Sweat Equity – Tax Consequences?

In their early stages, startups find themselves needing the right human resources to build momentum and launch successfully, but with little cash to do so.  The investment of time and talent of individuals and teams during this stage is referred to as sweat equity.

Sweat equity is the non-monetary investment of early “employees” and is typically in the form of long hours, business and technical knowledge, and efforts to meet business objectives.  Because there is no immediate or guaranteed financial compensation, the value of these efforts is not measured for tax purposes and is neither taxable as compensation to the individuals who are performing the services nor deductible by the company.  Similarly, with no exchange of cash, the value of an individual’s personal investment in time is also not deductible.

So why would one contribute sweat equity to a business?  The blood sweat and tears of those who have founded and built the business often lead to equity shares (or other forms of equity compensation) within a company that will become valuable as the company succeeds.  It is always the hope that those who there in the beginning, contributing their own sweat equity, will reap the fruitful rewards in the long run.