Many businesses are started with one or more persons putting up the capital, and the one or more persons putting in their efforts or experience in lieu of an actual cash investment in the start up of the business. This contribution of effort or experience is called “sweat equity” Unfortunately it gives rise to taxable compensation to the people receiving an interest in the business in exchange for their “sweat”.
Take for instance, a corporation started with Mr. Big Bucks contributing $200,000, and Mr. Just Sweat contributing his efforts, with the plan that Mr. Sweat would receive a minimal salary but with the plan that after meeting certain requirements, Mr. Sweat would by rewarded with some percentage of the business. This eventual reward (if it happens) of an ownership percentage in the business, creates a taxable event. Compensation in the form of an ownership of the business is received by Mr. Sweat and he has to pay income tax on the value of what he received (and is subject to payroll taxes). The value can be tricky to determine as it is the value of an ongoing business and may require a formal valuation of the company. In any case, Mr. Sweat will want to minimize the value and therefore the tax that results. The partial good news is that “sweat equity” compensation can be a deduction to the company.
These “sweat equity” deals are common but require some planning so the largely overlooked tax consequence doesn’t appear under an audit.
Good luck and here’s hoping it “all adds up” for you.
(If there is any area in accounting or tax that you think needs to be addressed in this newsletter please e-mail Dick at Ginnatycpa@aol.com and if it is of general interest, he will address it in future articles)