Can time invested be considered capital?

Question

If a business owner works for no salary, but puts time and effort into the business, can those hours be considered a capital investment? If so, is there a term for that kind of work?

Example 1:

A machinist builds a machine. The parts, materials and electricity cost for building the machine is $5,000. The machinist spends 800 hours building the machine and the business processes to lease the machine for which he is unpaid by anyone. In other words he invests his own time.

The machinist then sells the business that owns the machine for $100,000. If the machinist values his time at $200 an hour, then the 800 hours he spent is $16,000. If the machinist cannot include his hours, then his capital gain would be 100-5 = $95,000, but if he can include his hours as an investment, then his capital gain is 100 - 5 - 16 = $79,000. Which is correct?

Example 2:

A software engineer writes a computer program. It takes him 600 hours to write the computer program and those hours are well documented. He sells the source code and copyright to the program to a big company for $150,000. Is the capital gain $150,000 or can he deduct the value of the hours he spent writing the program?

Answer 1

This kind of investment is called "sweat equity". It is sometimes taken into account by lenders and other investors. Such investors look at the alleged value of the input labor with a very skeptical eye, but they often appreciate that the entrepreneur has "skin in the game".

The sort of analysis described by the original poster is useful for estimating "economic profit" -- how much better off was the entrepreneur than if he had done something else with his time. But this sort of analysis is not applicable for tax purposes for most small businesses in the United States.

It is usually not in the entrepreneur's interest to use this method of accounting for tax purposes, for three reasons:

1. It requires setting up the business in such a way that it can pay him wages or salaries for his time. The business might not have enough cash resources to do so. Furthermore, setting up the business in this way requires legal and accounting expertise, which is expensive.

2. If the entrepreneur does set up the business like this, the wages and salaries will be subject to tax. Wage and salary tax rates are often much higher than capital gains tax rates, especially when one considers taxes like Social Security taxes, Medicare taxes, and Business & Occupation taxes.

3. If the entrepreneur does set up the business like this, the taxes on the wages and salaries would be due long before the hoped-for sale of the company. The sale of the company might never happen. This results in a time-value-of-money penalty, an optionality penalty, and a risk penalty.

Answer 2

If a business owner works for no salary, put time and effort into the business, can those hours be considered a capital investment?

No.

Answer 3

There is no tax code I know that would grant you such a privilege. And it just isn't practicable.

In your examples, you always sold your product and were thus able, in retrospect, to give a value to your work.

What if you don't sell your product? What if in one case your worked hour is reimbursed with one price, with the next product at another (i.e. difference in margin)?

No, it won't work like that.

And by the way, I think you might have got some definitions upside down.

• If you rely on making money from your own work, by definition we speak about income, not capital gain.
• If, on the other hand, you own a company that hires and pays workers for a job, their profitability will increase your capital.

What you want is a salary that your own company pays out to yourself and you can deduct from other profits. But as long as you can't afford to pay yourself a salary, and you don't have access to investors who are willing to front you the money, the time invested is your personal investment and cannot be deducted anywhere - though it might pay off nicely in the long run. That's the risk entrepreneurs take.