Question: Is the expense for off-shore labor deductible even though no 1099 is issued? During an audit, the IRS told me that the expense wasn’t deductible because the contractor was not an employee and neither was a 1099 issued.
In general, a 1099 is not required for a valid business expense to be deductible. Keeping accurate records of the payment and the purpose for the payment is required. However there is a penalty for the failure to issue a 1099 when one is required.
Assuming that the off-shore contractor is only a contractor and not a partner or business owner or has some other relationship to the hiring business, the payment to the off-shore contractor would likely be a deductible expense for contract labor. The expense would be listed on Schedule C.
If the labor is performed entirely outside of the US and the person is a foreign individual, a 1099 would not be necessary as the income is “foreign sourced income” and the contractor is not subject to US tax.
However, there are other issues to consider in dealing with foreign persons. For example there may be liability for withholding such as if the off-shore contractor has a presence in the US. In such a case the payment to the developer would be what is known as “effectively connected income” and there may be a requirement to withhold 30% of payments to the developer.
International tax is a complex area and numerous rules and exceptions may apply. In the case of international taxation and audits, representation that is familiar with international taxation is strongly recommended. Note that not all IRS examiners are intimately familiar with the international tax provisions. This is where competent representation could be very helpful.