People make LLC Capital Contributions in order to become LLC Members (owners of the LLC).
In addition to being exchanged for LLC ownership, Capital Contributions also “capitalize” (fund) your LLC. Meaning, they give your LLC the money it needs to operate, pay expenses, and ideally, become profitable.
Capital contributions can be made in the form of:
- personal property, or
While contributing money is the most common form of Capital Contribution, LLC owners may also contribute services (aka “sweat equity”).
These services must be non-related labor. Meaning, the labor being contributed isn’t a part of the LLC’s main business activities.
An example of Service Contributions to an LLC
Paul and Fatima are starting a business called Pita Truck LLC. They each own 50% of the LLC. And they each agree to contribute $5,000.
Both Paul and Fatima have a culinary background, however, Fatima also used to work as a food photographer and graphic designer.
For his initial Capital Contribution, Paul will contribute $5,000 cash.
For her initial Capital Contribution, Fatima will contribute $500 cash and her photography and design services.
She’ll shoot all the photos for the website and social media. She’ll also design the logo and other digital branding. These services are valued at $4,500, which is what she used to charge clients.
After the photos and design work are done, both Paul and Fatima will work in the business and run the day-to-day operations of the food truck together.
How to determine the value of a Service Contribution to an LLC
If you are contributing non-related services to an LLC for ownership, you’ll need to figure out the fair market value of those services.
The fair market value is what it would cost to hire someone else to do the same work. To determine this, you can do online research or get a few quotes from similar service providers.
Once the value is determined, it’s best to make sure all the LLC Members agree.
Documenting service contributions to your LLC
Service contributions in exchange for LLC ownership should be documented in your LLC Operating Agreement.
You may need to customize your Operating Agreement to document your service contributions. If you need assistance, we recommend hiring a business attorney for help.
You should also give a record of this Contribution to your accountant. Call your accountant and ask what they need in order to document the Contribution.
What’s the tax treatment of contributing services in exchange for LLC Ownership?
Tip: Most people contributing services in exchange for LLC ownership won’t be taxed on the value of the Membership Interest they receive. That’s because the Service Contributions are most often initial Capital Contributions in new LLCs.
To better understand this, let’s go over some basics about exchanging services for LLC ownership (aka Membership Interest) and how that might be treated as “income”.
- Membership Interest in an LLC means that you own part of the business.
- Membership Interest itself may have value (or it might not).
- If your Membership Interest has value, the IRS will consider exchanging services for it to be “income”.
- You must pay taxes on income.
Said another way:
- If your Membership Interest has value, it’s income, and you owe taxes.
- If your Membership Interest doesn’t have value, it’s not income, and you don’t owe taxes.
How do I know if my Membership Interest has value?
The easiest way to determine this is by using the “new business test”.
Meaning, if your LLC is brand new, then the business itself doesn’t have value yet. And therefore, your Membership Interest doesn’t have value either.
Ask yourself this question: What would someone pay for your LLC today? For most people with a brand new LLC, a buyer wouldn’t pay anything ($0) for the business. This is because the LLC isn’t generating substantial revenue yet, and doesn’t have many assets.
For example: Jane owns 50% of a business that is worth $0 (because it’s brand new). And although she traded her services to get that 50% Membership Interest, her Membership Interest is still worth $0. And therefore she doesn’t owe taxes.
LLCs that don’t pass the “new business test”:
If you are exchanging services for Membership Interest in an existing LLC, then the LLC likely won’t pass the “new business test”. And the Membership Interest you receive will be considered “income”.
That’s because this LLC likely already generates a profit and has cash in the bank. It might also own real estate, inventory, or equipment. A business like this has a real market value (it could be sold).
Therefore, the Membership Interest you receive (in exchange for your service) will be considered “income”. And therefore, you’ll need to pay taxes on the value of that “income”.
For example: Bob is going to exchange his labor as a carpenter (building tables and chairs) to become a 25% owner in Lotus Bistro LLC. Because Lotus Bistro LLC is valued at $200,000, the Membership Interest Bob receives is worth $50,000. And the IRS considers this $50,000 in “income” and therefore, Bob will pay taxes on that $50,000.
Okay, I kind of get it… but will I have to pay taxes?
If you are contributing services in exchange for LLC ownership as an initial contribution in a new LLC, you don’t owe taxes on that contribution.
If you are contributing services in exchange for ownership in an existing LLC, you should talk to an accountant because you may owe taxes.