Small business owners and self-employed professionals often spend countless hours developing products, services, or processes that enhance their business operations.
A construction contractor might spend weekends designing custom software to track job costs. An engineer might devote evenings to developing a proprietary modeling program.
In these situations, many entrepreneurs wonder: if they had hired someone else to perform this work, the payment would clearly be deductible—so why shouldn’t they be able to deduct the value of their own time spent on these business-critical activities?
The answer lies in a fundamental tax principle that distinguishes between actual economic outlays and the perceived value of one’s own efforts. This principle affects millions of Schedule C filers who might be tempted to assign a dollar value to their labor and claim it as a business deduction on their tax returns.
A recent tax court case, Nwafor v. Commissioner, T.C. Memo. 2025-X (March 26, 2025), provides an opportunity to consider why the value of a self-employed individual’s time—even when devoted to potentially valuable business development activities—is not deductible for federal income tax purposes.
Facts & Procedural History
The taxpayer in this case was the sole proprietor of an engineering firm based in Colorado. The business operated on the cash basis method of accounting. During 2019 and 2020, the firm worked on both conventional engineering projects (developing properties into single-family mountain homes) and non-conventional projects involving aircraft, defense structures, and other complex designs.
For his non-conventional engineering work, the taxpayer devoted substantial time to developing a mathematical modeling program. According to his testimony, he spent 1,302.49 hours on this work and valued his time at $285 per hour, resulting in a total claimed value of $371,210. The business never actually paid the taxpayer for this work nor recognized this amount as a company liability.
On his 2019 and 2020 Schedule C tax returns, the taxpayer reported expenses of $37,121 and $74,242, respectively, related to the time he spent developing this computer modeling program. He calculated these amounts using a six-year schedule applied to the claimed value of his labor.
The IRS conducted a tax audit and disallowed these deductions, along with several other claimed expenses. This resulted in tax deficiencies of $64,110 for 2019 and $71,105 for 2020, plus accuracy-related penalties under section 6662(a). The dispute ended up in the U.S. Tax Court.
What Does the Tax Code Say About Business Deductions?
To understand why the taxpayer’s claimed deductions were disallowed, we have to consider the fundamental requirements for business deductions. Under Section 162 of the tax code, taxpayers can deduct “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.”
Similar language appears in other deduction provisions throughout the tax code, including those related to development costs and research expenditures. Regardless of the specific type of expense, one requirement remains consistent: costs must be “paid or incurred” by the taxpayer to be deductible.
This is why one might think that an expense for the owner’s time is allowable, but later find out that it is not. The amount is not paid. Compare this to payments to third parties. Business deductions typically include costs such as salaries for employees, materials and supplies, payments to contractors or consultants, rent, utilities, and other expenses necessary for running the business. For Schedule C filers, these deductions directly reduce taxable income, making them valuable for tax planning purposes. But payments for the owner’s time do not.
What Does “Paid or Incurred” Mean in Tax Law?
The phrase “paid or incurred” appears throughout the tax code and serves as a fundamental requirement for various deductions. This language establishes when a taxpayer can claim a deduction based on their accounting method:
- For cash-basis taxpayers (like the taxpayer in this case), an expense is generally deductible in the year it is actually paid.
- For accrual-basis taxpayers, an expense is deductible when it is incurred—meaning when all events have occurred that establish the existence of the liability, the amount can be determined with reasonable accuracy, and economic performance has occurred.
Regardless of the accounting method, there must be an actual economic outlay or genuine liability created. This requirement ensures that deductions correspond to real economic costs borne by the taxpayer, maintaining the integrity of the tax system.
Why Can’t Self-Employed Individuals Deduct Their Own Labor?
The Tax Court addressed this question directly in this case by applying a longstanding principle in tax law: “Labor performed by a taxpayer does not constitute an amount ‘paid or incurred’ by him,” and therefore, the taxpayer is not entitled to deduct the value of such labor.
The court cited several precedents for this position, including Rink v. Commissioner, 51 T.C. 746 (1969), Grant v. Commissioner, 84 T.C. 809 (1985), and Rice v. Commissioner, T.C. Memo. 1967-54. These cases established that a taxpayer cannot deduct the estimated monetary value of their own time devoted to business activities.
The court explained this principle with a compelling comparison: “Just as ‘imputed income’ arising from the benefit a taxpayer’s own services yield to him is not taxable under our system of taxation, neither is the ‘imputed expense’ arising out of his exertions a proper deduction from income.”
This creates a symmetrical treatment in our tax system—if you don’t have to recognize income for services you provide to yourself, you also cannot claim a deduction for those same services. If you mow your own lawn, you don’t report income for the value of that service, and similarly, if you perform work for your own business, you cannot deduct the value of that work as an expense.
How Does Business Entity Structure Impact Owner Compensation?
The treatment of owner labor differs significantly based on business entity structure:
- Sole Proprietorships: The business and owner are treated as a single taxpayer. The owner cannot pay themselves a deductible salary or wages. All business profits flow directly to the owner and are reported on Schedule C.
- Single-Member LLCs (Disregarded Entities): Like the business in this case, these are treated as sole proprietorships for federal tax purposes unless they elect otherwise. The same restrictions on deducting owner labor apply.
- Partnerships and Multi-Member LLCs: Partners and members generally cannot deduct compensation for their own services. Instead, they receive distributive shares of partnership income.
- S and C Corporations: These entities are separate taxpayers from their owners. Owners who work in the business can be paid reasonable compensation as employees, and the corporation can deduct these payments as business expenses. However, these wages become taxable income to the employee-owner.
The taxpayer’s engineering firm was organized as a single-member LLC treated as a disregarded entity for tax purposes, which resulted in there being no deduction allowable for the cost of the owner’s time.
What Other Options Do Business Owners Have?
For self-employed individuals and small business owners seeking legitimate tax benefits for their business development activities, several alternatives exist:
- Change Business Structure: Operating as an S corporation would allow the business owner to pay themselves a reasonable salary that the corporation could deduct.
- Hire Contractors or Employees: Payments to third parties for development work are clearly deductible. In some cases, it might be more tax-efficient to hire others rather than performing all work personally.
- Consider R&D Tax Credits: For qualifying research activities, businesses might be eligible for the Research Tax Credit under Section 41, which provides a credit rather than a deduction for certain qualifying research expenses. This credit can include amounts, such as Schedule C profits, that are subject to self-employment tax.
- Document Capitalizable Costs: When developing business assets, maintain detailed records of all actual expenditures that can be capitalized and either depreciated or amortized appropriately.
The Takeaway
This case reinforces an established principle in tax law: self-employed individuals and sole proprietors cannot deduct the value of their own time, even when that time is spent developing valuable business assets. This limitation stems from the fundamental requirement that deductible expenses must be “paid or incurred,” which necessitates an actual economic outlay or liability. The symmetry in our tax system—not recognizing imputed income or imputed expenses—maintains its integrity but requires business owners to carefully consider their entity structure and tax planning strategies. By focusing on legitimate deductions for actual expenditures and potentially restructuring business entities when appropriate, business owners can maximize tax benefits while avoiding costly disputes with the IRS.