Founders cannot avoid a tax liability when receiving sweat equity after incorporating.
Before the company is incorporated. Entrepreneurs are allowed to distribute equity to the founders in any way without incurring a tax liability when initially incorporating. This is true for corporations and partnerships. Limited liability companies with multiple owners are usually taxed as partnerships. Tax law allows this because the company is worth nothing, so receiving an interesting in zero is not a taxable transaction or event. Thus, founders receiving sweat equity are can avoid a tax liability by providing no cash or a nominal amount of investment.
After the company is incorporated. After incorporating, a founder receiving sweat equity must pay taxes on the amount of equity they receive based on the explanation above. A few ways to lessen the tax burden for sweat equity founders that incorporated as a corporation, limited liability company or partnership is to use a vesting schedule or a loan.
A vesting schedule is a timeline where the founder receives equity over a period of time. This helps the sweat equity founder by spreading the equity and its associated tax liability over a period of years to avoid a giant tax bill in a single tax year.
Related: The Sweat Equity Myth
A loan is another option available to founders. David Reischer, an attorney from LegalAdvice.com explains that the company could give the founder a loan equal to the amount of equity. This means that the founder receives equity in the company and can pay the company back at their own leisure. Alternatively, I've seen companies give perpetual loans or loans that automatically renew every year (this includes interest on the loan) for sweat equity. This effectively defers the tax liability for years without requiring the sweat equity partner to immediately pay out cash.
83(b) election for corporations. A corporation may lessen the tax burden on a sweat equity founder with an 83(b) election. Alan J. Straus, CPA, J.D. explains, that the 83(b) election allows the sweat equity founder to be taxed at the current valuation of the stock or equity. Because the company's value is expected to be greater in the future, so the tax liability should be lower.
Profit sharing for partnerships. Partnerships are allowed to provide sweat equity to founders without a tax burden. But, it can only be in the form of a "profit sharing interest." This means that the founder would receive a percentage of the future profits in the company, but they would not receive an interest in the assets of the company. The "interest in future profits" does not have a monetary value in the present, so the sweat equity founder would avoid a tax liability by receiving an "interest worth nothing."
The sweat equity founder benefits by avoiding a tax liability, while still receiving an interest in the company. The drawback is that the sweat equity founder would not receive any of the assets in the company, if it were to close down. If the company were to be sold, they would still receive their share in the exit based on the partnership agreements.
Sweat equity is something that many entrepreneurs have to deal with because we often start as solo founders or with an informal agreement between partners. It's something we all need to consider early because it's often too late, when a business becomes stable or reaches the point where everyone involved is able to participate fulltime. Don't let the tax implications from sweat equity blindside you at the end of the year.
Related: What is Sweat Equity Worth?