Certain contributions made for ownership interests may be taxable events.
When the owner acquires an equity interest in exchange for compensation for services performed or to be performed, the owner will be treated as having received taxable income. The owner is taxed on the value received by the business for the equity interest because it is compensation for services rendered or to be rendered.
 |
Warning
Among the various strategic funding options, a contribution of future services can seem to be an excellent way to capitalize an entity with an equity interest, where the owner does not have sufficient capital, in the form of cash or other property, to contribute.
This type of funding can serve an important asset protection purpose. Through this option, the owner is able to adequately capitalize the equity interest, and thus perhaps stave off any attack based on "piercing of the veil" of limited liability, while at the same time avoiding the necessity of placing vulnerable assets within the business form.
However, owners are personally liable for the value of contributions promised to the entity, in return for the equity interest, until the contribution is actually delivered. Thus, the owner must be cautious in not taking back too valuable an equity interest by promising too much. The actual per hour value of the services will be a function of the going rate for similar services. The entrepreneurial efforts required of a business owner will certainly make this per hour rate much higher than it would be in a different setting.
The owner must determine the per hour rate for his services and then, importantly, determine the number of hours he is willing to commit in return for the equity interest. Too long of a commitment (or too small of a rate) can mean there will be a difference between what was promised and what was delivered, at a time a financial crisis strikes. The owner would have personal liability for this difference.
That such a contribution is taxable to the owner immediately must be taken into account, too. As described above, the full value of the promised services must be included as income on the date the equity interest is received, and not over the time the services are rendered.
Finally, any compensation scheme between the entity and the owner must be documented and approved at the entity level, as explained below
|
|
Individuals are always taxed on amounts received for services rendered. However, taxation normally takes place only when the owner receives the salary. Here, the owner is, in effect, prepaid in one lump sum. Thus, he must immediately recognize income equal to the full value of the contribution upon capitalizing the entity with the promise of future services.
It is essential that the amount of services to be contributed is specified, and a mechanism must be set up to value these services. The number of ownership interests (shares) that will be issued in return must be specified and documented. Thus, an agreement must be authorized and executed, which details the rate of pay (an hourly rate or annual salary), the total value of the contribution, and the number of ownership interests issued.
Of course, subsequently, the owner must actually perform the services, and the performance, too, must be documented. This type of documentation should be part of the accounting system in place for any small business.
 |
Work Smart
"Organizational costs" are the costs of forming the business entity. They are incurred before the entity legally comes into being (i.e., before the articles of organization are filed and approved by the state). Organizational costs cannot be deducted immediately by the business. Instead, the entity must capitalize these costs and expense them over five years.
If the compensation to the owner is for services performed in creating the entity (pre-formation services), they will be organizational costs. If the owner wants an immediate deduction for the business for this compensation, the compensation agreement should specify payment is for services provided after the formation of the entity.
A contribution of services, solely in exchange for an interest in profits, may not be immediately taxable if the recipient does not obtain an equity or ownership interest in the entity. The recipient is, instead, taxed on his shares of profits, as the profits are generated.
|
|