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  • Equity & Distributed Earnings LLC or SCrp

    A couple of questions...

    1) when calculating a company's total equity, do you include sweat equity? For example if the total capital equity (actual $$) is $100,000 and someone contributes $10,000 in sweat equity... is the total company equity then $110,000? Would this then mean that the individual contributing the sweat equity hold 10% (on $100,000) equity share or 9% (on $110,000)?

    2) as i understand it, there is no such thing as an S Corporation. it's simply a designation that an LLC can select for tax consideration by the Feds since the Feds to actually recognize an LLC as a taxable entity (e.g. you're taxed as a person when an LLC or as a corp when electing SCorp status). that said, does one need to structure distributed earnings as a corporation based on % or can you establish whatever distribution you want since you're an LLC? meaning would the individual in the example above have to be paid 10% of earnings or could an arbitrary distribution schedule be established.

    sorry, kind of confusing how i wrote that. lol. thanks for the info!

  • #2
    equity

    I am not a lawyer, accountant, tax adviser, or anything related so this is not meant to be advice. There are members here more savvy regarding issues such as this but I will take a stab...

    1) From an accounting and tax standpoint sweat equity basically means nothing. There are a lot of terms to know and the tax code book is big and scary but generally speaking in an LLC equity and capital contributions are two separate things. In your example if Partner A contributed $100,000 that is a capital contribution of $100,000 and would be reflected on that members capital account. Partner B who contributes "sweat equity" would still have a capital account balance of $0. Now this is where LLC are good. Members equity stake in the business does not necessarily need to reflect their capital contributions. For example, just because partner A contributes all of the capital to the company, the equity stake in the business could be split 90/10 in which member A has a 90% equity share and member B has a 10% equity share. This can lead to some hefty tax implications (specifically for member B) and you should really seek out a good lawyer (familiar with tax and business law) and an accountant to make sure you get things get started on the right track. Sure you can try and do this all your self but down the road I am quite sure you will find it is money well spent.

    2) To be brief here I BELIEVE you can still split distributions as you see fit since you are still an LLC. The S corp is simply a tax election. However I am only taking a guess on this one. Again I will say a good lawyer and accountant are invaluable members to your team.

    Hopefully someone else will chime in here.

    Cheers!
    Last edited by sw341034; 02-24-2012, 02:16 PM.

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    • #3
      LLC/SCorps/Etc

      So we just went through this whole process and our lawyer is a family member so I had the good fortune to spend many free hours with him instead of being billed at $300/hr.

      To answer the LLC vs S-corp. Correct, the LLC is a civil entity and has nothing to do with taxes. The S-corp is a tax entity and has nothing to do with the civil structure. As a civil entity, you can go for an LLC or a Corporation and this is how you are viewed by the state or court if you are ever sued. The IRS cares about the tax structure which you can choose a partnership, C-corp or S-corp. You choose the civil entity and then the tax entity, but, and this is very important, you must choose your tax structure at the beginning. If you don't, they default.LLC to partnership. Corp to C-corp.

      We chose the LLC because it gave us the flexibility of how we wanted to organize thing. For instance, we chose the ownership to be one percentage and the profit/loss payout to be a different percentage (not something you can do as a corp). However, we chose the S-corp as a tax entity to bypass some minimum tax issues in CA and to have to ability to pay out dividends at a lower tax rate.

      For sweat equity, you can deal with this in stock or unit. Technically an LLC does not issue stock, but you can structure it to issue membership units. In this case, you can award owners with units for their time (this is categorized as services rendered).

      There are a lot of ways to do it and this is just one that we decided after talking with the lawyer. It is best to consult the lawyer and accountant during the beginning to figure it out. Feel free to PM me if you'd like.

      Thanks
      Nick

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      • #4
        RE: a couple of questions...

        1) You can structure the "partnership agreement" agreement anyway you want -- the company doesn't have to be split strictly based upon the capital contributed by the members (LLC) or stockholders (corp). "Sweat equity" comes into play when you're talking about valuation of the enterprise.

        Think of it this way: equity is an accounting concept; accounting aims to capture the actual expenses and revenues of an enterprise. Example - you purchased widget A and widget B that worked together to produce revenue of X.

        "Sweat equity" is a valuation concept -- it aims to capture the 'over-reaching' value of an enterprice. Example - you purchased widget A and widget B that YOU spent C hours on to get them to work together to produce revenue of X AND can work together for N number of years producing revenue of X^y which equates to Z value at T=0.....

        So, the answer to your question is: it depends. For accounting purposes, you would not include sweat equity in the balance of stockholder's / owners equity. If you're pitching the your BP to VCs you should look to valuation metrics that MAY assign a value your sweat equity -- but likely won't.

        2) An S Corproation is a tax election for a corporation (or LLC). The election effectively enables the owners to pass through income resulting in single taxation, while still enjoying limited benefits of a corporation. Without the election, the enterprise earnings would be subject to double taxation: once when the income is earned by the corporation (at corporate income tax rates), and again as a distribution (taxed at rates depending upon the nature of the distribtion and the bracket of the receipient). I believe there are also some restrictions on the distributions of an S Corp, but can't recall for certain off the top of my head. Here's a good place to start researching for tax implications:


        The primary advantage of an S Corp is avoidance of the self employment tax you'll be subject to under an LLC (without election to be taxed as a C Corp / S Corp). Under an LLC structure, all income passed through to the owner is subject to self employment taxes, as well as standard income taxes. Under an S Corp, only your employment wages/tips are subject to self employment taxes and income taxes, while the remaining pass through income is subject to income taxes. Just to be clear, under an LLC or an S Corp, you're not taxed on distributions -- you're taxed on income of the enterprise. Under a C Corp, you're only taxed on distributions.
        Last edited by Guest; 02-24-2012, 03:37 PM.

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        • #5
          thanks everyone!!

          so to make sure i understand:

          an llc member contributing only $10,000 in sweat equity to a company with $100,000 capital equity would result in a 10% sweat equity contribution not 9% (10% of $100,000 rather than 9$ of $110,000).

          and as a LLC electing scorp status for tax purposes would not be obliged to compensate the afore mentioned member with 10% of the revenue, instead, an arbitrary Earning Distribution agreement can be drafted that specifies what the earning will be regardless of any equity contribution.

          do i have that all right?

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          • #6
            Originally posted by apoxbrew
            thanks everyone!!

            so to make sure i understand:

            an llc member contributing only $10,000 in sweat equity to a company with $100,000 capital equity would result in a 10% sweat equity contribution not 9% (10% of $100,000 rather than 9$ of $110,000).

            and as a LLC electing scorp status for tax purposes would not be obliged to compensate the afore mentioned member with 10% of the revenue, instead, an arbitrary Earning Distribution agreement can be drafted that specifies what the earning will be regardless of any equity contribution.

            do i have that all right?

            The second piece: yes, you've got it correct. Distributions (absent an agreement) are typcially based upon a member's CAPITAL (not sweat equity) contributions. In your case, you should get an agreement together.

            The first piece: not quite... you can state whatever ownership % you want in the partnership agreement... you just have to get the other parties to agree on the split. If I were to contribute $100k in cash while the other party contributed $10k worth of services, I would gravitate to granting 9% (or less) to the party contributing services -- "Cash is King".

            Contributing $10k worth of services with total contributions totaling $110k does not preclude you from asking for more than 9%. Conversely, contributing $10k in services does not guarantee that the other parties will agree to it. I would pitch it to the members as 9% or up the contribution if I were you.

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            • #7
              Wages are earned. Equity is purchased. The proper way to look at this is that if you want equity, you have to buy it, but you cannot buy it with a promise to perform services in the future. If you've performed services in the past, and have not been paid wages, you can be paid in cash or equity (or beer!). If you haven't performed services in the past, but intend to in the future, and you want both cash and a potential share of the company, focus on developing a thorough employment agreement and have one of the components of your compensation be options. Options are a great way to compensate a hard working brewer who isn't getting paid quite the cash he's worth!!! You should all request options from your employer! :-) I wrote about similar issues here.


              Also, a corporation is a C corp by default, but can make an S election and is then known as an S corp. LLCs don't have to make S elections, as they already have the pass through tax advantage that S election is designed to provide. S elections are only for corporations to make (or not make).
              John Little | Auburn, Alabama
              General Counsel, Southern Farmhouse

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              • #8
                Originally posted by banjolawyer
                Wages are earned. Equity is purchased. The proper way to look at this is that if you want equity, you have to buy it, but you cannot buy it with a promise to perform services in the future. If you've performed services in the past, and have not been paid wages, you can be paid in cash or equity (or beer!). If you haven't performed services in the past, but intend to in the future, and you want both cash and a potential share of the company, focus on developing a thorough employment agreement and have one of the components of your compensation be options. Options are a great way to compensate a hard working brewer who isn't getting paid quite the cash he's worth!!! You should all request options from your employer! :-) I wrote about similar issues here.


                Also, a corporation is a C corp by default, but can make an S election and is then known as an S corp. LLCs don't have to make S elections, as they already have the pass through tax advantage that S election is designed to provide. S elections are only for corporations to make (or not make).
                It would be helpful to know all the background information leading you to these questions but banjo has very good thoughts. If this is an existing entity you probably don't have any flexibility in changing the entity (LLC v S) and there are some painful reasons not to change it once it is set up. If you're looking to get a piece of the upside then some form of equity incentive is the way to go whether it is stock options or some form of restricted stock. In either case you should have an attorney and/or cpa take a look at the document to avoid any unpleasant tax issues that can occur if not set up properly. Feel free to PM me if you have more specifics.
                Rich Lindsay CPA/ABV
                Boston, MA

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                • #9
                  It may not seem like it but sweat is cheap. You can't equate an hour worked as an $1 earned. I would say that an hour worked is worth 20 cents tops. I know thats tough to hear but you have to factor risk. The person contributing sweat equity isn't risking anything beyond the limited amount of time they are there. It's patently unfair to the investor putting in actual capital to give equal or even partial status to someone risking virtually nothing.

                  As far as S corp vs LLC we went S corp because it places the burden of taxes on those that are receiving the profits instead of the company. The downside is that you are limited to just 10 investors so if your capital needs are greater than a couple hundred thousand dollars you may want to consider a different structure.
                  Owner
                  Grind Modern Burger
                  PostModern Brewers
                  Boise, ID

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                  • #10
                    Originally posted by Brewtopian
                    The downside is that you are limited to just 10 investors so if your capital needs are greater than a couple hundred thousand dollars you may want to consider a different structure.
                    The IRS website quoted above states 100 shareholders and one class of stock.

                    Originally posted by banjolawyer
                    LLCs don't have to make S elections, as they already have the pass through tax advantage that S election is designed to provide. S elections are only for corporations to make (or not make).
                    By default, banjo is correct in that an LLC passes income through to its members for reporting on the member's/members' personal tax returns. While S corp elections are only for corps, an election can be made to have an LLC treated (for tax purposes) as a Corporation. See the link below AND (as previously stated) consult a CPA/tax lawyer familiar with the regulations in your state to make sure you're in the best situation possible.



                    While it can be painful, the IRS website can be and INCREDIBLY helpful resource.

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