Sweat Equity

[Zee]

I think an example might help illustrate my question. Let's assume two investors contribute $25,000 each to capitalize an S-Corp. They'd like to hire a manager for the business at $30,000 yr, but are concerned about cash-flow. As such, they're considering offering the manager a salary of $12,000 and an equity interest. The manager likes the idea because he's 63 years old collecting social security and doesn't want to return earnings exceeding SS limits. It's assumed his share of the S-Corp will be a dividend. The question: Does the receipt of the equity interest create taxable income?If not, what is the value if the interest is later sold?

[taxmandan]

I think an example might help illustrate my question. Let's assume two investors contribute $25,000 each to capitalize an S-Corp. They'd like to hire a manager for the business at $30,000 yr, but are concerned about cash-flow. As such, they're considering offering the manager a salary of $12,000 and an equity interest. The manager likes the idea because he's 63 years old collecting social security and doesn't want to return earnings exceeding SS limits. It's assumed his share of the S-Corp will be a dividend. The question: Does the receipt of the equity interest create taxable income?If not, what is the value if the interest is later sold?

Yes, it's taxable and W-2 income, not dividends. S-Corps don't pay dividends. There may be distributions of profits over and above wages to shareholders, but payments for work in the business is treated as wages for tax purposes.

And, SSA is aware of the various attempts to evade the income limits using business entities in an attempt to recharacterize income. They will notice, and the penalties are stiff.

[Bees Knees]

You could do it with a partnership, but you can't give a non-shareholder shares of stock without issuing a W-2. Distributions must be in proportion to stock ownership interest, so any distribution to a non-shareholder would terminate your S status.

If the business were organized as an LLC taxed as a partnership, then the two capital interest partners could give the manager a profits interest. A profits interest is not taxable until profits are actually distributed to the profits interest only partner.

[Zee]

Thanks Taxmandan and Bees Knees.

I believe both answers are correct. This situation could be structured as an partnership or LLC, but not in an S Corp. There may be some sort of an exception for founder's shares in a Corporation. As you're aware, founders shares are purchased at a minimal price by the organizers of a corporation. The cash raised isn't intended to meet capital needs. Shares sold to others at a higher price provide the necessary capital. I believe I read that taxation on the bargain price might be avoided by carefully separating the timing of the founder's purchase from investor's purchase, but I'm not quite sure how that would work.

I understand that S-Corps do not issue dividends in the true sense of the word. But the distributive profit is routinely described as treated like a dividend. If reasonable compensation has been paid to the shareholder collecting social security, what's the problem? The distributive profit isn't wages for FICA, so why would it be considered wages for social security purposes? Does Social Security specifically define such as wages?

[Bees Knees]

I understand that S-Corps do not issue dividends in the true sense of the word. But the distributive profit is routinely described as treated like a dividend. If reasonable compensation has been paid to the shareholder collecting social security, what's the problem? The distributive profit isn't wages for FICA, so why would it be considered wages for social security purposes? Does Social Security specifically define such as wages?

The distributive share of profits is not subject to FICA. That is not the issue. The issue is how do you get the manager who is not contributing any money shares of stock? You can't give him a distributive share of profits until he owns stock. But he can't own stock until he pays for the stock. You said he would become a stockholding by working for the stock. If that is the case, working for stock is taxable as W-2 income. Instead of getting cash for his services, he gets stock. It doesn't matter whether you pay him in cash, or stock, or chickens, receiving something in exchange for working is considered wages.

[OldJack]

Well I have to agree with Bees (d-a-m-n). However, I might add that the S-corp issues the shares to the new guy at fair-market-value at the time of issue (and his W2). If the original owners have spent their capital and the value of the S-corp is zero there could be little or no cost for the new shares.

[Zee]

The distributive share of profits is not subject to FICA. That is not the issue. The issue is how do you get the manager who is not contributing any money shares of stock? You can't give him a distributive share of profits until he owns stock. But he can't own stock until he pays for the stock. You said he would become a stockholding by working for the stock. If that is the case, working for stock is taxable as W-2 income. Instead of getting cash for his services, he gets stock. It doesn't matter whether you pay him in cash, or stock, or chickens, receiving something in exchange for working is considered wages.

Yes, I understand the stock receipt is taxable and wages are taxable as W2 income in this situation. And, that the tax on the sweat equity might be avoided using a partnership or LLC.

TaxmanDan seemed to indicate the distributive share of S-Corp profits is counted toward the earnings limitations for those receiving social security because it isn't a dividend. That sounds reasonable if reasonable compensation wasn't paid to the social security recipient. I would think if reasonable compensation is paid, the distributive share of the earnings would not. As such, if in 2007 a social security recipient and S shareholder is paid $12960 (and it is reasonable compensation) any excess distributive S-Corp profits would not be counted towards his earnings limitation and his social security checks wouldn't be reduced. I'm simply looking for verification of what's correct

[Zee]

Well I have to agree with Bees (d-a-m-n). However, I might add that the S-corp issues the shares to the new guy at fair-market-value at the time of issue (and his W2). If the original owners have spent their capital and the value of the S-corp is zero there could be little or no cost for the new shares.

Hi OldJack, I'd like to understand "spent" a little better. Let's assume the initial S-Corp investment was franchise fees and was "spent". A invested $25,000, B $25,000. They've invited C to join them for "sweat equity" offering him a 1/3 interest in the business. The franchise fee is mostly "blue sky" printed marketing materials. No other assets. If he joins them at the inception, how much goes on his W2? $16667?

[BOB W]

What ..........

....... would be the problem with each shareholder GIFTING a portion of their shares to the new shareholder?

Another choice is issuing w2 (sweat equity) in yearly increments until the new shareholder has his full % ownership.

[taxmandan]

Yes, I understand the stock receipt is taxable and wages are taxable as W2 income in this situation. And, that the tax on the sweat equity might be avoided using a partnership or LLC.

TaxmanDan seemed to indicate the distributive share of S-Corp profits is counted toward the earnings limitations for those receiving social security because it isn't a dividend. That sounds reasonable if reasonable compensation wasn't paid to the social security recipient. I would think if reasonable compensation is paid, the distributive share of the earnings would not. As such, if in 2007 a social security recipient and S shareholder is paid $12960 (and it is reasonable compensation) any excess distributive S-Corp profits would not be counted towards his earnings limitation and his social security checks wouldn't be reduced. I'm simply looking for verification of what's correct

The operative words are "reasonable compensation," many arguments occur with theIRS and SSA about what is reasonable. What I'm saying is that your client needs to be prepared to fight that fight if/when it comes from SSA. But giving shares of ownership in lieu of cash for work performed is still W-2 income.

[Zee]

The operative words are "reasonable compensation," many arguments occur with theIRS and SSA about what is reasonable. What I'm saying is that your client needs to be prepared to fight that fight if/when it comes from SSA. But giving shares of ownership in lieu of cash for work performed is still W-2 income.

Yes, that's correct. In this situation, the business is a "seasonal" business. As such, the compensation for 3-months would unquestionably be "reasonable" when compared with prevailing rates. This is a start-up business, and probably will lose money the first year. So, the first year's interest in profits is probably zero. But, the owner's are planning on opening 5 more shops next year and the manager would also manage those. That's the reason for the "sweat equity" being considered. However, the business has already been incorporated as an S-Corp but won't start business until January 1st. So, there isn't much time to undo things and operate as a partnership or LLC which would appear to allow sweat equity without immediate tax consequences.

[OldJack]

Hi OldJack, I'd like to understand "spent" a little better.

Well Zee... the word "spent" was tied to "fair market value" of the business after spending. You say its a startup business with a loss the first year meaning the "equity" or fair market value of the shares of stock will probably be very little as the loss will offset the asset for franchise cost. Also, as the number of shares would not be a majority owner there could be a discount as well as a discount of the fair market value for the lack of marketability as you would have a restriction on the sale of the stock for a time and first right of purchase by the other shareholders. The end result is the stock could probably be sold at little or par value.

The other option mentioned that each shareholder could gift some of their shares.

[BOB W]

The best........

........... choice is an LLC. Your SS member only has to wait 2 or 3 years (62?) and then he can earn any amount of "earned" income.