Clients frequently tell me they are planning to issue stock for no cash investment. This is generally referred to as “sweat equity”. The most common scenarios are:
- Issuing stock to one founder (the “money guy”) for cash, and to the other founder (the “idea guy”) who has the idea or will be doing most of the work
- Issuing stock to the founders for little or no money around the same time they issue stock to “money investors” at a high valuation
- Issuing stock to contractors or employees in lieu of paying them cash
If you are a business owner or trusted advisor, it is important for you to know that this is a potential tax issue. The IRS considers any property issued in connection with the performance of services to be compensation, which is taxed as ordinary income. Stock is property (and for the purposes of this article, when I say “stock” I also include membership interests in an LLC). If someone pays money for stock, it’s an investment, not compensation. If the person pays no money, then he or she is paying with labor (hence the “sweat” part of “sweat equity”). The stock is compensation for the labor and therefore taxable.
For example, let’s say Joe is an entrepreneur with a great idea but no money. He contacts his friend Sue, who agrees Joe has a great idea. She decides to invest $20,000 for 20% of the stock, and Joe gets 80% of the stock for doing the work. Joe just received $80,000 of property, taxable as compensation for services. (We are assuming the idea is not mature enough to be considered a contribution of IP that is worth $80,000.)
Or let’s say Joe and Sue come up with the idea together but neither one can fund it. To save money they don’t form a corporation at this stage. They spend several months creating a product they think will be marketable. When they need money for proof of concept, the product is far enough along to get some investors interested. Now they have to form a corporation, because the investors need to get stock in something. The investors pony up, say, $200,000 for 20% of the company. Joe and Sue get 80%. Well, Joe and Sue just received stock worth $800,000, and the IRS will tax them on that amount at ordinary income rates.
A third example would be If Joe and Sue don’t have the expertise to do the work themselves. They might contact a friend or two, or former co-workers, and ask them to put in some time (the classic example being to develop the code for a tech product). They don’t have any cash to pay these contractors, so they offer them stock. In the early days when the valuation is minimal, this may not be a problem. But if there is a valuation event as above, the ten or twenty thousand shares these contractors receive could be valued in the tens of thousands of dollars and guess what? They’ll have to pay tax on the receipt of that stock, even though they received no cash with which to pay the tax.
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.
To summarize, it’s important to remember that stock for no cash (or “sweat equity”) is generally considered compensation for services and is taxable as such. The obstacles are not insurmountable but require an awareness of the potential issue, and some good planning to avoid or reduce the tax hit.
This article is not intended and should not be relied upon as legal or tax advice pertaining to any specific matter. You are encouraged to seek competent legal and tax counsel prior to implementing any specific transaction.