In general, no Form 1099 is required for payments to foreign contractors for services performed outside the U.S. Sometimes taxpayers get concerned about how to substantiate the deduction if no Form 1099 needs to be issued to the foreign contractor.
The simple answer is that you substantiate the deduction the same way you substantiate all other deductions --- by maintaining books and records evidencing how much was paid, why it was paid, and to whom it was paid. Filing a Form 1099 is not required to substantiate a deduction. Treas. Reg. §1.6001-1(a) provides generally that taxpayers must keep:
books of account or records * * * as are sufficient to establish the amount of * * * deductions * * * shown by such person in any [tax] return * * * .
Pursuant to this regulation, taxpayers must keep books or records that substantiate expenses they deduct on their tax return. One way to substantiate deductions to a foreign contractor might be to produce the monthly invoices sent from the foreign contractor to the U.S. company at the end of each month. Copies of the monthly invoices along with copies of monthly credit card or bank records showing payments in the corresponding amounts to the foreign contractor would likely be sufficient to substantiate the deduction (unless there is some other evidence suggesting that the payments were not for the services described on the invoices).
This is merely an example of one way to substantiate a deduction. There are many ways to substantiate deductions, depending on the circumstances surrounding the payment.
The following is an excerpt from Holden v. Commr., T.C. Memo. 2015-131. This case dealt with a situation where the IRS was attempting to disallow certain deductions claimed by an S corporation. The IRS argued that the deductions were not adequately substantiated, the IRS lost. Jane Garcia was the bookkeeper for the S corporation, and she testified at the trial.
During 2007 Dr. Holden operated his medical practice entirely through his wholly owned S corporation, CHMD. * * * At the beginning of 2007 CHMD employed about 25 people, some of whom were independent contractors. * * * Jane Garcia provided management services to CHMD as an independent contractor * * * . Ms. Garcia's duties consisted of paying bills, managing the two offices and their staffs, and maintaining CHMD's books using Quickbooks software. * * *
CHMD relied on a payroll processing company, Automatic Data Processing (ADP), to prepare its payroll checks. * * * Ms. Garcia kept CHMD's books. * * *
Deductions are a matter of legislative grace, and taxpayers bear the burden of proving their entitlement to any claimed deduction. A taxpayer must identify each deduction available, show that he or she has met all requirements therefor, and keep books or records that substantiate the expenses underlying the deduction. If a taxpayer's records are lost or destroyed because of circumstances beyond his control, the taxpayer may instead substantiate the expenses with other credible evidence.
[I]f a taxpayer claims a deduction but cannot fully substantiate the expense underlying the deduction, the Court may generally approximate the allowable amount, bearing heavily against the taxpayer whose inexactitude is of his own making. [However, t]he Court must have some basis upon which to make its estimate * * * .
Section 162(a) permits a taxpayer to deduct all of the ordinary and necessary expenses paid or incurred during the taxable year in carrying on the taxpayer's trade or business. * * *
[The taxpayer] produced copies of canceled checks, all cashed during 2007, establishing total payments of $74,994, 12 consisting of $28,000 paid to Dr. Mann, $4,000 paid to Dr. Andujar, $8,755 paid to Ms. Do, and $34,239 paid to Ms. Niangnouansy (salary checks). Ms. Garcia identified Drs. Mann and Andujar as physicians who saw patients at CHMD's Anaheim office, Ms. Do as a nurse practitioner who worked at the Anaheim office, and Ms. Niangnouansy as an office manager at the Anaheim office. She further recognized the salary checks as payroll checks prepared by ADP. Ms. Garcia explained that the salary checks represented payment for services as employees or independent contractors. * * *
[The IRS] contends that the foregoing evidence does not adequately substantiate any portion of the disputed salaries because: (1) [the taxpayer] provided no written evidence of the services provided, none of the named individuals testified, and Ms. Garcia did not provide enough detail in her testimony concerning the specific services rendered by these five individuals; (2) CHMD did not issue Forms W-2 or Forms 1099-MISC to any of the named individuals; and (3) although Ms. Garcia testified that Drs. Mann and Andujar had their own professional corporations, the salary checks were made payable to and endorsed by them personally.
* * * Ms. Garcia credibly testified to the roles Drs. Mann and Andujar, Ms. Do, Ms. Niangnouansy, and Ms. Rivera played in CHMD's practice. She noted, for example, that Dr. Mann “provided family medicine services to our patients in the Anaheim office.” [The IRS] demands greater detail about these “services”, but for most anyone who has ever visited a doctor's office, medical services are privileged and private. Moreover, family medicine is hardly a mysterious and esoteric subspecialty demanding further elucidation. [The IRS] points to no authority, and we know of none, that requires the service provider's own testimony or particular forms of written documentation for substantiation of compensation expenses. Ms. Garcia's specific, uncontroverted testimony and the canceled checks clearly suffice. If [the IRS] desired the doctors’ testimony, he was free to subpoena either or both of them * * * .
That CHMD failed to issue Forms W-2 or 1099-MISC to these five individuals does not mean that it did not pay them for services. * * * [W]e need not speculate about why tax forms were apparently not issued because issuance of such forms is not a prerequisite to the deduction of salaries and wages. [Citations omitted and emphasis added.]
In summary, taxpayers must keep books or records that substantiate expenses being claimed. The more detail that is contained in the books and records, the more likely it is that the expenses will be considered substantiated. However, issuing a W-2 or Form 1099 is not a requirement to claim a deduction.