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Does sweat equity have value in a S CORP? How does sweat equity compare to a cash investment in a startup?

Petaluma, CA |

There were four principles in our startup S corporation. Three of us put in sweat equity with one putting up cash. At the time of our setup and on our first K-1, we had accessed a value and percentage to ownership. My contribution was entering my already established business into the corporation. I had a business offering the same service as the new corporation; however the new business would bring this service to a higher level. The problem we are having now is the owner that put up the cash hired his accountant to do the corporation books. Now, this owner and the accountant took our value off the books and K-1 and stated that his contribution is the only one with an asset since “sweat equity” has no value. On our K 1s it looks like he’s the only owner with a value attached.

Can this individual take off the value that was attached to our percentage of the corp. when we started our start up without consent of the other owners?

Attorney Answers 3


  1. Best answer

    The three of you principals should hire your own accountant as well as a corporate lawyer. It sounds like the guy is applying partnership accounting principles to your S corp. You made no mention of shares, which should have been issued in the beginning. Future services are not legal consideration for shares in the sense that the shares issued are considered paid for, but past services are valid, which is what you have now. The value of your prior business is not sweat equity, but a valuable asset, so you definitely have paid for your shares. The three of you should arrange for issuance of shares in the percentage originally agreed upon. You will then control the board as well as who prepares the financial statements.
    You should also be getting rid of this greedy shareholder. Do you have shareholder’s agreements? These would permit you to repurchase his shares after you fire him. If not, that will be sticky.
    One drawback to sweat equity: The shares are not a capital asset, so the holders have ordinary income on their sale.
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    (Bryant) Keith Martin
    sbbizlaw.com

    Circular 230 Disclaimer - Advice given in this response cannot be used to eliminate penalties with the IRS or any other governmental agency.


  2. BKM set forth a good answer. My biggest concern is (1)do you have a ready value for the business you put in, and if so, communicate it to the accountant immediately. (2) as to the other two non-cash contributors, I would worry about watered stock. I would try to ascertain the value of what they put into the business (plans, drawings, formulas, customer lists etc etc etc) which might put them on a similar footing (and have them communicate it to the accountant also).

    It is not immediately apparrent to me why the weird accounting is being done, maybe its an oversight,,, but you have the right to scream your position at the accountant, and if he ignores it, he may have problems.

    Curt Harrington Patent & Tax Law Attorney Certified Tax Specialist by the California Board of Legal Specialization PATENTAX.COM This communication is general information and not legal advice, and does not create an attorney-client relationship. This communication should not be relied upon as any type of legal advice. Please note that no attorney-client relationship exists between the sender and the recipient of this message in the absence of either (1) a signed fee contract and (2) remission of an agreed-upon retainer. Absent such an agreement and retainer, I am not engaged by you as an attorney, nor is any other member of my law firm.


  3. No, the CPA and the investor may not terminate the equity interest of the other investors. The work you and the other investors put in was no doubt in exchange for something. This is a matter of contract law. I expect the persons involved all expected and intended the work to be for corporate equity, bringing in corporation law too.

    I just finished litigating such a case in the appellate court. It is briefed on my avvo profile page. In short a LLC manager claimed to have terminated the equity interest of several investors. So I organized a formal vote by all equity members and voted the manager out of office. The court upheld the vote, and so did the appellate court. The Courts also approved $65,000 in attorney fees against the manager personally for ignoring the investors’ equity and voting rights, and forcing litigation to resolve the issue.

    You should see business lawyer to discuss you situation. You need a lawyer to review the corporation’s Articles, Bylaws, voting procedures for Directors, Board and Shareholder minutes, and the financing/loan agreements. Also, a consultation on Directors duties to shareholders, and on the duties of a majority shareholder to minority shareholders would be helpful. Understanding these legal relationships and duties, you will be better able to make decisions in the future, and will understand what makes your current situation legal, or not, and what remedies you, the other investors, and the corporation, may have.

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