It is not uncommon for taxpayers to create a C corporation and provide "sweat equity" rather than cash or property to the corporation in exchange for shares of stock. Sweat equity commonly refers to a situation where an investor agrees to provide services to the corporation in exchange for an ownership interest in lieu of taking a salary.
C Corporation Formation
To understand the tax implications of a corporation issuing shares of stock in exchange for services, it’s important to understand the basic tax rules that govern investor contributions. The Internal Revenue Service doesn’t consider the exchange of money and property for stock in a new or existing corporation as a taxable event. At the time of the contribution, neither the shareholder nor the corporation pays income tax. If the shareholder sells his shares, or the corporation sells the property it receives, both taxpayers must pay income tax on the gain, with the shareholder reporting it as a capital gain. However, when the corporation issues sweat equity stock, valuation issues complicate the tax implications for the shareholder.
Providing Sweat Equity
Federal tax laws never allow you to defer paying income tax on the income you earn from providing services. When you provide services rather than cash or property in exchange for corporate stock, the IRS treats your receipt of stock as taxable income and you must report it in the year of receipt. For the corporation, the transfer of stock represents a deductible expense, such as an employee’s salary. However, evaluating how much the corporation can deduct and the amount of ordinary income the shareholder will recognize requires a valuation of the stock.
Sweat Equity Value
If you receive sweat equity in a new corporation that doesn’t possess any assets of value or operate a profitable business yet, you will not recognize any taxable income and the corporation cannot claim a deduction since the value of the stock is zero. This is because the tax law requires you to recognize the value of the stock at the time you receive it. In contrast, if an existing corporation hires you, but pays your compensation in shares that trade on a public exchange, it’s still sweat equity, but the income you recognize will be the price the stock trades at on the day you receive it.
Once the corporation transfers the stock to you, there are no other corporate tax implications. However, if you don’t sell the shares on the same day you receive them, a future sale will result in a capital gain or loss, depending on your tax basis in the shares. Your tax basis is the value of the shares on the day you receive them -- the same amount you recognize as gross income on your tax return that year, even if zero.
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