The Phantom Income Issue

When starting a new business, the question that every new venture faces is how to fund the operations of the business. Often times, one person agrees to contribute money, while the other person agrees to contribute services. This can lead to an issue known as “phantom income.”  Presently, the tax code places a value on capital contributed to a business, but not labor or “sweat equity” (the future services a partner in the business will perform for the business). If one partner contributes money, while the partner contributing “sweat equity” receives an equal share in the business, the partner contributing services will be required to pay taxes on that “phantom income,” meaning that he will have a tax liability for receiving the value of his share in the business. 

The partners may be able to avoid this by structuring how the company is funded.  One method is to have the partner contributing the services make a promissory note in the amount of capital the paying partner contributed to the business. As the partner contributing services works for the company, a portion of his cash compensation would be applied to pay down the note until the value of services has been paid down. The note payments would be taxable but would be spread out over a period of time so as to avoid a large tax bill up front.  

A second option is for the money contributing partner to be the sole owner of the business, and give the sweat equity partner options to purchase equity in the business that vest over time at a certain price. The sweat equity partner would have to pay for his equity, but he would hopefully be earning enough to cover his contribution without a big tax bill. 

Lastly, each partner could contribute a small amount ($100 for example) to the business in exchange for a 50% equity stake. The partner contributing the cash could then loan the business money, taking a promissory note back from the business. The loan terms would be between the contributing member and the company. That way, the partners could share in the company 50-50, while the contributing owner had a (hopefully) guaranteed return on his investment.  

If you are thinking about starting a new business, and you have questions or need advice, we at Janssen Malloy LLP are here to help.