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Please Help:Tax Question About Hiring Freelancer From India.

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Latest post Sun, Feb 26 2017 3:47 PM by Taxagent. 27 replies.
  • Tue, Mar 19 2013 4:19 PM In reply to

    • jons123
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    Re: Please Help:Tax Question About Hiring Freelancer From India.

    Taxagent, 

    This is probably the most helpful answer I saw in all of the internet about this topic :), so I will dare to ask a follow up question in the hopes that you will respond (even though this is an old thread).

    I am in a similar position as the OP.

    The difference is that I run an LLC (little to no revenues so far). I am the only owner of the LLC. But I will use the "pass through" method and will try to claim the expenses on my own tax return which I will be filing jointly with my wife. 

    Here is the situation. I paid approximately $20K to an Indian tech developer. This money will be used to set up a state of the art website, and an ecommerce cart to buy and sell stuff on my website. The entirety of the work will be done in India. The website will be designed and developed in India. I don't control when the developer works, just that the work be delivered by x date. The work hasn't really taken off yet, but it will be performed this year. The money, however, was paid out December 2012. I would like to use this money as an "expense" on my tax return. 

    From what I read above, it appears that this independent contractor IT guy must fill out a W-8BEN. Does he then send it to me, or the IRS directly? Becuase if I am e-filing my taxes through TurboTax, I am not sure how I would be able to submit a filled out form which he may send. 

    Second, now that I understand I did not have to withhold taxes, that is a great thing. But did I have any other reporting requirements to the IRS back in December when the payment happened?

    Third, do I still have to fill out a 1099-MISC to submit with this year's tax returns?

    Thank you, 

    Jon.

  • Tue, Mar 19 2013 6:35 PM In reply to

    Re: Please Help:Tax Question About Hiring Freelancer From India.

    jons123:
    From what I read above, it appears that this independent contractor IT guy must fill out a W-8BEN. Does he then send it to me, or the IRS directly?

    He sends it to you. You do not include it with your tax return. You keep it safe with your other important records so that you can show the IRS the form should you get audited or face some other inquiry from the IRS about withholding on the payments made to that contractor.

    jons123:
    Second, now that I understand I did not have to withhold taxes, that is a great thing. But did I have any other reporting requirements to the IRS back in December when the payment happened?

    No.

    jons123:
    Third, do I still have to fill out a 1099-MISC to submit with this year's tax returns?

    I assume you mean completing a Form 1099-MISC for the amount paid to the Indian contractor. The answer to that is no. Payments made to nonresident alien contractors are not required to be reported to the IRS unless it is U.S. source income. If you were to pay U.S. source income to that foreign person, you'd file a Form 1042-S.

    Note that when the Form 1099-MISC is required, the form is NOT filed with your income tax return. Instead, you prepare and file all the Forms1099-MISC together with the cover Form 1096 and file that package with the IRS no later than February 28 of the following year, i.e. 2/28/2013 for the 2012 Forms 1099.. If you file late, you a subject to a penalty for each Form 1099 that is late filed.

    jons123:
    Here is the situation. I paid approximately $20K to an Indian tech developer. This money will be used to set up a state of the art website, and an ecommerce cart to buy and sell stuff on my website. The entirety of the work will be done in India. The website will be designed and developed in India. I don't control when the developer works, just that the work be delivered by x date. The work hasn't really taken off yet, but it will be performed this year. The money, however, was paid out December 2012. I would like to use this money as an "expense" on my tax return. 

    You cannot deduct the $20,000 you paid on your 2012 tax return. This is not a deductible expense. It is a capital expense, since it is purchasing something (in this case a web site computer program) that is expected to last at least a year. What that means is that you must depreciate this cost over its useful life starting from the date the web site is placed in service (i.e. is up and running and being used to sell stuff). As you did not place it in service in 2012, there is no depreciation deduction for you for 2012. Note that section 179, which allows you to take as a deduction the cost of certain capital items in the year you placed them into service rather than depreciating or amortizing them over a period of years would not apply here. 

    Moreover, other expenses that you have that would ordinarily be deductible are not deductible if they occur in the start-up period of the business, i.e. the period before the day that active trade or business occurs, that is, the day that you are up and running and open to the public for business. Those start-up expenses must generally be amortized over 15 years, starting from when the business begins its regular operations, i.e. is open for business to customers. However, there is a limited exception that allows you to deduct up to $5,000 of start-up expenses in the year that that you begin your active trade or business. As it appears that you did not start active trade or business in 2012, you may not deduct any of these expenses for 2012. 

    What all this means is that you'll pretty much not have anything to deduct on your 2012 return for this enterprise. You'll start to do that the year that the active trade or business begins. 

    See IRS publication 535 on business expenses and publication 946 on depreciation for more details.

  • Wed, Mar 20 2013 1:02 AM In reply to

    • jons123
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    Re: Please Help:Tax Question About Hiring Freelancer From India.

    Wow, thank you so much for that terrific response. I am fully with you on all responses except the last one which confuses me a lot. 

    I paid 20K for someone to develop a website. The 20K was for their programming ability and not for the end product itself (sort of). After the programmer renders their "service" worth 20K, then a product becomes available which is then an asset. I am just not able to understand how the 20K would be treated as a capital expenditure. I mean, using that logic, I could hire 30 programmers and pay them a million dollars a year to create, support and run the software and none of that would be a tax deductible expense? Somehow I am not able to come to terms with that. Do you have follow up comments?

    Would things have changed if I paid a marketing fellow in India 20K to market my US consulting services and bring me clients? Is that a "pure" service which doesn't get tainted as a capital expenditure? I am just trying to understand the difference between those two here. 

  • Wed, Mar 20 2013 5:05 AM In reply to

    Re: Please Help:Tax Question About Hiring Freelancer From India.

    jons123:
    I paid 20K for someone to develop a website. The 20K was for their programming ability and not for the end product itself (sort of). After the programmer renders their "service" worth 20K, then a product becomes available which is then an asset.

    The basic test for whether the cost is capitalized is whether it is an expense that goes into creating an asset that will have a useful life of greater than one year. The asset with a useful life of more than one year is thus a capital asset, and you do not deduct the costs you incurred to create or buy the capital asset. At best, you may depreciate it or amortize it over a period of years.

    You are creating a web site to sell your goods. The program used for that web site is an asset that will have a useful life of more than one year. That makes making the web site program a capital asset. Because it is a capital asset, all the costs you pay that go into creating it it must be depreciated over the useful life of the program starting in the year that the program is placed in service in an active trade or business. The $20,000 you paid the programmer is a cost you incurred to create the asset. Thus, you'd include that cost as part of your basis in the program and you recover that with depreciation deductions over a period of years starting the year you place it in service.

    Even if it were not a capital item and was a cost you could ordinarily deduct in the year paid, you could not do that here when the cost was incurred in the start-up phase of the business. You'd have to instead amortize that over 15 years starting the year that the you start the active trade or business (i.e. put the site online and start selling to customers) with the possible exception of up to $5,000 of start expenses that you may elect to deduct in the year that you start the active trade or business. There are restrictions to when you can take that election. But start-up expenses exclude those costs that are part of a capital asset.

    jons123:
    Would things have changed if I paid a marketing fellow in India 20K to market my US consulting services and bring me clients? Is that a "pure" service which doesn't get tainted as a capital expenditure? I am just trying to understand the difference between those two here. 

    If the marketing involved is advertising type activities, that is pretty much always a deductible expense in the year you pay it IF it is paid after the business is up and running, i.e. not in the start-up period. Remember, during the start-up period you pretty much don't have anything to deduct for the business the way the rules work. A lot of advertising is for immediate benefit and doesn't develop any asset that will be used for more than one year.

    And, in the case of advertising, it is generally deductible even if it was part of a long term ad campaign that built goodwill or tradname assets that would have a very long useful life. While under the basic theory of capital assets and depreciation that long term ad campaign should be capitalized and depreciated (and the IRS has sometimes argued for that) it is nevertheless typically allowed. The reason for this is tradition: adverstising has since the beginning of income tax been a deductible expense. Congress and the courts are loathe to change that now.

    Marketing activities other than advertising, however, will face the same analysis as with the web site: if they contribute to creating an asset with a useful life of more than one year, they are capital expenses, not ordinary expenses, and you recover those through deprecation or amortization in most cases. 

    jons123:
    I mean, using that logic, I could hire 30 programmers and pay them a million dollars a year to create, support and run the software and none of that would be a tax deductible expense? Somehow I am not able to come to terms with that.

    The cost to create or improve it would again be costs that contributed to a capital asset and would be subject to depreciation. The fact that you pay millions to create it doesn't change the analysis any. Costs simply to maintain it, on the other hand, would be a deductible expense in the year paid for a cash basis taxpayer if the cost is incurred after the start-up period.

    It's like the costs that go into constructing an office building. Let's say you directly employed a lot of workers to do the labor needed to construct your office building for your business. Those costs are part of the cost of the building and will be recovered through depreciation, not as a wage expense that is deducted in the year you paid it. The cost of the building is not simply the building materials you purchased for constructing it. It is also the labor that went into it as well. I think that example is pretty easy to understand, and the web site expenses are analyzed the same way.

    If what you are thinking is that all costs of personal services are deducted in the year paid, that's obviously not correct based on the discussion above. If those personal service costs are part of creating an asset that will have a useful life of more than one year, then they are part of the cost of that asset and are depreciated or amortized over a period of years in most cases.

    This is one of many issues that trip up new small businesses when it comes to taxes, and is one reason why I strongly suggest anyone going into business consult CPA or tax attorney for advice on the tax issues that are involved in the business.

  • Wed, Mar 20 2013 3:31 PM In reply to

    • jons123
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    Re: Please Help:Tax Question About Hiring Freelancer From India.

    Taxagent, 

    Your response is so detailed, that I simply don't have enough words to thank you. Simply superb. Thank you.

    I think I "get it" now. I want to quickly illustrate via an example to confirm that I did indeed get it (I did some supplementary online research to fully illustrate). Can you please confirm that my understanding is correct. 

    Definitions:

    • Capital Asset - Any asset that has a useful life of more than 1 year.  All expenses that go toward building this capital asset are NOT deductible as an expense. (the exception is section 179 deduction which is not applicable here since software is an intangible property)
    • Expense - Any business expense that does NOT go into creating a capital asset. 

     

    Startup phase:

    This is the phase before the company starts offering its products or services. This can be anywhere from weeks to months to years. This is the "preparation" phase of the company where it prepares itself to offer its products or services to customers. 

    • In the startup phase, there is no deduction of expenses, period. 
      • There is one exception, and that is to deduct up to $5K of expenses (non capital items) in the year that your company opens the business for customers.  NOT the year when your company starts, but the year in which the company starts its operations and begins selling products/services. 
    • For capital assets, you amortize the asset's cost in terms of its useful life. This includes the cost of materials (for physical assets, it could be building material; for software assets, it could be programming and code) AND the costs of labor (for physical assets, straight labor; for software assets, programmer time).  So if the website costs 20K to build and the useful life is 4 years, you amortize the 20K over 4 years and deduct that depreciation in the tax returns. You can only start amortizing a capital asset in the year it is placed in service in an active trade or business. 
    • For all other non-capital asset expenses and the non $5K election, the expense has to be amortized over 15 years.  E.g. An advertising campaign pre-launch costs $15K. The amortization happens over 15 years, and the company is able to take $1K in depreciation deductions every year for the next 15 years (using a straight line method). The first depreciation deduction can happen the year the expense was incurred, and does not have to wait until the company goes into the "running" phase.  

     


    Running phase:

    This is the phase where the company started operations and started offering its products or services to customers. Now, all capital assets can be amortized based on their useful life, and all other expenses can be deducted as you would probably expect them to be deducted. NOTE: Costs incurred to "maintain" a capital expense (not create or improve, but maintain) are deductible as an expense in the year the expense is incurred. 

    --

    In terms of the original question which started this off. 

     

    • If I hire an Indian programmer who lives and works in India, the money I pay him will be "foreign source" income for the programmer, so I don't have any reporting requirements to the IRS. However, if the programmer ends up coming here to the US and works here for some time, I may have to file a 1042-S.  Whether or not I file a 1042-S will depend on the citizenship of the programmer, the tax treaty (if any) that the US has with that country, and how long the programmer is here.  For example, according to IRS publication 515, the US-India tax treaty allows a programmer to stay here for up to 89 days without incurring a tax liability. In that case, I don't need to withhold any taxes for that programmer. 
      • If I hire a marketer instead of a programmer, and my company is in the "running" phase, I could deduct the monies paid as an expense in the year that it was paid. If the expense is a capital expense, I can capitalize it over the useful life. If the expense is incurred in the "startup" phase, the expense can be amortized over 15 years, and if it is a capital asset in the "startup" phase, amortize it over the useful life of the asset. 
    • But, even if the payment to the programmer is a "foreign source" income to him, I would still need to get him to fill out a W-8BEN form. I don't have to submit this, but simply keep it with me for records and verification. 
    • In case I hire someone here locally and trigger a 1099-MISC requirement, I will need to keep tabs on how much I pay them all year and if the totals exceed $600 a year, I need to send them a 1099-MISC statement by January 31 of the following year, and mail the 1099-MISC forms with the IRS by February 28th (or e-file by March 31). 

     

  • Thu, May 8 2014 7:39 AM In reply to

    • JT2014
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    Re: Please Help:Tax Question About Hiring Freelancer From In...

    I know this post is quite old, but I am in a similar situation and would need some initial guidance from a Lawyer.

    I would like to work as a freelancer from outside the US, as an individual and not a company, and when it come to withholding taxes by my employer, the IRS website states as follows (link)

    General Rule

    In general, a person that makes a payment of U.S. source income to a foreign person must withhold the proper amount of tax, report the payment on Form 1042-S and file a Form 1042 by March 15 of the year following the payment(s).

    But in this conversation I've read that taxes need not be withheld.

    Am I missing something, or are the rules revised in IRS, post these discussion here.

  • Thu, May 8 2014 3:43 PM In reply to

    Re: Please Help:Tax Question About Hiring Freelancer From In...

    JT2014:

    I would like to work as a freelancer from outside the US, as an individual and not a company, and when it come to withholding taxes by my employer, the IRS website states as follows....But in this conversation I've read that taxes need not be withheld.

    Am I missing something, or are the rules revised in IRS, post these discussion here.

    The IRS statement is accurate — U.S. persons that pay out U.S. source income to foreign persons generally must withhold tax from those payments and remit the withheld tax to the IRS. The key is the phrase "U.S. source income.” When it comes to compensation for personal services performed for an employer, the source of the income is determined by where the services are performed, not where the person paying for the services is located. Thus, for example, if an Indian citizen and resident performs personal services in India for a U.S. person, the income the Indian citizen receives for those services is foreign source income and the U.S. person need not withhold any tax. The IRS discusses this in more detail here: source of personal service income

  • Tue, Aug 11 2015 8:38 AM In reply to

    • sun21170
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    Re: Please Help:Tax Question About Hiring Freelancer From In...

    I have been reading your posts on hiring programmers in India and they are extremely informative/helpful.

    Most of the discussion you provided is for the hiring side. What about  the taxes or forms that the Indian programmer has to come up with in order to comply with IRS requirements? The programmer is hired through Elance and performs all work in India on his own computer and he is an Indian citizen.

  • Tue, Aug 11 2015 10:34 AM In reply to

    Re: Please Help:Tax Question About Hiring Freelancer From In...

    sun21170:
    Most of the discussion you provided is for the hiring side. What about  the taxes or forms that the Indian programmer has to come up with in order to comply with IRS requirements? The programmer is hired through Elance and performs all work in India on his own computer and he is an Indian citizen.

    As I noted in the previous response, a nonresident alien (a person who is not a U.S. citizen or resident) and who performs all of his/her work in India is not receiving any U.S. source. The nonresident alien therefore has no U.S. income tax obligations whatsoever. In short, there are no IRS requirements that the nonresident alien must meet. The U.S. employer will want to get a certification that the person is a nonresident alien, of course, but that is a requirement needed to ensure the employer is meeting its obligations, not something U.S. law imposes directly on the nonresident alien. 

  • Sun, Feb 26 2017 2:31 PM In reply to

    • watlandc
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    Re: Please Help:Tax Question About Hiring Freelancer From India.

    Taxagent, thank you for this information – very helpful.

    Assuming a similar fact pattern except I would like to *hire* someone from Malaysia as an employee for software development oppose to an independent contractor, would the outcome be the same  – meaning I would have no reporting requirements.

    Details:

    I'm a US based startup (LLC) located in the US.

    Employee would perform all work remotely (thus foreign source income).

    I'm currently working with the individual with him as an independent contractor (used W-8BEN).

    I'd like to solidify the relationship to show our interests are align for a long term relationship by having him become a full time employee (even if it's just semantics between contractor and employee).

    Would there basically be no reporting – just standard employment agreement with business terms and pay the agreed upon salary and it's a done deal?

  • Sun, Feb 26 2017 3:47 PM In reply to

    Re: Please Help:Tax Question About Hiring Freelancer From India.

    watlandc:

    Details:

    I'm a US based startup (LLC) located in the US.

    Employee would perform all work remotely (thus foreign source income).

    I'm currently working with the individual with him as an independent contractor (used W-8BEN).

    I'd like to solidify the relationship to show our interests are align for a long term relationship by having him become a full time employee (even if it's just semantics between contractor and employee).

    Would there basically be no reporting – just standard employment agreement with business terms and pay the agreed upon salary and it's a done deal?

    Assuming that the Malaysian employee is not a U.S. citizen or resident and that all work is performed in Malaysia then you would have no US. employment or unemployment tax obligations with respect to that employee. All you need to do is get the proper certification for that.

    But you may well have tax obligations in Malaysia. I suggest you contact a Malaysian tax professional about that. 

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