Scenario 5 - Rounded expenses | Internal Revenue Service

You have a new client named Murray Laramie. After your first meeting, you learn Murray:

Is married to Lydia Laramie
Lydia is a stay-at-home mom with their only child
Murray is a carpenter
His total income was $30,000
Has the following list of expenses:
- Advertising, $10
- Insurance, $500
- Legal & professional, $200
- Office expense, $50
- Machine rental, $400
- Small tools, $500
- Supplies, $12,000
- Cell phone, $300
- Meals & entertainment, $1,427
- Utilities, $3,012
- Mileage of 15,000 total miles and 5,000 non-business miles

What are some due diligence issues?

Murray’s carpentry business has a few inconsistencies which include:

Round numbers for gross receipts
Round numbers for business expenses
Records for income, but not for business expenses
Income seems relatively low to support three people
Income appears to maximum the EITC
In some states a carpenter must be licensed

What steps should you take for due diligence compliance?

Before you accept this new client, you must:

Make additional reasonable inquiries to determine if the business is real. Ask Murray applicable questions and document his responses.
Explain that the IRS requires all income and allowable expenses be reported on his tax return.
Advise Murray that if the IRS examines the tax return, he will have to provide support for his income and the business expenses claimed on the return.
You may guide him through a reconstruction process to arrive at a substantially correct net profit from the business.

Asking these questions and documenting Murray’s reasonable answers should provide you with enough information to make a practical reconstruction of his business records and satisfy your due diligence requirements.

What other questions could you ask?

Do you have any of the normal information or documentation that may be required to prove your business is operational?

Do you have a license?
- If no, is it reasonable that the services provided do not require a license?
Are you listed in the yellow pages?
Do you have business cards?
How do you get your customers?

How did you compute your income? What records do you have to support this figure?

What kind of services do you offer?
How much do you charge for each service?
Do you keep an appointment calendar or schedule each day?
What records do you have to support the expenses reported here?

It seems unlikely that all the expenses are round numbers. Are these estimates?

Does this amount include any personal expenses? How do you separate your personal expenses from your business expenses?
Are the supplies always the same? Where are they purchased? How often are they purchased? How much are they?
Do you have any receipts for any of the supplies that you purchased for the business?