How to document cash payments to contractors?

[David Jiang]

What would be sufficient proof that a cash payment I make to a contractor is an expense for a project? I always have trouble with this as I do a lot of flips and have a few people who moonlight for me on their weekends and prefer a cash payment. Is the cash withdrawal showing up in my bank account enough proof or do I need some kind of receipt or invoice from the person I'm paying?

[Linda Weygant]

Cash withdrawal from the bank is definitely insufficient.  The IRS has no way of knowing that you paid a contractor vs went to the strip club and stuffed in all in somebody's thong.

I always have mixed thoughts on these types of questions, so I will answer this in two ways.

CPA Advice

Stop doing this.  Stop helping others dodge their taxes.  The people you are hiring are probably also neither licensed nor insured and that's a heckuva lot of liability you are taking on.  You can ask them for a receipt and that satisfies the IRS, but if you pay these people more than $600 in a year, you are still supposed to issue them a 1099 at the end of the year.  

So declaring all this subcontractor expense on your return without also having a bunch of 1099s logged on your account with the IRS is a pretty big red flag.  The penalties for not issuing 1099s are going up every year.  For 2016, the penalty for "Intentional Disregard" (note - this means you) is $530 per form that you should have issued and did not.  With this kind of potential debt (the IRS can go back multiple years and issue this penalty) hanging over your head, ask yourself what you've actually saved.  By hiring these guys, you've saved cash up front, but if you end up with these penalties, my guess is that you'd have been better off hiring somebody licensed and insured and to who you could also give a 1099 at the end of the year.

Investor Advice

I understand your need to cut costs on your flips and maximize profits.  I also applaud your willingness to hire people who perhaps could not otherwise get regular jobs.  Maybe you're hiring undocumented labor, perhaps felons, perhaps others and I have no issues with this and even support the vast majority of it.

Investing is about risk and understanding all of your liabilities and potential liabilities.  I just ask you to understand all the ramifications and pitfalls of what you are doing so that when the day comes that you do find yourself in hot water, that you understand that all of the blame and issues fall squarely on your own shoulders and nowhere else.