Sweat Equity and the S Corporation

By Christine Funk, J.D.

Sweat Equity and the S Corporation

By Christine Funk, J.D.

An S corporation, commonly referred to as an S corp., is a corporation that protects the business's directors, officers, owners (called shareholders), and employees by providing limited liability protection. It also allows for pass-through taxation, meaning the shareholders report business profits or losses on their individual tax returns rather than a corporate tax return. S corporations allow for "perpetual existence," meaning the business continues even when a shareholder leaves the business. S corporations are small and may not have more than 100 shareholders. Because of the small number of shareholders, each owns a significant portion of the company.

Coworkers collaborating at a conference table

Sweat equity is a way for shareholders to "purchase" their shares of the corporation. Instead of investing money in the business for those shares, however, sweat equity refers to an investment based on one's skills, time, or knowledge to add value to the corporation.

Shareholder Contributions

There are few different ways an individual can become a shareholder in an S corp. You could donate cash to the start of an S corp. to invest in the business marketing plan, purchase equipment, or pay for talent. Alternatively, you might contribute property to the S corp. to become a shareholder. In this situation, a shareholder provides the factory where the business manufactures goods or the building wherein the employees of the S corp. provide services. Finally, you could provide sweat equity to the business to become a shareholder.

It is easy to "value" the amount of money one invests. It is only a bit more challenging to value the amount of money the use of a building or factory equipment is worth. Sweat equity, on the other hand, is sometimes even more difficult to value. It must be done, however, because the value of each individual shareholder's shares is based on the value of their contribution.

Understanding and Valuing Sweat Equity

Sweat equity refers to an investment of skills, time, or knowledge, rather than of assets or from your checkbook. For example, you might use your skills to install shelving, walls, or a ramp to make the building handicap accessible or replace the shingles on the roof at the S corporation's office. Alternatively, you might lend the S corporation book keeping skills to help run the business during the first year. Another form of sweat equity might be one who offers to write business proposals to secure government contracts. There really is no limit to the form sweat equity might take. It is based on the skills and talents of the individual.

There are also different ways to value sweat equity. One might value sweat equity "by the job," such that renovating the office space is worth a flat fee of a certain amount. Alternatively, the sweat equity may be valued by the hour, with an anticipated number of hours required to accomplish the goal and an agreed upon price for the work. There are many different ways to value one's sweat equity contribution. Regardless of how the sweat equity is valued, once agreed to, the parties commit to this amount. For example, if one person contributes $100,000 in cash, another person contributes a building valued at $100,000, and one person contributes $100,000 in product design, each has a 33.3 percent share in the company.

Sweat equity is just one of many details that must be carefully considered when developing an S corp. Contact an experienced business lawyer or use an online service provider to assist you in accomplishing your goals.

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