Sweat equity and the S corporation

There are several ways S corporation shareholders can make capital contributions to their company. Cash contributions are probably the easiest way for an S corporation shareholder to make their capital contribution; with a cash contribution, the shareholder hands over a check, and the amount is entered into that shareholder's capital account.

Capital contributions can also be made with property or services. Property-based capital contributions can be a little more challenging to account for, with valuation being the main issue. In general, though, capital contributions made in services, while quite popular, will also pose the most potential problems for the S corporation.

Sweat equity definition

Are you, or one of your fellow S corp. shareholders, looking to offer your services as your capital contribution to your S corporation? By doing so, you'd be following the time-honored tradition of sweat equity; after all, many small businesses today have been built on the shoulders of sweat equity. So, what exactly is sweat equity? Put simply, it's when you provide services or labor that add value to your company in return for an ownership interest.

Valuation of sweat equity

As you can imagine, sweat equity is particularly useful in the realm of small business startups. Many entrepreneurs are strapped for cash, and, in such circumstances, contributing their services or labor to their nascent companies can be an ideal way to make their capital contribution.

As a solo entrepreneur, it's not at all unusual to own sweat equity shares in your own company. And when you are the sole owner of your startup, sweat equity may indeed be an ideal way of making a capital contribution.

But, if there are fellow shareholders of your S corporation, a capital contribution in the form of sweat equity can become extremely problematic if all the owners do not sit down to carefully plan for and discuss how to value the sweat equity that one or more of the shareholders wishes to contribute to the company.

It may seem simple at the outset, but there are actually a few different ways to value sweat equity. Obviously, you'll want to pay fair market value for labor or services, but what is fair market value? It may be the amount that the person would have earned by providing the same labor and services for an employer. But an argument might also be made that the labor and services are worth more to your S corporation than what would be reflected by a fixed hourly wage.

For example, a shareholder might contribute his or her time to build equipment that the corporation might otherwise have to purchase. If the purchase cost of this equipment turns out to be more than the cost of the shareholder's labor or services—valued by applying an hourly wage, plus materials—the sweat equity shareholder may prefer to have an amount equal to the purchase cost reflected as his or her capital contribution.

Negotiation is key

If any of the shareholders of your S corporation wishes to make a capital contribution in the form of sweat equity, all shareholders must sit down and discuss how the sweat equity should be valued before any such contributions are made.

Issues that should be considered include the following:

• Is an hourly wage an appropriate method of valuing a shareholder's sweat equity?
• Is the work's value greater than an hourly wage would suggest?

Even when you agree on the proper valuation for a shareholder's sweat equity contribution, you will need to consider when the sweat equity will be credited to the shareholder's capital account.

• Will the shareholder receive the full sweat equity value up front?
• Or is the better solution to value the sweat equity regularly?

For example, you may have decided on an hourly rate for a shareholder's labor that feels fair to everyone, but what if—at a later date—it becomes apparent that the work itself is substandard?

If you've all decided on a value for the total shareholder's services at the start, and this value has been recorded in the shareholder's capital account, you can't then decide to reduce that value later because of what you consider subpar work.

And don't forget about the tax consequences

So, all of your S corporation's shareholders have met and agreed about the value of the sweat equity you or another shareholder will contribute to the company. It's not time to celebrate yet: There's one final thing that must be considered, especially if you're the one who's planning to provide the sweat equity, and that's the tax consequences of your actions.

Unfortunately, in the eyes of the IRS, contributing sweat equity is not the same as contributing cash. The value of the labor or services a shareholder provides to the company is viewed as that shareholder's earned income. In other words, he or she will have to pay taxes on it.

There are ways to avoid a huge potential tax liability—for example, the sweat equity arrangement could be structured so that the shareholder receives an increasing ownership percentage over a specified amount of time—but it's a smart move to consult with a tax advisor first to discuss potential tax consequences before you take the sweat equity plunge.