Sweat Equity and the S Corporation

By Jeff Clements

Various contributions are made to startups and small companies by their owners in the form of cash, property and services. However, contributions made to the company by S corporation shareholders that are not in the form of cash can be harder to value. This is especially true of labor and services, which give rise to what is known in the business world as sweat equity.


Sweat equity means labor or services performed by a shareholder that adds value one way or another to the corporation, as opposed to a strict amount of financial capital contributed into the business. This informal term is a way of describing the contributions of time and effort by the founders and early employees of a small business, such as an S corporation.

Startup Capital

In the context of an S corporation, sweat equity represents the value of a particular shareholder's capital contribution and relative ownership interest in a corporation when it is formed. For example, if the S corporation has three shareholders, two might invest cash in the business while the third agrees to contribute his services to the new corporation. If everyone agrees as to the value of the services, the relative ownership stakes can be assigned up front.

Ready to incorporate your business? Get Started Now


The shareholders can assign a fixed value on the sweat equity at the startup phase and decide how much ownership interest the owner should get in exchange for his services up front. However, once the shares of stock that represent each shareholder's ownership interest are distributed, the valuation of the sweat equity contribution is fixed and cannot be changed later. For example, if it is decided that an owner gets 33 percent of the outstanding stock in exchange for his work done for the company, that share allocation can't be changed retroactively, even if the shareholder provides inadequate services or stops doing work for the company prematurely. To avoid these types of issues, rather than value all sweat equity up front, a better way to value ongoing labor contributions is by assigning a reasonable hourly rate to the shareholder's time working on the company's behalf. This means his ownership stake will increase over time as he makes his contribution to the company, and it prevents common disputes from arising regarding the quality or extent of services rendered.

S Corporation

An S corporation is designated by the IRS as a small business corporation with relatively few shareholders. Accordingly, with a smaller number of owners, each individual shareholder owns a relatively greater share of the company. Thus, any unresolved disputes about money, ownership or management issues between shareholders in this common small business situation can have serious adverse consequences because of their individual power and relative level of control of the business. So, it should be a high priority for all shareholders to avoid these types of disputes by carefully agreeing in advance on how to value sweat equity.

Ready to incorporate your business? Get Started Now
How Are Profits Split in an LLC?


Related articles

S Corp Vs. Corp

Incorporating a business creates a separate legal entity and protects shareholders with limited liability. However, a corporation can be either a C corporation or an S corporation. An S-corp is a C-corp that has made a special election. The differences relate to who can be a shareholder and how the company and shareholders pay taxes on the business's profits and losses.

What Is the Difference Between Bylaws & Shareholder Agreements?

Bylaws and shareholder agreements are two very different things. A corporation's bylaws set out the day-to-day operations of the organization; they also include extensive rules pertaining to committees and the board of directors, among other things. Shareholder agreements address the respective rights of minority and majority shareholders regarding equity shares and the sale of equity.

Opportunities of Sole Proprietorships

A sole proprietorship is a simple form of business in which the owner is in business for himself as an individual without any business partners or corporate formalities. Sole proprietorships are not required to comply with complex organizational requirements during their formation or operation, and this simplicity is one of the main benefits of this type of business structure.

LLCs, Corporations, Patents, Attorney Help

Related articles

Does an LLC Need to Place a Value on Each Membership?

An LLC should place a value on each membership. A membership interest is the value of all of the rights enjoyed by LLC ...

How to Remove a Shareholder From an S-corp

While an S corporation functions like a C corporation, it is taxed differently. Each shareholder pays taxes on his ...

Switching Ownership of the S Corp

An S corporation begins its life as a regular corporation. At some point after creation, the corporation makes a ...

When Is it Better to Form an LLC Instead of a Corporation?

LLCs and corporations are similar in a number of ways, but LLCs feature distinct advantages and limitations that make ...

Browse by category
Ready to Begin? GET STARTED