I mow my own lawn. Most of the other houses in my neighborhood pay a lawn service to do that. But I’m too cheap to pay someone $40 to do what I can do perfectly well. To some economists, my act of mowing my own lawn is income to me. As the great economist Benjamin Franklin might say, the $40 saved is $40 earned. Thank goodness I do not have to count that imputed income as gross income!
The point is that my labor may have a market value. I could go into the lawn care business and others would pay. But until I actually get paid, how do you know whether my labor is worth $40 or $35 or $45? And when I labor instead at my desk at Tech Law, my labor is rewarded with a decent salary. But does the fact that I get paid for my labor mean that when I perform labor above and beyond—such as writing this blog post for example—such uncompensated labor is an expense? Have I “incurred” an expense that, if performed in the carrying on of my trade or business, is deductible under §162? That is the question posed by the case of James Edward Bradley Jr. and Margaret Letitia Hayes-Hunter v. Commissioner, T.C. Summary Op. 2018-13 (Mar. 19, 2018). There, Judge Panuthos teaches a seemingly simple lesson: a taxpayer may not deduct the value of the uncompensated labor they put into their business. Unpaid labor is not deductible. Underneath this seeming simplicity, however, lies some interesting complexities.
More below the fold.
During 2014 Mr. Bradley, a former detective for the Washington D.C. Metropolitan Police Department, was in the business of providing litigation consulting services as a sole prop. He held himself out as an expert on police practices and served as an expert witness on a National Standard of Care in Police Procedure (here’s a case, for example, where his testimony was critical for the plaintiff’s victory).
On their joint income tax return for 2014 Mr. Bradley and Ms. Hayes-Hunter reported a net loss of $29,500 from his consulting business, which they used to offset their reported wage income of $190,000 and pension/annuity income of $44,000.
The biggest expense creating the loss on the consulting business was a $25,000 deduction for what Judge Panuthos describes as “Research on Cases 100 Hrs @$250 per hr.” The IRS had denied that deduction and Mr. Bradley protested that denial. Mr. Bradley explained to Judge Panuthos that while he had not spent any actual dollars on the research, the research was important for him in preparing his expert testimony in a pro-bono civil action and paying clients would have paid him $250/hr for it. Mr. Bradley argued that the research project was deductible either under §162 because the work was “ordinary or necessary for the carrying on of” his business, or else it was deductible under §174 as a “research or experimental expenditure...in connection with” his business.
Judge Panuthos agreed with the IRS that the claimed deduction was not allowed by either §162 or §174. Both sections, he explained, required that the taxpayer “pay or incur” the expense in order to take the deduction. Judge Panuthos goes over several different cases where courts held that the mere expenditure of labor was not the payment or incurring of an expense within the meaning of §162. The short opinion is worth reading for that alone; you can just hand it to your clients.
This holding, that unpaid labor is not an expense "paid or incurred" has parallels in charitable donation law. Donations of services are not deductible contributions. So if I mow my church’s lawn, the donation of my labor is not a deductible contribution to my church. But if I give the church $40 to it can pay someone else to mow the lawn, that can qualify as a gift under §170. In fact, the leading case on that---Grant v. Commissioner, 84 T.C. 809 (1985), aff’d, 800 F.2d 260 (4th Cir. 1986)—is one that Judge Panuthos uses to explain why Mr. Bradley cannot deduct his labor as an “expense."
Underneath the theory, however, is a very practical reason why we don’t really want taxpayers to be able to take §170 deductions for contributions of their labor, or §162 deductions for the uncompensated labor they put into business. Such an rule would create a nasty valuation problem.
The IRS ran into exactly this practical problem of valuing uncompensated labor in the 1950’s in connection with the dependency deduction. Here’s the story.
The current dependency deduction first appeared in the 1944 Individual Income Tax Act, part of that series of statutes during World War II by which Congress changed the “class tax” on upper income taxpayers to a “mass tax” on middle income taxpayers. Recognizing that the new income provisions would now apply to masses of people, the tax writers made simplification a chief goal of their legislative efforts. For example, Congress created the standard deduction, in large part, to simplify returns for most taxpayers. I think the House Ways and Means Report, H.Rep. 78-1365, gives a good sense of the drive to simplify. In the opening paragraph of the Report one finds this sentence: "The bill is confined to the simplification of the individual income tax." The Report then lists 5 objectives, all of which involve some form of simplification.
As part of this simplification effort Congress also expanded and simplified the deduction for “dependents.” Previously, a “dependent” was classified as someone who was incapable of any self-support. Congress eased that requirement by allowing a taxpayer who provided over half of a person’s support to claim that person as a dependent. The Ways and Means Report says (at p. 5): “The present law requirement that a dependent over 18 must be incapable of self-support is unnecessarily limited and confusing.... Instead, there will be substituted the concept that a dependent is anyone for whom the taxpayer furnished over half the support....” With some modifications, that support requirement is still in the current definitions of “Qualifying Child” (§152(c)(1)(D)) and “Qualifying child” (§152(d)(1)(D)).
Computing the new support requirement was still tricky. Until 1957, the IRS followed an “actual expense” rule to decide whether a taxpayer had provided more than half of a dependent’s support. The IRS would count only the actual dollars spent to determine support and would not count the market value of property provided to the dependent. See e.g. Rev. Rul. 53-235, 1953-2 C.B. 23. In 1955, however, the Tax Court held that a married couple could count the fair market rental value of lodging in their home as support and so could claim the wife’s mother (who lived with them) as a dependent. Blarek v. Commissioner, 23 T.C. 1037 (1955). In 1957 the IRS responded with a new regulation that not only counted the fair market value of lodging towards the support requirement, but also counted the fair market value of “services or other benefits.” T.D. 6231, 1957-1 C.B. 77. In August, 1958, however, the IRS amended the regulation to delete the “services or other benefits” language. T.D. 6302, 1958-2 C.B. 53. There, the IRS explained that “[t]he Regulations providing for the valuation of services proved extremely difficult to administer. It was virtually impossible to arrive at a proper value for support furnished in the form of services...” So the IRS went back to an actual dollar measurement.
Despite the change in the regulations, taxpayers continued to argue that the value of their services should count in computing support for a claimed dependent. They lost because the valuation problem was simply insurmountable. Not only was it difficult to place a market value on the services (“Well, Mrs. Conner, just how valuable is that meatloaf you made?”) but it was also difficult to put a market price on love. Here’s how the Tax Court put it in Bartsch v. Commissioner, 41 T.C. 883, 886-887 (1964), where the Court rejected the taxpayer’s attempt to include the value of services (such as cooking and cleaning) she provided to her mother:
"...it is beyond our comprehension why or how such services must be measured in the market place, or anywhere. How can a quantum meruit be put upon a daughter’s care for an aged mother? Do we balance our judgment of such ‘value’ against the ‘value’ of the personal satisfaction which the daughter in this case receives in giving such care? ...We say no. The term ‘support’ in the Code must mean something more than furnishing the ordinary kindnesses and helpfulness and the cooking and the cleaning and the dishwashing that one able member of a household furnishes another less able. These things are not to be valued in the market for tax purposes."
Other courts agreed and approved the IRS rule counting only actual dollars spent plus the fair market value of property provided towards the support requirement. Even though the courts recognized that the IRS rule discriminated against poorer taxpayers, who could not afford to pay for services but instead gave their labor of love, courts found that the “administrative exigencies tip the scales” in favor of the IRS rule. Markarian v. Commissioner, 352 F.2d 870, 873 (7th Cir. 1965) cert. denied, 384 U.S. 988 (1966).
Adam Smith and Karl Marx both agreed (with some slight variations (!)) that labor is the foundation of wealth. All value in society traces back to someone’s labor. Owning the stuff (capital) is not enough; you need labor to give the stuff economic value. And you need to pay for that labor. It’s the market transaction that sets the value. When you labor for love, money may or may not follow. But until it does, the Tax Code pays no nevermind, both for income reporting and, as we learned in this week’s Lesson From the Tax Court, for deduction-taking.