by Peter Hough, April 2003
Sweat equity is generally considered all the voluntary unpaid work that is often required in the first years of a new business. This work is usually unpaid because the new business cannot afford to pay wages or salaries during start-up. The commitment by members to provide sweat equity is often essential for the success of the business.
Several issues are often raised around sweat equity: How does one ensure a fair or equal contribution between members and how can the sweat equity be recognized within the accounting system?
It may be desirable to show the sweat equity within the accounting system for then the investment of work by the members is recognized on the Balance Sheet. This increase in the members’ shares makes it clear to outside lenders or investors how much the members have contributed to the business. Another result in accounting for the sweat equity is that the co-op’s expenses are increased. This reduces the co-op’s net income or increases its net losses, as may be the case. In either way, the current or future tax liabilities levied upon the cooperative’s profits are reduced.
To account for sweat equity follow these steps:
Determine whether or not the members are employees of the cooperative or independent contractors. This is a technical distinction made by Revenue Canada based upon specific criteria. (If you need more information on determining the nature of your co-op/member relationship (see EI Brief: Guidelines for Determining Whether or Not There Is an Employer/Employee Relationship in a Worker Co-op). If you are not sure whether you have an employee-employer relationship, you should definitely get this clarified as it determines whether or not you will be eligible for EI should you be laid off. If you receive EI payments when you are not eligible, Revenue Canada requires you to repay the money received. It makes a difference for accounting and tax purposes whether the members are employees of the co-op or classed as independent contractors. A cooperative is required to deduct CPP, EI and income tax when wages are paid to the employee. For cooperatives which are composed of independent contractors, no deductions are withheld when payments are made to the member.
To recognize sweat equity the labour must be converted to a dollar amount. This means that the work of member-employees or member contractors needs to be tracked in terms of time or work completed and given a specific dollar value. Depending upon the job a different level of compensation may be determined. Basically the sweat equity work should be tracked and compensated in the same manner as has been determined for paid hours. By using the same compensation arrangements as for regular work you ensure people are treated fairly and receive appropriate credit for the work they contribute.
To enter sweat equity in the bookkeeping, make identical entries as you would if paying the amount of wages in cash. However, instead of writing a cheque for the balance after deducting EI, CPP, and income tax, you simply enter this amount into the share account of the member. The reason deductions are made is that the wages are considered income for the employee as soon as they are earned regardless of whether the employee receives cash or shares. The co-op of course must remit these deductions and the co-op’s matching contributions to Revenue Canada in cash each month as usual. For independent contractors, since they are technically self-employed, no immediate tax liability is incurred, as their actual income is not determined until their year-end, so the full amount of the payment can be allocated to shares.
Another option: combining sweat equity and paid wages
Another option is to track all work and then to pay some in cash and allocate some to shares each regular pay period. A set amount of shares could be purchased each week or all overtime wages could be allocated to shares. You can develop a system suitable to your circumstances.
Example: One Pay Period
50 hours @ $10 = $500
Deductions: CPP 10
Cash Payment: $275
The partial deduction for shares is the sweat equity portion. This allows the co-op to pay for all the work at a fair (market) rate but doesn’t require the cash flow to pay it out in cash. If this is to be done, the Board of Directors should pass a motion requiring all members to purchase shares through a wage deduction. This benefits the co-op by showing increased share investment on the balance sheet. It also benefits the members as their ownership in the co-op increases. This means that the equity structure of the cooperative will reflect the true contribution of the founding members. In addition, if one is laid off one’s EI payments will be based upon the full hourly rate even though some was received in shares and some in cash. The layoff slip only indicates the total wages earned per week, not the form in which the payment was received.
Effect on other forms of income assistance
If one is receiving another form of income support from the government, such as social assistance, accounting for the sweat equity will increase your official income and may reduce your cash income support. You should clarify this with your caseworker.
Since the employee incurs a tax liability for the sweat equity, it is to the employee’s benefit to place the shares in a Self-Directed RRSP. This defers the tax obligation.