Taxpayer Pays Contractors in Cash, Does Not Issue 1099 Forms, Can This Expense Be Deducted?

ANSWER: YES, According to US Tax Court

How often have you heard it said…If a taxpayer pays someone in cash and does not issue a 1099 form, the taxpayer cannot claim an expense deduction.  Let’s take a look at a Tax Court case, Victoria L. Duket v. Comm. of Revenue, T.C. Summary 2017-84, 11/9/17,  which says otherwise, and why.

William Delaney, EA
Westwood MA

Victoria L. Duket operated a cleaning and maintenance business and reported her income and expense on Schedule C.  For tax year 2011, she claimed $59,544 in contract labor expense; for tax year 2012 the amount claimed was $3,260; she also claimed wages of $29,260.  For both years, the IRS allowed -0- deductions.

“Petitioner (Ms. Duket) hired contract laborers (piece workers) for the housekeeping jobs.  Petitioner and Mr. Huber (her significant other) worked alongside these workers.  Petitioner paid the workers in cash every two weeks.”  “Petitioner kept a contemporaneous record of her housekeeping work and payroll using calendars, which served as her bookkeeping system.”

So far, so good.  It’s not a Quickbooks system, but it is a systematic contemporaneous record.  She has documented what she did.  At the end of the year, “She issued Forms 1099-MISC…to Mr. Huber and one other individual…, but not to any of the piece workers.”

The Tax Code requires that tax deductions be documented; the burden of proof is on the taxpayer.  The case goes into considerable detail when explaining how to apply these tests and the authority for so doing.  Well worth a read (see Discussion of Burden of Proof on page 5 and subsequent).

The Court found (page 7) that the “Petitioner’s testimony at trial was honest, forthright, and credible.  We therefore rely on her testimony to resolve this substantiation issue.”  “Petitioner testified that her business used only contract labor.  She provided detailed information regarding the number of people she hired, along with estimates of time worked and amounts paid to these individuals.  She also offered into evidence Forms 1099-MISC corroborating payments to Mr. Huber and Mr. Ramariz.  On the basis of this testimony, we conclude that petitioner was entitled to deduct the full amounts of the labor costs she reported on her return for each year in issue.”

What particularly interested your Editor is that the IRS completely ignored the 1099-MISC forms which corroborated (see the Court’s language, above) most of the payment amounts deducted, and disallowed everything.  And, in an 180 degree turn-around, the Court ignored the fact that the payments were in cash and allowed full deductions for both years because the taxpayer maintained contemporaneous and credible bookkeeping records and provided them to the Court.  It, apparently, did not matter that the payments were in cash and some were not documented by issuing a 1099 form.

There are other deduction and documentation issues addressed in the case, but this one jumped out at me.