A “C corporation” is the name given to regular corporations by the Internal Revenue Service. The IRS taxes C corporations at the corporate level and then taxes shareholders on any distributions they receive from a C corporation. In certain situations C corporations must pay payroll taxes on stock given as sweat equity and shareholders must pay income taxes on stock received as sweat equity.
All corporations are formed by filing articles of incorporation with the secretary of state of the state in which the firm primarily conducts business. Corporations protect their shareholders from personal liability for the debts and obligations of the business. Corporations are governed by a board of directors selected by the shareholders.
Although few corporate shareholders actually work up a sweat performing their duties, “sweat equity” refers to the granting of equity in exchange for services performed on behalf of the company. A corporation may grant shares as sweat equity to founders upon its inception. A corporation may also grant shares as compensation to officers, directors, consultants and managers in lieu of cash payments. When contributors pay less than fair market value – including paying $0 – and receive shares for services rendered, the sweat equity tax situation arises.
Equity and Founders
To keep the fair market value low or near zero, corporations can issue sweat equity shares in advance of issuing stock for cash. Alternatively, corporations can issue special restricted stock or stock options as sweat equity to minimize taxation issues. In general, founding or early shareholders receiving stock for sweat equity must pay income tax on the difference between the shares’ fair market value on the day they received the shares and the price they paid for the shares.
Example – Founders
Three people found a corporation. One person contributes $25,000 for a 50 percent stake; another contributes $12,500 for a 25 percent stake. The third person contributes $5,000 and agrees to work as the CEO for free for a 25 percent stake. The third person must pay income taxes on the $7,500 in compensation. This is the difference between the fair market value of $12,500 and his $5,000 cash contribution.
Employees and Consultants
Companies do not pay taxes on stock issued as sweat equity unless the recipient is an employee, in which case the corporation must withhold and pay payroll taxes on the income. If the corporation fails to withhold and pay payroll taxes, it may be subjected to penalties. For consultants and directors, the corporation must issue a 1099-MISC showing the value of the compensation.
Example – Employees and Consultants
An external investor contributes $50,000 in exchange for ten percent of a company’s outstanding shares. The corporation subsequently recruits a CEO and offers ten percent equity upfront in lieu of monetary compensation. The corporation and the CEO owe payroll taxes on the $50,000. If the corporation hired the CEO as a consultant instead of an employee, the corporation must issue a 1099-MISC for the $50,000 which the CEO must include as income on her personal tax return.