Definition and Valuation
Sweat equity refers to a person or company’s non-monetary contribution in labor and time toward a business venture. It is rewarded with sweat equity shares given by a company in exchange for work rather than money.
There are many ways to value sweat equity. One method is to allocate 20% of an entrepreneur’s invested cash plus personal guarantees as the sweat equity value. However, there are no perfect ways to measure one’s sweat equity.
Application in Business Ventures
S Corporations
When contributing sweat equity to an S corporation, shareholders should agree on its monetary value. Contributed sweat equity increases the shareholder’s basis, allowing them to claim losses and avoid taxes.
Real Estate and Construction
Sweat equity is also found in real estate and construction, as owners do repairs and maintenance themselves rather than pay others. For house flippers, sweat equity saves costs.
Startups
In startups, owners and employees often work for equity instead of market-value salaries. Monitoring founders’ sweat equity is important since startups may not have cash to pay for certain tasks. Sweat equity allows cash-strapped startups to conserve capital while attracting talent.
Accounting for Sweat Equity
The Internal Revenue Service sees sweat equity as two transactions: the work, and the equity gained.
How do you account for sweat equity?
To account for sweat equity, shareholders should assign a monetary value to it. This action can affect the shareholder’s financial standing, particularly with regard to tax implications.