Taxation and Value of “Sweat Equity”

by Mario J. Fazio, Esq.

For people with an entrepreneurial spirit, one way to gain ownership in a company is through so-called “sweat equity.”  The idea is that you work for an ownership interest in the company, rather than investing cash or other capital.  If a company decides to implement such an arrangement, one or more key employees would be selected by the company to receive a grant of equity in the company.  The equity would consist of a small percentage of the ownership of the company and is often subject to forfeiture under specified circumstances set forth in writing.  Very often, the vesting requirement is for the employee to remain in the employment for a specified period of time or for the employee to meet certain performance goals. When structuring these arrangements, the taxation to the employee and the company is an important consideration since the tax treatment can vary widely.  It benefits all parties to make sure that equity grant arrangements are done in a tax efficient manner.

There are various types of “sweat equity,” including stock options and restricted stock in the case of corporations (although they can also be used for partnerships and limited liability companies (“LLC”)) and grants of “profit interests” typically used in LLCs.  For simplicity, I refer to all of these types of “sweat equity” as “equity grants.”  Each grant can be tailored for the particular goals of the company and for each employee and each key position.  The overall structure of any equity incentive arrangement for a key employee or management team needs to take into account both the goals and the needs of the company as well as the goals and needs of the key employees.

Over time the equity grant presumably will appreciate in value, but of course there are no guarantees.  The value of the equity grant typically depends on the overall increase in value of the company over time.  From the company’s standpoint, the advantage of equity grants to key employees is that the grants serve to attract and retain quality people in management and align the interests of the key employees with the owners of the company.  The equity grant may also eliminate or reduce the company’s need to do substantial cash bonuses at year-end since the growth in value of the equity grant serves as the annual bonus.

A company will usually require an equity grant to be “earned” by the key employee over time through a vesting schedule that is set forth in the grant agreement with the employee or in an equity incentive plan adopted by the company.  For example, a grant of stock options may be contingent on the employee working in the business on a full-time basis for five years, at which point the stock options become fully vested.  If the employee terminates employment prior to the five year period, all, or a portion of, the stock options may be terminated.  There is no set time period for a vesting schedule and the terms and length of a vesting schedule are at the discretion of the company.  However, once the vesting terms are agreed upon, they should become binding on both the company and the employee through the adoption of a written incentive plan or agreement.

For example, a so-called “golden handcuff” arrangement typically provides that the equity grant does not vest until sale of the company or a specified retirement date.  This provides an incentive to the employee to work long-term for the company that will ultimately be cashed out upon sale or retirement.  However, equity grants are often structured to vest over shorter periods of time (such as ratably over a 3-5 year period).

For tax purposes, the employee normally recognizes compensation income upon the vesting of the grant.  For example, a grant of stock of a corporation would typically not be taxable to the employee at the time of grant.  However, when the shares vest, the employee has taxable income equal to the value of those shares.  In the case of an LLC, equity grants are typically made in the form of “profits interests” that meet the requirements of IRS Rev. Procs. 93-27 and 2001-43.  Neither the grant nor the vesting of a profits interest in an LLC is taxable to the employee until the membership interest is sold. This represents the best of both worlds for an employee since the employee is not taxed on the equity grant.  The only taxable event occurs when the profits interest is sold, and the employee is entitled to capital gain tax treatment on such sale.

In the case of an S corporation, the use of a profits interest for the equity grant is not available.  However, a somewhat similar result can be achieved by issuing shares of the corporation to the employee and having the employee execute a promissory note in an amount equal to the value of the shares at the date of grant.  If this is done early in a corporation’s existence, the value of the shares would be presumably low, making the purchase price also relatively low for the employee.  Since the employee is purchasing the shares at fair market value, the employee is not subject to compensation income at the time of issuance.  The vesting of the shares over time also would not trigger compensation income provided that the employee makes a “section 83(b) election” with the IRS at the time the shares are issued.  Finally, the employee would be entitled to capital gain on the sales of those shares in the event of a future sale of the company or redemption of the shares by the company upon termination of the employment.

Keep in mind that there are many other important provisions that should be considered when entering into an equity incentive arrangement from both the company and the key employee’s perspective.  A short list of such items include non-compete restrictions, non-disclosure requirements, and assignment of intellectual property to the company that the employee develops while in the employment of the company.