Sweat Equity – How On Earth Can It Be Taxable!?!

Whether it’s fixing up an investment property or starting a business, most entrepreneurs find themselves putting in some serious sweat equity. Sweat equity is essentially unpaid labor. The owner of an investment property does renovation work herself to keep costs down and to increase the value of property she plans to flip. She’s contributing sweat equity. Owners of a service business contribute expertise and efforts to get a business off the ground. They’re giving sweat equity.

Why write a blog post on sweat equity? Here’s why: If you’re giving sweat equity in exchange for ownership, it’s probably taxable to you. Here’s a short story to illustrate how this can play out: Over a third pint of IPA, Pat and Sam stumble across a brilliant idea for a craft brewing service business. Pat has loads of money but little time to give. Sam has plenty of time and business skills, but no money to invest. They form a corporation and issue stock to Pat (who gives $50,000 to the business for 50% of the shares) and Sam (who is giving services to the business for the other 50% ).

Over a third pint of IPA, Pat and Sam stumble across a brilliant idea for a craft brewing service business. Pat has loads of money but little time to give. Sam has plenty of time and business skills, but no money to invest. They form a corporation and issue stock to Pat (who gives $50,000 to the business for 50% of the shares) and Sam (who is giving services to the business for the other 50% ).

Sam just got stuck with $50,000 of taxable income. The IRS sees it like this: Sam is providing services in exchange for something of value, stock of the corporation. It’s not any different to the IRS than if, say, Sam were to receive $50,000 cash from the corporation then turn around and use it to buy half the shares of the corporation. Sam needs to report taxable income. Since half of the shares are worth $50,000 (that's what Pat paid) the IRS figures the other half are worth the same. Sam needs to pay income taxes and please recall Sam was broke to begin with so this unexpected tax bill is definitely no fun.

The moral: don’t be Sam. Be sure to consult with appropriate and trusted tax and legal advisors so you fully understand the impact of such key business decisions. Good long-term tax/legal planning can help you structure and fund your business in a tax-beneficial way.

Please know this blog post contains no tax, accounting, nor legal advice. Our posts are intended to be informative and useful for business owners. And we want you to know we are offering high-quality bookkeeping and certain tax services -- let us know if we can help.