Taxing Sweat

Like most entrepreneurs, two of my clients were surprised this week to learn that the US Internal Revenue Service (IRS) taxes “sweat equity.”

The IRS taxes income, and its definition of income includes both cash and non-cash compensation for services.  This actually makes some sense, as otherwise employers could circumvent the tax laws by giving property of value to their employees rather than cash (e.g. paying car and house payments).

Sweat equity is deemed to be non-cash compensation that is subject to income and payroll taxes if the following two conditions are present:

1) the equity is issued “in connection” with the performance of services; and
2) the person receiving the equity pays less than fair market value for the equity.

Generally speaking, the amount of income subject to tax is the difference between the fair market value of the equity on the date of receipt and the price paid for the equity. If the person receiving the equity is an employee, then the company must withhold and pay payroll taxes on the amount of the income.  If the person is a consultant, the company must report the value on a form 1099 Misc.  Failure to withhold and pay payroll taxes may subject the company to penalties.

The sweat equity tax issue arises commonly under the following circumstances:

1) formation of a legal entity.
2) the founding team wants to reallocate equity among themselves because the equity value held by team members is no longer perceived to be proportional to their relative contributions; and
3) the company wants to incentivize employees, advisers, consultants, and/or directors with direct equity in the company after formation (as opposed to an option to purchase equity in the future).

Here’s an example from the first scenario:  let’s say the founder of a company decides to wait to form a legal entity until the founder has some outside funding.  The founder now has commitments for $100,000 in funding, and the founder’s plan is to form a corporation and issue simultaneously 10% to the outside investors and 90% to the founder.  To keep it simple, let’s assume that the founder and the outside investors are all receiving the same security – common stock.

Given that unaffiliated third parties are willing to pay $100,000 for a 10% stake, the IRS might argue that the founder’s 90% has a fair market value of $900,000.   The IRS would also likely argue that the $900,000 in value was earned compensation for the services rendered by the founder to the company.  Why else would the company agree to issue the stock, if not to compensate the founder for past work on behalf of the company and/or incentivize the founder to perform services in the future?

The result — $900,000 in taxable income to the founder for the calendar year in which the equity is received, and the entire proceeds of the investment would go towards paying withholding and payroll taxes.  Understatement – Not a good result.

There are many nuances to this subject impossible to address in this one post, including differences in treatment between membership interests in limited liability companies and stock in corporations and the effect of receiving so called “restricted stock.”  The idea of this piece is not to inform you of everything you need to know about the taxation of equity, but rather to sensitize you to some of the issues.

In closing, here are the important take a ways:

1) Due to the significant tax implications, I can’t help but caution to review any “sweat equity” scenario with knowledgeable legal counsel.  This is true not only for founders and other interested parties that are currently US taxpayers, but also for non US taxpayers.  Receipt of sweat equity could subject a non US taxpayer to tax in the US

2) Form your entity as soon as possible.  The best time to form your entity is when you are still at the idea stage, and you can convincingly argue that equity in the company is worthless.  This is the time when you can you buy that “founders’ stock” at a fraction of a penny per share.

3) Generally speaking, it is better from a tax standpoint to issue more equity up front and subject it to forfeiture if services are not performed, as opposed to issuing equity incrementally over a period of time based on past performance.

Finally, be sure that you make employees, advisers and consultants are fully aware of the tax implications of equity compensation.  You are not legally required to offer information on tax issues,  but it will certainly make for a better working relationship.