Sweat Equity | BEWARE
A friend of mine has a startup, has traction and is lining up seed investment. While they got going, the issued everyone shares as sweat equity. Simple formula, hours worked @ $50 per hour, once you had 4 hours, you earned 1 share.
This was for everyone from the founder to the everyone.
However, no-one, including the startup finance advisors picked up that sweat equity is TAXABLE.
And now the deal is at risk of massive delay, which could be a killer blow.
So, check your stuff first.
These links are helpful
https://www.entrepreneur.com/article/205310
https://www.randellaw.com/how-to-avoid-the-tax-traps-of-sweat-equity/
If you to lazy to click the link:
Fortunately, there are several ways to avoid this problem or at least reduce the tax hit:
Form the corporation early on, when valuation is basically zero, and the founders can pay a nominal amount for their stock. In this way the few thousand dollars the founders put in will be considered valid payment for the millions (or hundreds of thousands) of shares they are issued.
In the same vein, when the valuation is this low, you can grant contractors shares and their tax bill will be so low, it doesn’t matter (the value of the shares might be, say $100 or a few hundred dollars, and either they can pay the tax on that amount, or the company can bonus them the cash to pay the tax)
If it’s too late for the above, the founders can contribute property (usually intellectual property) rather than cash; but the IP must be “mature” IP or it isn’t really property. Be careful with this, because the IRS might argue they are really contributing the time and effort to turn the alleged IP into something marketable, and the stock is compensation for that time and effort.
Just go ahead and grant sweat equity and pay the tax if it’s not too much (often the company gives the contractor or employee a “bonus” to pay the tax)
Instead of shares, grant the person stock options. If the recipient is an employee, and the business is a corporation, they can receive “incentive stock options” so that, if certain conditions are met, there is no tax until they sell the shares. If a contractor, they will get “unqualified” (or “nonstatutory”) options, in which case they pay some tax when they exercise the options plus tax on the gain when they sell the shares. If the business is an LLC, it can issue what are called “profits interests” which in many ways mimic stock options (including that they are not taxable upon grant)
If the potential problem is that shares are being issued to outside investors at a (moderately) high valuation, thereby valuing the “sweat equity” stock too high for tax purposes, it can help to issue the investors preferred stock and the sweat equity recipients common, which has a much lower valuation than preferred. This will not eliminate, but can substantially reduce, the tax owed.
There are other more esoteric methods to grant service providers a stake in the upside, such as phantom stock or revenue share arrangements, but the above are the most common.