September 9, 2014
By Dan Gibson, CPA
Here is the scenario: You paid your subcontractors, but did not send them a Form 1099 for the payments. You’re being audited; the IRS requests verification and provides 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.
But you paid the expense, and can prove it.
Huh? Is this possible? It seems so unfair.
It is not possible, and it’s wrong. The IRS auditor is confusing two separate rules. Here are the steps to overcome the issue:
Rule 1: Prove 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 subcontractors, you would need to prove to the IRS auditor that the work performed was done in the ordinary course of your business and was necessary to it, 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).
Rule 2: Send a Form 1099 to the IRS so they can check that your contractor reported the payment on his tax return.
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 subcontractor providing services to send the IRS a Form 1099-MISC reporting the amount paid.
The IRS 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 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 for you: Under Section 6721 of the Internal Revenue Code, the IRS can charge you with a monetary penalty for every person for whom you did not send a Form 1099. This is pretty important for the IRS, so IRS auditors like to wrap it into Rule 1. That’s incorrect – you can comply with the deduction requirements and be entitled to the deduction.
What to do if your IRS auditor will not budge
You have rights if you disagree with an IRS auditor. An IRS auditor not allowing a business expense that can be verified for which a 1099 was not issued is a definite source of disagreement. Initially, ask to speak to the auditor’s supervisor if you can’t resolve this with him or her.
If you aren’t satisfied, you have 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).
Hopefully, it won’t come to this, but 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. You can testify to the judge, tell her your story, and present your evidence. The IRS would need proof that you did not pay your subcontractors. Without this, 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.