Converting Sweat Equity to Personal Wealth


If you are a small business owner, you’re probably familiar with the term “sweat equity.” Essentially, sweat equity is a measure of the added interest or increased value that you’ve created in your business through plain hard work (that is to say, through physical labor and intellectual effort). Typically, business owners just starting out don’t have the necessary capital or don’t want to hire a large staff to run the business or to purchase high-tech, so they put in untold extra hours, do much of the work themselves and try to “think smart” in terms of marketing or production. They often use this opportunity to develop a clientele and a business process they enjoy. If well designed it can be profitable, but at some point the owner must put in place strategies that can convert business profit into personal wealth.

In other words, to be considered a truly viable business, at least two things must happen (there are others, but for the purposes of this article we’ll just focus on two). One, you must evolve the business to the point where it is sustainable with only the amount of personal labor you want to dedicate and in a way that allows you to maximally build Owner Wealth while covering business cash flow needs. Moreover, the goal is a process that gives you a sense of accomplishment and satisfaction. This is what we call a “life-style” business. Or two, you must organize and prepare the business to a degree or footing that it can be sold for a profit, at least enough and in a manner that will allow you to retain the profit as personal or “Owner Wealth.”

I should note, for those who are not self-employed, that employees can also generate sweat equity for their firm by creating additional ways to increase the bottom line. For startups, you may defer your vacation and even put off earnings. All these things add value to the company, but employees will expect to receive some form of compensation either in the form of existing benefits (bonus, parental leave, or nonqualified plans) or in shares of company value.
As a business owner, the first question you must ask yourself is “What do I want my life to look like while I’m creating this equity, and what do I want to accomplish in the long term?” Once you answer this question, and only then, can we come up with a proper plan to support your direction.

It is our experience that business owners without such a plan likely encounter challenges that can undermine their ability to convert their equity to personal wealth. These challenges come either in terms of selling the business or ensuring that the life-style business is sustainable. For instance, there is a good chance that instead of generating wealth to your maximum potential, you’ll be funding Uncle Sam (and the California Franchise Tax Board) and coping with cash flow problems.

Presupposing your business is already generating profits, a well-tailored plan can (at least potentially) make a big difference in terms of retaining or accumulating Owner Wealth. Aside from using earnings to support current lifestyle, your business can create benefits that permit the owner to retain earnings for future use and reduce current tax liability, particularly important in California, where the tax liability on business owners with profitable business can exceed 50% of their business profit.

For example, a business owner with sweat equity from their start-up or life-style business that yields around $500K per year (after business expenses) might have a tax liability of $110K (IRS only) or $155K in California (see table below). Using available benefit tools/strategy an owner can (in this scenario) build wealth annually of about $230K. Much of their wealth is built from deferring taxable income and lowering their tax liability to $45K (or $70K within California).


Allowed to grow over 5, 10, or 20 years this strategy could (at a conservative 5% annual return) yield wealth of $1.3M, $2.9M and $7M respectively for the business owner. On its own, tax and benefit planning can yield a high conversion of sweat equity to Owner Wealth.

When starting a business, the last thing we ever think about is how we’ll exit from it and collect on all the hard-earned sweat equity we’ve invested. We’re usually focused on creating value and determining how we can generate sufficient earnings. Yet for some businesses it is only from a well-designed and planned sale that the owner will realize any personal wealth from their risk and hard work. For the owner of a life-style business, selling your firm may seem akin to selling off your first-born, but there comes a time in all our lives when such decisions are unavoidable, even advantageous. At the very least, it may be worth considering selling part interest in the business as a way of reducing workload and simultaneously augmenting Owner Wealth.

As an owner ready to sell you will want to be confident that you are choosing the right time, securing the best price, and structuring the transaction wisely. You’d be well advised to seek expertise in selling your business (particularly new entrepreneurs), and give plenty of thought to how it will impact Owner Wealth, which is all too often overlooked.

When considering how to exit from their business, entrepreneurs need to at least follow these 7 steps to maximize Owner Wealth.

  1. Plan your exit well in advance since the best fit team and solution may take time to identify and develop.
  2. Understand and acknowledge your emotional connection to the business. It can be deeply personal and leave you unsatisfied if not fully addressed – regardless of profit.
  3. Prepare the business for the sale so that it is financially attractive to the financial advisors of potential buyers.
  4. Choose experienced individuals in your specific type of business to guide you through the process of selling your business BUT include your personal advisor to ensure that the best exit also meets with your personal financial goals. Again, building a team that is right for you.
  5. Think clearly about family succession – don’t make assumptions on how your family or key employees feel about the business.
  6. Gauge the interest for a friendly buyer from co-owners, family, employees, vendors, and even customers.
  7. Develop a thorough wealth strategy plan. The wealth strategy plan should NOT be just about the business but should address how your efforts will be used to build your personal wealth and meet your personal goals.

Take the time to know yourself, know your goals and make absolutely sure your financial advisor has a clear picture of your objectives. Together, your plan will convert all that valuable sweat equity into wealth to fuel your dreams.

Edi Alvarez, CFP®

Retirement Plans for the Self-Employed – An introduction to reducing taxes by increasing retirement savings

The self-employed small business owner has at least three ways to save for retirement while saving on current taxes. The best known is the simplified employee pension plan (SEP). Not quite as well known, is the individual 401K-profit sharing plan (401K-PSP). And definitely least known is the Defined Benefit (DB) plan. Your choice should not be based on familiarity but on your retirement needs, current cash flow, and tax liability. Without planning the choices are limited to a SEP IRA or other IRAs. SEPIRAs can be created any time prior to tax filing but the contributions can only be as much as 20-25% of net earnings from self-employment (up to $52K).

A 401K-PSP, on the other hand, must be created in the same year (meaning that if it is used for 2014 contributions it must be created before Dec 31 of 2014). Ideally the contributions are made by December 31st for employee deferred compensation but employer contributions are made later, prior to tax filing. Employee deferral limits this year are $17.5K (plus an additional $5.5K after 50) or to the maximum earned, whichever is less. Profit sharing contributions can top up to $52K (plus an additional $5.5K after 50). Tax filings for the plan are required once the total assets exceed $250K. For most small business owners the 401K-PSP allows for higher annual contributions (than the SEP) and therefore lower tax liability.

DB plans are the least used by self-employed and yet the most powerful at reducing tax liability by allowing very high tax-deferred contributions. A business must have sufficient profit and cash flow to take full advantage of this type of plan. DB plans, like 401k, must be established in the same year and have specific requirements including annual tax filings. These types of plans are not limited by the fixed maximum contribution of $52K but instead on annually calculated contributions based on a future benefit. The maximum annual benefit is up to $210K this year. DB plans provide the highest contribution amounts particularly when combined with a 401K-PSP.

The best type of retirement savings plan for you, as a self-employed individual, is partially dependent on your business’s current and projected cash flow. Ideally you will match the features in all available plans with your retirement needs, selecting the plan that maximizes your retirement savings while reducing your current tax liability.

The key is to plan ahead with someone that knows the self-employed plan options and your personal and business finances. Working together you can provide for your future while reducing your tax liability today.

Edi Alvarez, CFP®

Business Entities: Business for profit, nonprofit or a bit of both?

Thinking to start your own business? Or maybe your business is growing and some form of reorganization is necessary to manage it all? If you are engaged in the sale of a product or service commercial law pretty much governs your options for setting up and administering your business. These entities include corporations, cooperatives, partnerships, sole proprietors, limited liability companies and others.

So, which type of business structure is right for you? The answer depends on the type of business you run, how many owners it has, and the overarching financial situation. Some of the most important factors to consider, include:

  • the potential risks and liabilities of your business
  • the formalities and expenses involved in the various business
  • structures
  • the motivation behind the venture (profit, social, or charitable)
  • your income tax situation
  • your investment needs, and
  • the sources of revenue.

In large part, the best ownership structure for your business depends on the type of service or product it provides and the sources of revenue. Often the ownership structure is ruled only by tax and risk questions but there are many other reasons. I will highlight legal, tax and motivational reasons that are associated with specific business structures and in particular provide information on two new entities.

If your business engages in what most people would consider “risky activities” you ought to consider a business entity that provides some personal liability protection (such as a limited liability company, or LLC), which shields, to a certain degree, your personal assets from business debts. Note that I said it offers some personal liability protection.

Under a traditional corporate structure, corporate directors have a fiduciary duty to exercise business judgment with the goal of maximizing profits. In fact, corporate officers and directors can be held legally liable to shareholders if they do not maximize profits to the exclusion of other goals.

New to the mix are benefit corporations (sometimes informally called a “B Corp,” not to be confused with a certified “B Corp”). Benefit corporations don’t follow the traditional profits-only model. Instead, these have a dual purpose, to generate some type of public benefit while creating value for their stakeholders. For example, if the charter of a benefit corporation makes it clear that it is organized to build affordable housing, officers and directors are therefore held accountable to achieve both this objective and a profit. Legally this means benefit corporations are shielded from lawsuits by shareholders who argue that the corporation has diluted their stock by putting social objectives over profit.

Of course there is also the full non-profit corporation where the social mandate is the only mandate and large profits are not permitted. Most nonprofits are known by their 501 tax-exempt status. Owners of sole proprietorships, partnerships, and LLCs (LLC for tax purposes) all pay taxes on business profits in the same way. These three business types are “pass-through” tax entities, which means that all of the profits and losses pass through the business to the owners, who report profits (or deduct their share of losses) on their personal income tax returns. Therefore, sole proprietors, partners, and LLC owners can count on similar tax complexity, paperwork, and costs. Owners of these unincorporated businesses must pay income taxes on all net profits of the business, regardless of how much they actually take out of the business each year. That said, LLCs do have the option to file as a corporation for tax and benefit purposes.

In contrast, the owners of a corporation do not report their share of corporate profits on personal tax returns. Owners pay taxes only on profits they actually receive in the form of salaries, bonuses, and dividends. The corporation itself pays taxes, at special corporate tax rates on any profits that are left in the company from year-to-year (called “retained earnings”). Corporations also have to pay taxes on dividends paid out to shareholders, but this rarely affects small corporations, which seldom pay dividends. A double taxation occurs when the corporation pays taxes on its profits AND the owners pay taxes on the dividends. Subchapter corporations (S Corp) are popular with professional services businesses primarily for tax reasons.

Unlike other business forms, corporations can sell ownership shares in the company through stock offerings. This makes it easier to attract investment capital and to hire and retain key employees. But for businesses that don’t need to issue stock options and will never “go public,” forming a corporation may not warrant the added administration and expense. If it’s limited liability that you want, an LLC provides the same protection as a corporation. If it is ease of use, then sole proprietorship or partnership may be the most appropriate. Moreover, the simplicity and flexibility of LLCs and sole proprietorships can offer a clear advantage over corporations.

An L3C is a new variation on the LLC. What sets it apart from regular LLCs and other for-profit entities is its ability to pursue charitable, educational or socially beneficial objectives. Although the L3C can also pursue profit oriented objectives, they are secondary to its social goals. The L3C is a hybrid entity taking on the flexible characteristics of an LLC in combination with a low-profit socially beneficial objective. The verdict is still out on their usefulness and whether or not these business entities will endure, but they are currently an option in some states, including Hawaii and California. For social and community conscious business ventures to succeed, they need a flexible, lightly regulated business structure that allows access to investment capital.

The L3C format was designed to satisfy this need. Before you can decide how you want to structure your business, you’ll need to review your vision for the business against all the available structures. Here’s a brief rundown on the most common ways to organize a business:

  1. sole proprietorship
  2. partnership
  3. limited partnership
  4. limited liability company (LLC – profit mandate)
  5. low profit limited liability company (L3C- profit & social/community mandate)
  6. corporation — usually C or S Corp (for-profit mandate)
  7. benefit corporation (profit & social/community mandate)
  8. nonprofit corporation (not-for-profit or 501 firms), and
  9. co-operatives

If you are contemplating a new business or thinking to restructure an existing one, you should seek both legal and tax professional advice. Aikapa can help integrate this advice with your vision.

Edi Alvarez, CFP®