Background:
Small businesses represent 60%-80% of net job creation in our country every year. As a result, the greatest economic engines of our country are the people who take financial risks to create new businesses. People who risk their livelihoods to create new businesses are at the center of the American dream of ownership and critical to our nation’s continued economic growth.
One way that many small private businesses get off the ground after they are initially founded is through the devotion of employees and contractors who are willing to forgo some or all of their cash income in return for equity in the business or deferred compensation. These individuals put at risk their personal finances in return for “Sweat Equity” in the business, thereby creating risk for them that is equivalent to the risk an investor takes when investing cash in the business. Without the devotion of such individuals many businesses would never get off the ground because it is the exception that outside financing is available from the outset to fund the creation of the business. A number of the major corporations in our nation including Microsoft, Fedex, Apple and many others got there start in just this way.
Issue:
When an employee or contractor accepts an ownership stake in a small private business in return for investment of their time in building the business the equity they receive is illiquid as there is no public market for it and very often transfer of the equity is restricted by the company itself. Yet, the IRS sees this equity compensation as taxable income and requires persons receiving equity compensation in a small private company to pay tax on it (IRC §83(a)) even though it is typically impossible for them to liquidate any portion of that equity to pay the tax. In addition, at the end of 2004 the ironically named “American Jobs Creation Act” was passed into law. One provision of this law has caused the IRS to promulgate new requirements regarding the taxation of deferred compensation (IRS notice 2005-1). Not only does the American Jobs Creation Act effect the tax treatment of stock options in small private companies but, of greater importance, it virtually eliminates the ability for employees and contractors serving small private companies to agree to accept creative deferred compensation (that might later convert to equity) in lieu of current payments because the types of creative agreements that are often used would be subject to a phantom income tax on the deferred portion of the compensation.
Small businesses which desire to grow beyond a few people nearly always need ways in which they can bootstrap and compensate early employees and contractors when they are still growing and cash is tight without the IRS wanting to be paid tax on income which the individual either did not receive or has no way to liquidate. Even worse, if the company is unsuccessful and never has a “liquidity event” (e.g., sale of the company or an initial public offering) then the tax paid was on something that never had any cash value! This “phantom” income tax is especially onerous. This tax situation dramatically reduces the value and incentive for a person to put “Sweat Equity” into growing a small business and therefore impedes the growth of new small businesses. People who otherwise might be willing to invest sweat to earn equity turn away from the opportunity because the tax makes the return not worth the risk.
Some small companies will attempt to mitigate this situation by investing the considerable time and financial resources required to implement a qualified (ISO) stock option plan…time and money that could have alternatively been invested in growing the business. While such a plan enables the company to offer stock options at current “fair market” value to their employees without there being a tax consequence, it creates two other problems. First, an option is not ownership in the company but rather a right to buy ownership at a fixed price. Thus, an employee or contractor who is already taking a financial risk of working for reduced compensation to build the business will have to subsequently pay to purchase their stock (which will be illiquid once they purchase it) when they already are foregoing cash income in the first place. Because of this, few such persons are able to purchase the stock prior to any liquidity event of the company. This means that, if a liquidity event occurs, those persons will pay ordinary income tax rates on the gain they receive as opposed to the long term capital gains treatment that cash investments receive. Their investment of time and forgone compensation is penalized by the IRS as somehow being less than a cash investment. Yet, for the middle class person who is typically earning this Sweat Equity the risk they are taking is often much greater than that taken by any cash investor because their financial resources are much less.
In addition, because a qualified stock option plan can only be used with employees, it does not solve the problem with respect to contractors (e.g., attorneys, public relations firms, accountants, programmers, etc.) who may be willing to accept significantly reduced cash fees from a small business in return for some equity in that company. Such suppliers who are willing to make a bet on a small company and help it grow are often as critical as the devoted employees who are willing to do so.
For those intrepid individuals who do invest their time in a company in return for equity, if they received a stock option they usually receive ordinary income tax treatment (and AMT tax) on their investment at any liquidation event while wealthier individuals who are able to invest money appropriately obtain long term capital gains tax treatment. Further, in those situations where the employee received an actual stock grant and the business is not successful, the employee or contractor will have been penalized by having to pay Phantom Income Tax on the value of stock received that was ultimately never worth anything..
The result of the current tax law is an environment where fewer individuals are willing or able to justify taking the risk of earning Sweat Equity and those who are willing to take the risk are penalized by the tax system for doing so. One must believe that this causes fewer businesses to be able to grow through those key early stages and therefore the greatest economic engine of our country is being impeded.
Solution:Revise U.S. tax laws with regards to equity compensation in private small businesses only such that equity compensation received by employees or contractors would be taxable only at the time of a liquidity event (e.g. the sale of the business for cash to a third party or at the time of an initial public offering ). This should apply to any potential “Alternate Minimum Tax” implications as well. At the liquidity event, the original value of the equity received would be taxed as ordinary income and the gain beyond that taxed at capital gains tax rates. The IRS already has systems in place for assessing the value of equity in small private businesses from which the basis value would be estimated because the IRS has to have this in order to determine how much they want to tax a person today on any equity compensation they receive in a small private company.
Such a revision would create an environment where more small businesses would be started and more would be able to be successful. It also would send a strong message that entrepreneurs should be encouraged and rewarded for taking the risk to create new businesses which are the primary fuel for our nation’s economy rather than being penalized for doing so. At the end of the day, Sweat Equity is no less valuable than the money which investors contribute to a private business.
For more information go to http://www.parapent.com/sweat-equity.htm
