We are frequently met with a situation where one or more individuals wish to form a limited liability company to engage in a new business or real estate enterprise. Limited liability companies are preferred vehicles for many such endeavors because they combine low maintenance and tax-free treatment as a partnership, along with limited liability to the entity’s owners.
So far, so good. However, in many situations a problem with capitalizing the limited liability company immediately arises. Often one of the company’s members puts up cash or an actual piece of property to start the endeavor, while the other member contributes services and labor to the company. In that instance, assuming as is normal, that the company is to be taxed as a partnership, the member who puts up the cash or contributes the property has no tax consequences. Alas, however, the owner who contributes his services and labor, will be taxed on the value of that sweat equity in the year the company is capitalized. How is the sweat equity valued for those purposes? There will be at least a presumption that the value of the cash/property contribution will be used to set the value. For example, Member A contributes $10,000 to an LLC to make the down payment on a property, meanwhile; Member B contributes his services. The Members each own 50% of the company. Member B’s “sweat equity” contribution will be, presumptively, $10,000; and his individual 1040 for that year will reflect ordinary income of that amount.
There are ways of minimizing the tax bite. For example, to delay the tax, the service partner who provided services may be given his interest over time, or he can be granted options exercisable in the future. Another approach is to grant the service partner only a “profits interest” which if done properly does not trigger a taxable event.