Tom Talks Taxes - July 30, 2021
Debunking the "no 1099, no deduction" myth
You Can Deduct Payments with No Form 1099
If a taxpayer makes a payment to a worker in the course of his or her trade or business, the taxpayer can deduct the payment provided it is an ordinary and necessary business expense under §162.
Case law defines “ordinary” as one that is customary or usual within the particular trade industry or community and “necessary” as one that is appropriate and helpful, rather than essential to the taxpayer’s business. See Welch v. Helvering, 290 U.S. 111 (1933).
Even if a taxpayer incurs an ordinary and necessary expense in a business, a tax law provision may still make that expense nondeductible. For example, the Tax Cuts and Jobs Act made most entertainment expenditures nondeductible under §274.
Now for the Form 1099-NEC, Nonemployee Compensation, issue: if a taxpayer pays a contractor more than $600 in his or her trade or business during the calendar year, then the business must issue Form 1099-NEC (or Form 1099-MISC, Miscellaneous Income, for tax years prior to 2020) to report the nonemployee compensation to the IRS unless an exception applies.
If the taxpayer fails to file the Form 1099-NEC, the penalty is not the disallowance of the deduction. There is no provision in the tax law, or any case law, stating that the absence of Form 1099-NEC reporting means the contractor expense is nondeductible. Instead, there is a financial penalty per Form 1099-NEC not filed ranging from $50 per return up to $550 per return depending on how late the Form 1099-NEC is and whether the taxpayer intentionally disregarded the filing requirement.
If the IRS examines the deduction, then the taxpayer will ultimately need to provide substantiation for the deduction amount and purpose. Issuance of the Form 1099-NEC helps to substantiate the deduction; however, failure to do so “casts… doubt as to the compensation payments.” See Edwards v. Comm., T.C. Summary Opinion 2007-182.
In Tax Court, the taxpayer has to prove the expense by a preponderance of the evidence - which means more likely than not, not beyond a reasonable doubt!
In Nurumbi v. Comm., T.C. Memo 2021-79, the taxpayer received significant revenue from his Uber account; however, he subcontracted out much of the driving to others and paid them for services provided. The taxpayer, who did not issue Forms 1099-MISC, made payments in both cash and electronic bank account transfers to the subcontractors.
Relating to the subcontractor payments, Judge Pugh ruled the following:
Finally, we do not allow a deduction or offset against gross receipts in an amount greater than respondent already conceded for the payments petitioner made to his drivers from the amounts he was paid by Uber. Respondent conceded that petitioner is entitled to a $157,803 Schedule C deduction for payments to drivers made through the BBVA account (computed by comparing weekly payments from Uber to corresponding transfers out of the BBVA account). While petitioner testified credibly that he also paid his drivers in cash out of those proceeds, he gave us no basis on which to estimate how much he paid, and we are unable to hazard a guess as to what additional amounts might be properly deducted or excluded from his gross receipts. Without such a basis, any additional allowance would amount to unguided largesse.
It is important to note that the IRS conceded deductions for payments made through the bank account for which there were no Forms 1099-MISC issued. While the opinion does not provide a rationale for the IRS concession, it is likely the bank statements provided sufficient documentation of the payments made by electronic transfer.
Also of note is that the Court declined to use the Cohan rule to allow the taxpayer a limited deduction for the cash payments even though Judge Pugh said the taxpayer credibly testified that he actually made cash payments.
Here are three takeaways to ensure this is not an issue for one of your clients:
Have the taxpayer collect a Form W-9, Request for Taxpayer Identification Number and Certification, before authorizing any payments to a contractor.
Encourage taxpayers to pay contractors by credit card or a third-party payment network such as PayPal because a taxpayer does not report those payments on Form 1099-NEC pursuant to Treas. Reg. §1.6041-1(a)(1)(iv).
Explain to the taxpayer that he or she should keep accurate, contemporaneous records or logs for all payments to contractors, especially cash payments. It would be prudent for the contractor to provide signature verification of all cash payments as part of this process.