March 28th, 2018 Dominique Molina (Taxloopholes.com Tax Strategist)
Many business owners, particularly during the start up phase, spent countless hours establishing the business, ensuring its viability, market testing, and setting pricing. While its certainly an exciting time for a new entrepreneur, most businesses aren’t yet producing enough cash flow to compensate the owner for this development time put in.
If you do a quick search online, one can find plenty of business coaches and consultants readily available round the clock to assist startups with the chores of launching a company or being its CEO. You may find the costs of these services ranging from $150 per hour up to thousands of dollars each month in coaching fees. Whether your business is a startup or a well-established company promising you an IOU due to lack of cash flow, from a value standpoint, there is certainly value in the work you are doing.
The point is, that while the labor of love you pour into your business may have a fair market value on the street, how do you know whether your work is worth $100 or $50,000 per hour? (as some publicly traded company CEO’s make) You won’t know the value until you have been paid.
This causes confusion for some taxpayers looking to donate their time given to charity or looking to deduct the time not paid for self-employment (unless you count the quarters you use for snacks in the vending machine).
The legal answer to this question can be found in a recently decided court case1. The case decided the issue as to whether or not a taxpayer can deduct the value of his labor for which he is unpaid. In 2014, the taxpayer, a former police detective, owned a sole proprietorship that provided litigation consulting. He reported a loss from his business providing expert witness testimony of $29,500 for the year. (side note – I’m not one to pick apart a tax return, OK I am, but it is always curious when business deductions end in perfectly round numbers.) The taxpayer used this loss as a deduction against his other income of $234,000 earned during the year.
The taxpayer claimed a large expense deduction for researching a case. During the audit, the IRS disallowed this deduction under Internal Revenue Code Section 162, citing that the expense was not actually incurred. The taxpayer, however disagreed and appealed the decision. Interestingly, the taxpayer used the same Internal Revenue Code Section 162 to argue his position that his research was an ordinary and necessary exercise to prepare him for a pro-bono case and carrying on of his business. While he agreed he had not spent any actual money on the expense, it was needed to succeed in his business; call it “sweat equity” if you will.
While I love a good story in favor of the underdog, can you see where this is going? Unfortunately the court ruled against the taxpayer in this case because in order to take a deduction, one must pay or otherwise incur an expense to be eligible to deduct it. The labor itself is not within the meaning of Code Section 162.
That may make perfect sense for a business, but what about taxpayers, even business owners, who donate their time to a charitable cause? Isn’t there value present to deduct? Certainly the court must allow for this – else why would anyone volunteer their time?
Donations of services are not deductible charitable contributions. I have used my skills as an accountant and tax planner for many charitable organizations over my career, but unfortunately the value of my knowledge or time spent in service is not a tax-deductible donation to the organization. However, if I donate the value of my work in cash so the organization can pay someone else to do the work, that IS a tax-deductible donation.
This example serves as a perfect illustration, why donated labor is not deductible even to nonprofits. Aside from the question of valuing the services performed, if you consider what happens in the normal earning cycle of a business, the net value of the services donated is zero.
Consider for example my time spent on various nonprofit boards. If I charged a third party for this work, I may earn $40,000-$50,000 per year in consulting income. However, in donating my services I don’t earn this money as the group did not pay me for my services. If instead, the group paid me $50,000 for my services, and I in turn donated this money, I’d report this as income, pay tax on the revenue earned, and then take the deduction of my cash donation. $50,000 of taxable income less $50,000 in tax deductions equals 0. By not receiving the income, I avoid reporting the $50,000 in additional revenue for the year, and I also forego the charitable deduction. Either way, we arrive at the same result.
While your personal valuation of the sweat equity you put into your business may land you on the Wall Street Journal’s top CEO pay list, it won’t help you reduce your tax bill.
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References: James Edward Bradley Jr. and Margaret Letitia Hayes-Hunter v. Commissioner, T.C. Summary Op. 2018-13 (Mar. 19, 2018)