Small business owners put their blood, sweat, and tears into ensuring the success of their company, which, though difficult to measure, are no less valuable than capital contributions. At the same time, if you are investing your time and energy into a limited liability company (LLC), you should establish a method of valuation for your services—also known as “sweat equity.”
The method that you and the other LLC members arrive at for valuing your labor, should be documented in writing in the LLC operating agreement. All LLC members should be aware of the potential pitfalls of LLC sweat equity members, including the tax consequences.
LLC Ownership Shares and Sweat Equity
Typically, when a multimember LLC is formed, each member's ownership share—as well as their share of any profits and losses and other rights and responsibilities such as voting rights—is determined by their capital contribution to the business.
For example, if an LLC has two owners, each contributing 50 percent of the startup capital, then a typical operating agreement would specify that each owner has equal rights and responsibilities. But because LLCs are more flexible than corporations, they can allocate ownership any way they see fit; it just has to be specified in the operating agreement.
Startup contributions to an LLC can take the form of tangible assets like cash or property. They can also take the form of sweat equity, or labor. Let's say that, instead of the two owners each contributing 50 percent of the startup capital, one owner contributes 100 percent of the cash, and the other owner, who may not have cash to contribute, agrees to perform the day-to-day work of running the business.
In this case, the owners could formalize their pact in the operating agreement, with each receiving a 50 percent ownership share. Alternatively, they could decide to divide ownership 60-40, 70-30, 80-20, or however else they want. The main takeaway here is that the owners should assign a specific monetary value to the noncash contributing owner's labor. This capitalized figure should then be reflected in the operating agreement as an ownership percentage.
Be Aware of Sweat Equity Tax Consequences
LLC profits are distributed to members (i.e., owners) as distributions. Distributions are often determined based on the amount of capital (including capitalized labor or services) invested. They can also be based on interest ownership or more complicated arrangements that the owners agree on in the operating agreement.
Sweat equity, unlike a standard capital contribution, is considered taxable ordinary income (that is, compensation in exchange for services subject to income and payroll taxes). And the amount of income that is taxable is based on the company's value (or more specifically, how much it would be worth if it liquidated all of its assets).
If a multimember LLC is valued at $1 million, and a sweat equity member's ownership share is 10 percent, the value of that share for tax purposes would be $100,000. This could pose a big problem for the sweat equity member, whose services are rewarded with equity rather than cash, and who may not have the cash to pay those taxes. Note that only sweat equity members are taxed in this way. Members who contribute cash or other assets are not.
There are workarounds to this tax on phantom income, such as allowing a sweat equity member to buy in to the LLC over time, having them purchase an interest in the LLC through a loan from the business, or deferring the sweat equity until the LLC turns a profit. Sweat equity taxation strategies should be discussed with a business law attorney.
Make Sure That All Members Understand Their Rights and Responsibilities
Beyond income and tax consequences, membership in an LLC comes with several rights and responsibilities, including management duties and voting rights.
The first thing to remember is the default rules set forth in the state law applicable to your LLC. In some states, the default rule is that an LLC is member-managed, which gives broad authority to members to perform transactions on behalf of the business, like securing loans and buying real estate. In a manager-managed LLC, on the other hand, nonmanager members give up most of their agency powers to designated managers. When bringing in a sweat equity member, think about the LLC's structures and the powers you are comfortable giving to a noncapital contributing member.
Similarly, the default rule of some states is to grant voting rights based on a member's capital contributions (not their ownership interests). For a sweat equity member, this means the value of their capitalized services as recognized in official LLC documents.
Member rights and responsibilities should be set forth in the LLC operating agreement, which can be written and amended in a manner that the members agree on. To avoid conflict and surprises, LLC members should align their goals and make sure that the operating agreement reflects consensus decisions.
Contact Us for a No-Sweat Approach to Sweat Equity
Sweat equity is highly valuable to startups and established businesses. A study published in The Quarterly Journal of Economics found that for US private businesses, sweat equity has value similar to that of fixed assets used in businesses (about 1.2 times US gross domestic product).
A sweat equity member can be part of a new LLC from the startup phase, providing valuable time and effort that helps the business get off the ground. Sweat equity can also be a way to reward employees with an ownership interest in the company and incentivize worker engagement.
The flexibility of LLCs provides several ways to add a sweat equity member to your business. But careful consideration is required to accurately value a member's services, establish a formal agreement that avoids the problems that can result from handshake deals and vague promises, and avoid adverse tax consequences.
To discuss the pros, cons, and sometimes-overlooked aspects of sweat equity for LLCs, contact our office and schedule an appointment with our business law professionals.