Realization of Income for IRS Purposes

Tax law can be overwhelming for many people in the business sector. To combat uneasiness and create a semblance of familiarity with tax obligations, Demorest Law provides the following synopsis of tax implications involved with sweat equity and property transfers:

Sweat equity is most readily defined as the performance of a service for compensation. This compensation can come in the form of immediate payment or an ownership interest in the company. Where monetary compensation is paid in return for work performed, it is easy to see that that compensation would be treated as income.  Did you know that where an ownership interest in the company is given in return for work performed, it also constitutes taxable income?

An ownership interest in a company can be split up into two main categories –  profit interest and capital interest. The choice in receiving one or the other may not be yours, but you must nonetheless be aware of the implications.

In receiving a profit interest, you are essentially deferring payment until a profit is made and distributed.  It is then that your income is realized and considered reportable. Business personnel should be aware that income could also become reportable earlier if the profit interest is easily ascertainable by being either (1) predictable and related to a stream of income from partnership (2) disposed within two years of receipt, or (3) is a limited partnership interest in a publicly traded partnership.

A capital interest gives the owner a claim to assets when the company is dissolved.  A taxpayer who performs services in exchange for a capital interest recognizes income in the amount of the fair market value of the capital interest. Tax implications may be deferred if the capital interest is exchanged for future services or requirements (i.e. receiving a certification) that are subject to a substantial risk of forfeiture.  In short, if there is a strong chance that you may not be able to complete your obligations and ultimately lose your capital interest, it may not be immediately reportable.

Property transfers in exchange for capital interests will also not be immediately taxable for these purposes, as the transferring of property does not constitute sweat equity.

We hope that this has helped calm some of the turbulent waters surrounding tax law, and we look forward to our readers’ continued presence on our blog.

This article was written by Nezar Habhab, Law Clerk.

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