Sweat Equity – You’ve Got It, But What Do You Do With It?

You’ve been working day and night. You’ve shed blood, sweat and tears to launch your new innovative idea off the ground. Your start-up has no cash, but there’s another way that you can be compensated for your efforts – sweat equity.

What does this mean? Start-ups and other newly formed companies typically offer sweat equity compensation for the unpaid work you and other founders have put in to getting it started. Commonly issued in the form of restricted stock or stock options, this type of compensation is a way to reward key players in the early days of a business when cash is hard to come by. Restricted stock is stock that is issued but not fully transferable from the company to the recipient until particular conditions are met, such as vesting. A stock option is the opportunity given to an individual to buy company stock at a later date and at a specified price.

Both types of sweat equity have their pros and cons based on the equity agreement formed between the recipient and the company; both can also have endless terms and conditions. As an employee or founder of a company being issued equity compensation, you need to be aware of the potential tax consequences for each option, as well as the tax planning opportunities available to you, to ensure that you get the most out of this equity while remaining compliant.

If you choose the restricted stock avenue, you might consider a common tax planning opportunity known as the 83b election. This election has the potential to save hundreds or thousands in tax if planned and executed properly given the specific scenario. It also provides an advantage if you’re electing to pay tax now instead of later because you expect that the fair market value of the stock will increase. If you’re interested in this option, however, time is of the essence; the 83b election must be made within 30 days of being issued the stock, and there are no extensions or do-overs.

Incentive stock options also have opportunities for tax planning ideas when forethought is given to timing of exercise of the option and subsequent disposition of the stock. Stock options provide just that – an option to purchase stock at a certain time at a stated price. Once that option is exercised, you might hold the stock for a time or decide to sell it. However, there are rules regarding when you can sell, and how your profits from the sale would be taxed (ordinary vs. capital gain), etc.

Each scenario will be unique and the tax planning and saving opportunities available to each scenario will be different. If you’re a recipient of sweat equity, it is important to know the basics and to consult with the appropriate professional counsel early on in the process to maximize the benefit to you and minimize any unwanted tax implications.

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