In the best of all possible worlds, equity in an LLC is acquired by a cash buy-in. But often, one member of the LLC has cash, yet the other does not, and can’t acquire it other than through sweat equity. In another scenario, an LLC wants to grant a valued employee equity in the LLC based on his contributions to the LLC.
Cash & Sweat Equity Buy-Ins
In the first situation, the simplest, yet worst, solution is to have the two LLC members – the one with the money and the one without – form an LLC, have the investor member capitalize it, then make both members 50% equity holders based on an agreement that the member without the money would run the LLC in exchange for that member’s interest.
If the members opt for this approach, the IRS will value both 50% interests at half the equity the investor member paid in. Further, the IRS will consider the sweat equity member to have received ordinary income consisting of the value of that member’s half interest in the LLC and tax him accordingly. Suppose, for example, that the investor member pays in $100,000 and in exchange receives a 50% interest in the LLC. In the eyes of the IRS, the sweat equity member received $100,000 for his 50% and must pay tax on the phantom income.
Two Workarounds to Minimize Taxes
There are at least two ways to soften the impact of the tax bill. First, the investor member could begin as 100% owner of the LLC, but grant the other member options to buy into the LLC over time. As the business developed, the other member would be contributing sweat equity and being paid by the LLC. He could then buy into his promised 50% interest over time so that there would be no phantom income.
The second workaround would involve each member buying a 50% interest in the LLC for a nominal amount. Then the investor member would lend the LLC the money he intended to use to buy into it. Over time, the loan would be repaid from profits generated by the LLC, thus avoiding phantom income.
The Profits Interest Solution
There is a third way to avoid ruinous tax consequences resulting from sweat equity. The LLC could allow the second member to acquire his 50% membership interest by granting him “profits interests.” What this means is that the other member would have only an economic interest in the LLC’s profits until such time as the profits interest matured, which would be when that member had finished performing the services necessary to buy in to the LLC. At that time, the membership interest acquired by sweat equity would be taxed at capital gains rates rather than ordinary income rates.
Sweat Equity Requirements
To take advantage of the profits interest solution, there are three requirements:
The LLC would not relate to a “substantially certain and predictable stream of income,” such as “from high-quality debt securities or a high-quality net lease.”
The sweat equity member must keep his profits interest for at least two years.
The LLC cannot be a “publicly traded partnership.”
Compare the Sweat Equity Solutions
Given an investor who wants to organize an LLC and bring in a member who will contribute sweat equity, tax consequences can be lessened either by deferring taxable income for the sweat equity partner by using one of the two workarounds or by taking advantage of capital gains rates using a profits interest.
For more articles please visit Fridman Law Firm’s blog.
Have questions regarding sweat equity? Schedule a free consultation with us today!