Sweat equity is the term used to refer to an employee’s labor that is invested into an asset as opposed to equity bought with capital. Ideally, it would be fair for all employees whose sweat equity increases the value of a private company to share in the ownership of that company. But under current tax law, this type of employee compensation policy can be prohibitively expensive.
Under current law, employees must generally include stock compensation in their taxable income when the shares become substantially vested. Likewise, stock options are generally included in income upon exercise, which allows for some timing of the income tax, but also subjects them to an expiration date. This means that employees who wish to acquire stock in the company may be forced to pay a high amount of income tax in the absence of liquid assets. If an employee cannot afford to pay this tax then the employee will be discouraged from sharing in the company’s wealth.
Fortunately, Congress has taken some steps to fix this problem. A bill introduced in September 2016, titled the “Empowering Employees through Stock Ownership Act,” was passed by the House of Representatives to help implement better policy. If the bill goes on to become law, it will limit the hardships imposed by the tax treatment of stock compensation.
The goal is to permit private companies to issue stock to their employees without triggering the immediate inclusion of taxable income. To accomplish this goal, the bill allows an eligible employee to elect to defer taxation for seven years, or until one of several events occurs. This effectively reduces taxation to the employee, similar to contributions made to a pre-tax retirement account, without the list of strict requirements attached to a retirement account.
To help ensure this tax expenditure will be used to properly incentivize shared ownership, the company would be required to provide the stock compensation to at least 80 percent of its workforce. Further, the income deferral would not be available for top management and top paid employees. Finally, as noted, the deferral period ends upon the occurrence of specified events, such as the sale of the stock or the stock becoming tradable on a securities market. These events create the cash or cash-equivalent that the employee needs to pay income taxes on the stock compensation, thereby empowering the employee to reap the benefits of increasing the company’s wealth.