You paid your subcontractors, but did not send them a Form 1099 for the payments. You get audited, the IRS requests verification of the labor expense, and you provide the auditor with copies of your checks verifying the payment. No problem, right?
But the IRS auditor says you cannot deduct an expense if you did not send out Form 1099. Your subcontractor labor can be a pretty significant amount, maybe your largest expense. The tax you would owe if your subcontractor labor expense is disallowed would be staggering.
But you paid the expense, and can prove it. Huh? Is that possible, it seems so unfair.
It is not possible, and its wrong.
The IRS auditor is confusing two separate rules. Here are the rules, what they mean, and how to navigate the audit to get your expenses allowed:
- Rule 1: Proving that the expense was a necessary part of your business, and that you paid it.
Section 162 of the Internal Revenue Code allows a deduction for ordinary and necessary business expenses that are paid or incurred during a year. In the case of subcontractor labor, you would need to show the IRS auditor that the work the contractor performed was done in the ordinary course of your business and was necessary to it, and then prove that you paid the contractor. A check to the contractor proves the payment (it is best if the check has a notation in the memo portion, notated along the lines of “labor for Smith job,” but that’s not absolutely necessary, just good practice for the future.)
And it’s even okay if you paid in cash, not by check.
These are evidentiary problems, but they are solved by application of the case of Cohan v. Commissioner, 39 F.2d 540 (2nd Cir. 1930).
Cohan – which is followed both by the IRS and the U.S. Tax Court – allows you to recreate evidence to prove an expense. In other words, you can have direct evidence of the expense (your check with the notation in the memo portion proving the expense), or indirect evidence (recreating how many contractors the job entailed, how many hours they worked, and what their hourly wage was). Direct evidence is better, but indirect evidence is allowable and permissable.
IRS auditors do not like indirect evidence. They struggle with it. But you are entitled to it by law.
So proving the expense was paid (as required by Section 162 of the Internal Revenue Code) can be by check, or not.
Nothing in Section 162 or Cohan requires a Form 1099 to be issued for a subcontractor labor expense to be deducted. You just need to prove you paid the expense in the operation of your business. Proof can be direct (a check) or indirect (recreating what you did and who you paid).
- Rule 2: Sending a Form 1099 to the IRS so they can cross-check that your contractor reported the payment on his tax return.
That’s right – Rule 1 is about your ability to prove your expense; Rule 2 is about the IRS tax enforcement to your contractors. They are both important, but they are two different things. Remember, proving an expense under tax code Section 162 does not require the sending of a Form 1099.
Section 6041 of the Internal Revenue Code requires a business that pays more than $600 to a subconcrator to send the IRS a Form 1099-MISC reporting the amount paid.
The IRS – justifiably so – wants to know how much your subcontractor was paid, and whether your subcontractor reported the income on his tax return. The IRS takes the Form 1099 you send them, and makes a computer match to your contractor’s tax return. If it appears the income was not reported, or if a tax return was not filed, the IRS could write to your subcontractor to collect the taxes not paid on the income.
This is an essential tool to enforce compliance with our tax laws.
But it is not in any way tied to your entitlement to write-off the expense on your tax return.
Not following Rule 2 has its own result: Under Section 6721 of the Internal Revenue Code, the IRS can charge you $100 for every person for whom you did not send a Form 1099.
Rule 2 is pretty important, so IRS auditors like to wrap it into Rule 1. That’s wrong – you can comply with Rule 1 and be entitled to the deduction; not complying with Rule 2 is a $100 penalty per Form 1099.
- Solution: What to do if your IRS auditor will not budge.
You have rights if you disagree with an IRS auditor. And an IRS auditor not allowing a business expense that can be verified because a 1099 was not issued is a definite source of disagreement.
Most every IRS decision comes with a legal right to appeal. That includes decisions of IRS auditors.
Your rights include requesting an administrative hearing with an IRS appeals officer, who is separate from audit and will take a fresh and impartial view of your case. Most IRS appeals officers understand the difference between proving an expense (Rule 1) and not issuing Form 1099 (Rule 2) and that they are not interrelated.
You also have the right to file a petition to U.S. Tax Court and have an independent judge – who is not affiliated with the IRS in any way – review your case. We can testify to the judge, tell her your story, and present your evidence.
The IRS would have to prove that you did not pay your subcontractors. Without more, not issuing the 1099 is not a defense for the IRS. It is the auditor’s opinion, an opinion which is subject to appeal, trial and being overturned.
Look at it this way: If you issued a Form 1099 to your subcontractors but have no records to prove you paid the expenses, the IRS would not allow you the expense. The Form 1099 does not make the expense deductible, and does not make it nondeductible. And remember, verification can be direct evidence (your checks) or indirect under the Cohan rule (recreating the expense from reliable information).