Sweat Equity Tax Issue Brief

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

Human Contribution to a Business

What is sweat equity?

Sweat equity is human contribution to a business.

Sweat equity refers to the efforts of executives or other shareholders into a company. This does not include money that is put into a business, which is financial equity. It is the time and knowledge that an individual or a group of individuals put into a business to make a result.

Sometimes a business can use sweat equity to cut start-up costs. You can offer shares of business stock to business service providers instead of money. This action is most often referred to as "equity compensation". The service providers benefit because they obtain shares into the company. However, it can difficult to finance a business in this way because most service providers want their money up front.

Sweat equity is best understood in the real estate sense. If you complete a repair on your home, or if you personally add on a deck you would be improving the value of your home. You increased your home's value by putting in your own efforts. It works the same way for a business.

At some point your business will need regular financial capital, and it can't grow solely dependent on sweat equity. Make sure that you have established solid business credit scores so you can actively go after the right funding for your business. Our Business Finance Coach will teach you how to setup your business so you have everything in place that lenders want before you go after your loan.

You can also use our unique business capital search engine to find over 4,000 sources for business capital. Searching our directory is completely free. We will help match your business needs with a list of lenders that can meet those needs for your business.

http://www.businessfinance.com/sweat-equity.htm

Sweat Equity: Work Your Way to a Cheaper Home

Created: Friday, 24 Oct 2008, 3:08 PM EDT
By SHEEKA STRICKLAND FOX8 News

GREENSBORO, N.C. (WGHP) -- Short on cash for a downpayment on a new home? A local developer is offering a program where homeowners-to-be can save on the price of a new home with some old-fashioned sweat equity.The program, which Old South Homes calls "work equity" is taken right from the Habitat for Humanity playbook. Homebuyers at any of six of the developer's communities can landscape, insulate or paint their way to a discount on the price of the home.Old South Homes Sales and Marketing Manager Mirsa Nieland said the company came up with the program as many families began wondering if owning a home was just not possible in today's economic climate."As the market has changed, a lot of the opportunities that first-time homebuyers have had with financing are gone," she said.Loans are harder to get, and consumers feel like their paychecks are shrinking as the cost of groceries and other goods go up.According to Nieland, participants in the work equity program are paid as if they are contractors. On a $150,000 home, the buyer earns about $5,000 as the down payment for their labor.Habitat for Humanity, which builds homes for needy families, uses a similar program. Future homeowners are required to spend a certain number of hours helping build their own homes in exchange for a significantly reduced mortgage payment.Even for Old South Homes, the program is not new. The developer used the work equity model seven years ago.

http://www.myfoxwghp.com/myfox/pages/News/Detail?contentId=7717009&version=1&locale=EN-US&layoutCode=TSTY&pageId=3.2.1

Sweat Equity Enterprises: Today Show 3/6/08

Sweat Equity: What You Need To Know

Q. SWEAT EQUITY - What does it mean?
A. If your home was ever considered a place to just hang your hat, reconsider the thought carefully. It is the greatest asset you can have as few things in life acquire equity. So you have to think of how to improve it's value, what to do, when to do it and when not to.

First off, when you hire someone, lets say at $40 per hour and you have a job that pays $30 an hour; it does not make sense to do the work yourself. Now if this statement sounds strange, think about this. The guy or gal that is performing the work is paying for insurances that you would not. Do not carry the types of insurances that they do is asking for trouble.
The worse part is that they more likely know more than you. To top it off, they have the tools. No offense to the experienced homeowner but there are just some tools that you cannot afford to buy for a one time use and call it a "good investment". Renting tools is always the best option but when it gets right down to it, can you afford the time to do this, get the materials and still do as good as they can for under $40 per hour? Didn't think so.

Secondly, are you really honest with yourself? Have you ever said I can do that in x amount of time only to find out it took many more hours to get it done and maybe it was not done right? It is the good old theory of "I can do that, for less money and it will be the best." Ok, so who is going to repair the bad parts if it needs to get done right? It makes that $40 per hour look pretty good.,
You have a girlfriend, boyfriend, wife, husband, and family; do they enjoy spending time with you, and you with them? Do you plan weekend outings, trips, quality time together, and school night activities? Well it is time to say goodbye to it all if the project is over your head to begin with. You better get a large calendar as the evenings and weekends may be gone for quite some time. It will drain you of spare time, that golfing you enjoy, that TV show you are addicted to or just make you so tired that you cannot perform well at your normal job. This is what I call Imagination Gone Wild.

I have always gotten a laugh out of the "sweat equity" statements. When this first came about, it was the best marketing tool around to get more potential homeowners to build their new home, maybe that nice addition or some interior improvements that required a professional to start it off and then you finish it. You probably heard the stories, "we will build the foundation and rough frame it, and you can do the rest, trust me." Yeah, right! The words echoed in your head at night, the next day you go buy that dream package and then it hits you, "what I thought I was saving is not saving anymore" unless you were absolutely honest with yourself. This seems to be the one major flaw with everyone, lack of honesty within us.
Maybe you should have asked some more questions to yourself? You know that Imagination Gone Wild stuff. The questions should have been:

Do I have the tools and know how to use them?
Do I know how things went together so I can take it apart?,
Can I totally envision what I want for an end product?
Do I really have the time to do this and sustain my 40-hour a week job?
Do I really know my own limitations?
For those that are so lucky, they can save money-doing things themselves. It is a heavy commitment and burden on the entire family. The sweat equity game is in the mind of the beholder. If you can believe it and are honest with yourself, do it. If not, reconsider your options.

To make sweat equity really work for you and not against you, you really need to understand the scope of the project. This means reading blueprints, if applicable, how to schedule the job, knowing what goes first, why and when to order things and when to install them and avoid the one step forward and two step back routine. What you do as a game plan should be followed. Once you start a project, you cannot go back and start over or you will be losing money! If you need to hire someone professional to do part if not all of it, then do not hesitate. It is going to be money well spent as we are talking about an investment that should have return at time of sale.

Advice: A good Do-it-Yourself project is one that you "honestly" can do it all yourself. Simple answer but hard for most to accept.

http://www.doityourself.com/stry/sweatequity

Sweat Equity Put to Use on a Farm in Sight of Wall St.

by Jim Dwyer, 7 Oct. 2008

The first and hardest part was deciding which crop to take to market from the farm in Red Hook, Brooklyn.
All arguments were charged with the stainless-steel passion of 15-year-olds.
“Corn,” Narcisso Rosado said.
“Raspberry jam,” said Malcom Walker.
“Mine was the best idea,” said Aseel Al Waqza. “Lemon sorrel. A juice drink from it.”
He paused. “It just didn’t taste that good,” he said.
“In the end, everyone agreed with our idea,” Nickeisha Hayden said. “The mint tea.”
Red Hook, an ancient finger of city waterfront that is lined with the husks of faded industry and old piers, sits two clear miles across New York Harbor from Wall Street. It is another galaxy.
There, on nearly three acres of asphalt that have been covered with 18 inches of topsoil, the Red Hook Community Farm operates in an economy that rises from the actual, not the imaginary: lettuce, spinach, chard, kale, collard greens, arugula, dandelion, radicchio, Chinese cabbage, tomatoes, peppers, beets, radishes, squash, cucumber, zucchini, and beans and herbs — oregano, sage, thyme, mint, six different basils.
“And carrots,” Narcisso said. “I love to eat them.”
The ground is worked by a squad of teenagers who come from across Brooklyn, in a program run by Added Value, a nonprofit organization. On Saturdays, they operate a farmers’ market, selling produce grown in Red Hook and on other local farms. Brooklyn restaurants buy from the farm.
This is sweat equity, not the steroid equity across the harbor.
About 30 families bring their food waste for the farm’s compost heap; an additional 1,000 pounds comes from the four Rice restaurants in Lower Manhattan and Brooklyn, delivered in a van fueled by the restaurants’ used vegetable oil. And, says Ian Marvy, one of the founders of Added Value, the farmers may soon get spent grain from Six Forks brewery in Brooklyn, and the crushed grape skins from the Red Hook Brooklyn winery, which recently pressed its first barrels.
About eight years ago, Mr. Marvy, then working in the Red Hook Youth Court, was walking with a teenager named Timothy. Mr. Marvy plucked a dandelion green from the ground and chewed on it. Timothy was disgusted.
“I started talking about healthy eating,” Mr. Marvy said. “He wasn’t interested. The nutrition in leafy greens. Didn’t care.
“Then I asked him to imagine the business that could be made from the produce on a 10-by-10 plot.”
This grabbed Timothy, whose family was in the heroin trade. By way of example, Mr. Marvy said they could make a tincture from dandelion root, which is sold as a remedy for various ailments. “It was going then for $9 a bottle,” Mr. Marvy said. “We could sell it below the market for $7. The bottle and the dropper would cost $1. So from that 10-by-10 plot, you could make $600, $700. Because of his family’s business, he really understood costs and return on investment.
“He said, ‘Do you have a job for me?’ ” No, Mr. Marvy did not. But the question propelled Mr. Marvy and Michael Hurwitz, who also worked in the youth court, toward the creation of Added Value and the farm, which they set up on a little-used asphalt lot owned by the city’s parks department. More than 5,000 kids have visited with their classes. About 135 teenagers have steady after-school jobs, receiving monthly stipends that range from $125 to $400 — and plenty of free vegetables.
“It’s more than a job,” said Kimberly Vargas, 19, who has been coming to Red Hook from Crown Heights since she was 15, a trek of an hour by bus and subway. “It’s my go-to place.”
Ms. Vargas said the farm showed that food did not have to come from some distant, unseen place. And Vanessa Nimblett, 14, said she had come around to the idea of collaboration. “Doing a bed — I can do it better with a group,” she said. “Weed it, turn it, rake it, seed it.”
Tariq Alexis, 15, nodded. “It brought me out of my shell,” he said.
Aseel’s grandfather, a farmer in Yemen, heard about the honest work being done in a corner of America’s biggest city.
“He’s proud of me, that I found a job like this,” Aseel said.

http://www.nytimes.com/2008/10/08/nyregion/08about.html?ref=nyregion

Caravati's Inc.

GOING GREEN?
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As Richmond, Virginia's oldest supplier of architectural salvage, Caravati's Inc. has been dedicated to serving the customer in every aspect of old house restoration, remodeling, and repair since 1939. They offer a wealth of salvaged house parts ranging from the simplest of rough cut heart pine lumber to the intricate decor of a Queen Anne Victorian home. Caravati's operates a forty thousand square foot warehouse in the historic Manchester district of Richmond, VA. and has three exterior lots filled with salvage such as old brick, cobblestone, marble, and granite curbing. Caravati's caters to the homeowner, contractors, designers, artists and the everyday passerby.

http://caravatis.com/

Sweat Equity: What You Need to Know

Q. SWEAT EQUITY - What does it mean?
A. If your home was ever considered a place to just hang your hat, reconsider the thought carefully. It is the greatest asset you can have as few things in life acquire equity. So you have to think of how to improve it's value, what to do, when to do it and when not to.

First off, when you hire someone, lets say at $40 per hour and you have a job that pays $30 an hour; it does not make sense to do the work yourself. Now if this statement sounds strange, think about this. The guy or gal that is performing the work is paying for insurances that you would not. Do not carry the types of insurances that they do is asking for trouble.
The worse part is that they more likely know more than you. To top it off, they have the tools. No offense to the experienced homeowner but there are just some tools that you cannot afford to buy for a one time use and call it a "good investment". Renting tools is always the best option but when it gets right down to it, can you afford the time to do this, get the materials and still do as good as they can for under $40 per hour? Didn't think so.

Secondly, are you really honest with yourself? Have you ever said I can do that in x amount of time only to find out it took many more hours to get it done and maybe it was not done right? It is the good old theory of "I can do that, for less money and it will be the best." Ok, so who is going to repair the bad parts if it needs to get done right? It makes that $40 per hour look pretty good.,
You have a girlfriend, boyfriend, wife, husband, and family; do they enjoy spending time with you, and you with them? Do you plan weekend outings, trips, quality time together, and school night activities? Well it is time to say goodbye to it all if the project is over your head to begin with. You better get a large calendar as the evenings and weekends may be gone for quite some time. It will drain you of spare time, that golfing you enjoy, that TV show you are addicted to or just make you so tired that you cannot perform well at your normal job. This is what I call Imagination Gone Wild.

I have always gotten a laugh out of the "sweat equity" statements. When this first came about, it was the best marketing tool around to get more potential homeowners to build their new home, maybe that nice addition or some interior improvements that required a professional to start it off and then you finish it. You probably heard the stories, "we will build the foundation and rough frame it, and you can do the rest, trust me." Yeah, right! The words echoed in your head at night, the next day you go buy that dream package and then it hits you, "what I thought I was saving is not saving anymore" unless you were absolutely honest with yourself. This seems to be the one major flaw with everyone, lack of honesty within us.
Maybe you should have asked some more questions to yourself? You know that Imagination Gone Wild stuff. The questions should have been:

Do I have the tools and know how to use them?
Do I know how things went together so I can take it apart?,
Can I totally envision what I want for an end product?
Do I really have the time to do this and sustain my 40-hour a week job?
Do I really know my own limitations?
For those that are so lucky, they can save money-doing things themselves. It is a heavy commitment and burden on the entire family. The sweat equity game is in the mind of the beholder. If you can believe it and are honest with yourself, do it. If not, reconsider your options.

To make sweat equity really work for you and not against you, you really need to understand the scope of the project. This means reading blueprints, if applicable, how to schedule the job, knowing what goes first, why and when to order things and when to install them and avoid the one step forward and two step back routine. What you do as a game plan should be followed. Once you start a project, you cannot go back and start over or you will be losing money! If you need to hire someone professional to do part if not all of it, then do not hesitate. It is going to be money well spent as we are talking about an investment that should have return at time of sale.

Advice: A good Do-it-Yourself project is one that you "honestly" can do it all yourself. Simple answer but hard for most to accept.

Habitat: From sweat equity to housing equity
Saturday, September 20
By Nancy H. McLaughlin
Staff Writer

GREENSBORO — Habitat for Humanity of Greater Greensboro just turned over a ceremonial check for more than $300,000 to the Greensboro City Council, representing this year’s property taxes for 260 homes purchased with the nonprofit’s help.

Habitat was founded on the belief that “all God’s children” should have a place to live.

The money, recently paid to the tax office by the nonprofit from escrow accounts on the homes, did not include about 50 Habitat houses whose mortgages with the nonprofit builder have been paid off. Those are paid by the individual homeowners.

“When a lot of the economic news we’re hearing … is causing anxiety, there are some things that we are doing that continue to work in our community,” said Winston McGregor, president and executive director of the nonprofit builder.

“This check also provides a tremendous, tangible example of how the city’s funding for this work is an investment that is returned to our community in many ways.”

Habitat by other numbers:

$50,000: Average cost to build in materials and labor. Doesn’t include land, which can range from $10,000 to $25,000 . Homeowners pay off only the first mortgage loan of about $70,000. Habitat and the city of Greensboro hold second and third mortgages on each home (the difference between the first mortgage and appraised sales price ), which are forgiven over the life of the loan.

This protects homeowners from predatory lenders and eliminates any incentive to sell the home for a cash windfall.

$18,000 to $30,000: Typical family income range for Greensboro Habitat homeowners.

The majority of homeowners build up home equity, which can be borrowed against for sending their children to college or taking out a small-business loan.

“That’s wealth building for the working class,” McGregor said.

10: Number of applicants out of which one might qualify. It’s not about a credit score but how much debt the family might be juggling. Current Habitat homeowners work a variety of jobs, including as medical technicians, call-center representatives and in retail and restaurants.

$450: Typical mortgage, including property taxes, insurance and principal.

320: The nonprofit is now constructing house No. 320. And that includes two recently finished homes and three under construction on Byers Road, near Lee’s Chapel Road; just-finished homes on Meadow Street and Mayfair Street in the Rosewood neighborhood off Summit Avenue; and in the Glenwood neighborhood.

Once focused on subdivisions, Habitat houses are now scattered throughout the city.

300: Hours of sweat equity required in working on the buyer’s home, on other homes and in training, such as credit counseling.

260: “There’s kind of a simple visual and concept that people have about Habitat — that’s volunteers and hard-working families who work together to build up people’s lives,” McGregor said.

But the check is representative of more, she says.

“Habitat is a builder; we’re a banker — we’re collecting 260 mortgages payments every month; we’re in essence a Realtor, finding buyers and training those buyers; and then we’re a retail operation, running the Habitat Restore store on High Point Road,” McGregor said.


http://www.news-record.com/content/2008/09/19/article/habitat_from_sweat_equity_to_housing_equity

SWEAT EQUITY

IMG 's Resource Center for the hands on approach to buying and renovating homes. Helpful hint for finding, buying and completing homes with cost effective, efficient materials. Finance tips, Historic preservation advantages and disadvantages. Salvage tips, and many many more.