Sole Proprietor Can't Deduct the Value of His Time Spent on Developing Software

(Parker Tax Publishing May 2025)

The Tax Court held that the sole proprietor of an engineering firm was not entitled to (1) deduct the value of his time spent on developing software for his business, or (2) reduce the gross sales of his business by either the general discounts or the customer-specific allowances he gave to clients because those discounts were already incorporated in the lower sale prices that he charged those clients. The court also agreed with the IRS that the taxpayer was liable for negligence penalties for failing to substantiate deductions taken on his return. Nwafor v. Comm'r, T.C. Memo. 2025-27.

Background

David Nwafor was the sole proprietor of Gordon Group, LLC (Gordon Group), a Colorado engineering firm that used the cash method of accounting. Gordon Group's conventional work focused on the development of Colorado properties into single-family mountain homes. To facilitate its projects, Gordon Group hired contractors that would provide pre-development services. To stay competitive, Nwafor applied a flat discount to Gordon Group's prices for engineering services at the beginning of both 2019 and 2020. Specifically, Gordon Group lowered its prices by 11 percent in 2019 and 6.5 percent in 2020. These price adjustments were internal, and Gordon Group's customers were unaware that they were being charged a lower rate.

Nwafor was also interested in building on certain theoretical concepts to gain nonconventional engineering work involving aircrafts, defense structures, and various other complex designs. To that end, Nwafor spent time developing a mathematical model (called Finite Element Analysis or FEA) and a related computer program that would determine how an object will behave under any application of force. He said he spent 1,302.49 hours on this work and that his hourly rate was $285, for a total value of $371,210. Gordon Group did not pay him for his work in this regard or recognize this amount as a company liability.

On his 2019 and 2020 tax returns, Nwafor reported gross income of approximately $189,000 and $230,000, respectively. A large part of his gross income stemmed from the net profits of Gordon Group. On his Schedule C, Profit or Loss From Business, Nwafor reported gross sales of approximately $496,000 for 2019 and $608,000 for 2020. He then reduced gross sales by returns and allowances to calculate Gordon Group's gross income. The returns and allowances were approximately $55,000 for 2019 and $39,000 for 2020 and represented the 2019 and 2020 internal price adjustments and discounts for engineering services of 11 percent and 6.5 percent, respectively.

In calculating Gordon Group's net profits on his tax returns, Nwafor took into account (1) the value of the time he spent in developing a mathematical modeling program to be used in his engineering work; (2) payments for contract labor; (3) expenditures to buy office equipment, Samsung phones, and a 2012 Toyota Camry; and (4) adjustments and discounts given to customers.

The IRS issued a notice of deficiency disallowing (1) the amounts reported for depreciation, (2) contract labor amounts deducted in 2019 but paid for in 2020 and deducted in 2020 but paid for in 2021, and (3) reductions in income for returns and allowances, leading to tax deficiencies of approximately $64,000 for 2019 and $71,000 for 2020 along with Code Sec. 6662(a) accuracy-related penalties of approximately $12,800 and $14,200 for each tax year, respectively.

Nwafor took his case to the Tax Court, where he explained that Gordon Group's depreciation expenses related to time he spent developing the computer modeling program and, for 2019, also related to the purchase of a Toyota Camry and office chairs. He claimed that Gordon Group discounted its rates for engineering services to stay competitive in the market and was thus entitled to reduce its gross sales to account for sale allowances of 11 percent and 6.5 percent for 2019 and 2020, respectively. He also asserted that Gordon Group was entitled to reduce its gross sales by customer-specific refunds provided when a customer was dissatisfied. For 2020, he said, the depreciation expenses related to the computer modeling program and the purchase of the Samsung phones and certain items from Ikea.

Analysis

The Tax Court upheld the tax deficiencies and penalty assessments against Nwafor. In denying Nwafor's deductions for the value he put on his own time in developing the mathematical modeling software, the court cited its decision in Rink v. Comm'r, 51 T.C. 746 (1969), in which it held that labor performed by a taxpayer does not constitute an amount paid or incurred by him and thus is not deductible by the taxpayer. The court likened this result to the fact that imputed income arising from the benefit of a taxpayer's own services does not result in taxable income to the taxpayer.

The court also concluded that Nwafor was not entitled to reduce Gordon Group's gross sales by either the general discounts or the customer-specific allowances because the discounts were already incorporated in the lower sale prices charged just as if Gordon Group had charged the higher rate and then applied discounts for each customer.

With respect to the deductions taken for the Samsung phones, the court found that Nwafor failed to establish a business purpose for those deductions and failed to explain how he used the cellphones as part of his business or who used them, particularly since he had no employees during the years at issue. Likewise, the court also concluded that Nwafor failed to substantiate the business purpose of the 2012 Toyota Camry and thus was not entitled to deduct that expense either.

With respect to Nwafor's contract labor deductions, the court agreed with the IRS that, as a cash basis taxpayer, Nwafor could not deduct in 2019 an expense that he paid in 2020, nor could he deduct in 2020 expenses paid in 2021.

Finally, the court concluded that Nwafor was liable for the negligence penalties because he failed to substantiate the deductions claimed on his 2019 and 2020 tax returns. The court noted that Nwafor did not contest this point, nor did he suggest that he satisfied the reasonable cause exception to the penalty.

For a discussion of the general rules for deducting trade or business expenses, see Parker Tax ¶90,101. For a discussion of the reasonable cause exception to the negligence penalty, see ¶262,127.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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