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.

Answer:

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.

Question: Are self-employment taxes due from the managing members of an LLC when the only income to the LLC is earnings from angel investing activities.

Answer:

By default an LLC is a disregarded entity unless an election is made to be treated as a corporation. When an entity is disregarded, income and losses flow through to the members and maintain their characteristics.

The characterization of gains and the issue of self-employment taxes owed by the managing members is complex question and is very fact dependent. However, in general, there are three broad characterizations of activity, each with its own implications for gains and self-employment tax.

The first categorization is that of “securities dealer”. A securities dealer is one who is engaged in the trade or business of selling securities. A securities dealer will hold an inventory of securities for sale to customers in the regular course of business. Securities held by such a dealer are not considered capital assets and therefore the gain or loss realized is ordinary gain or loss and would be subject to self-employment tax.

A second categorization is “securities trader”. A securities trader is one whose activities rise to the level of a trade or business, but they do not hold an inventory of securities for sale to customers. A securities trader derives income based on the changes in price of the held securities. Since the securities are not held for sale to customers in the ordinary course of business, the securities trader can realize capital gains and losses from the sale of the securities. IRC 1402(a)(3)(A) specifically excludes capital gains from income subject to self-employment tax.

Third is an “investor”. An investor is not engaged in a trade or business. Hence gains or losses on securities transactions are typically capital and not subject to self-employment tax.

It is likely that an LLC engaging in angel investing will be considered as a securities trader, the gains realized from the investment activities will be considered capital gains and will be exempt from self-employment taxes.