- Why should taxpayers conducting a trade or business keep records?
- What should be included in the taxpayer's books and records?
- What Business Expenses can be claimed on Schedule C?
- What are examples of supporting documents?
- What should you do if the taxpayer does not have records?
- What choices do you have if you are not satisfied with the records?
- Where can you get additional guidance on EITC due diligence?
Why should taxpayers conducting a trade or business keep records?
Good records will help the taxpayer do the following:
- Monitor the progress of their business. A taxpayer conducting a business needs good records to monitor the progress of the business. Records can show whether the business is improving, which items are selling, or what changes may need to be made. Good records can increase the likelihood of business success.
- Identify source and amount of receipts. A taxpayer will receive money or property from many sources. Your records can identify the source of your receipts. You need this information to separate business from non-business receipts and taxable from nontaxable income.
- Keep track of deductible expenses. A taxpayer is required to deduct the correct amount of expenses, and only the allowable expenses on their tax return. Good records are necessary to record the source and amount of expenses incurred in the business.
- Prepare tax returns. Taxpayers need good records to prepare tax returns. These records must support the income, expenses, and credits reported.
- Support items reported on tax returns. Taxpayers must keep business records available at all times for inspection by the IRS. If the IRS examines the tax returns, the taxpayer will be asked to explain the items reported. A complete set of records will speed up the examination.
A system of books and records may be as simple as a calendar showing business income earned each day and business expenses paid each day or they may be a detailed accounting system. The system of records should include enough information to correctly determine gross receipts, business expenses incurred and the purchase price of assets acquired for use in the business. These records should also include inventory purchases, payroll, and other transactions occurring in the course of operating the business.
The taxpayer's books and records should include supporting documents. Supporting documents include sales slips, paid bills, invoices, receipts, deposit slips, and canceled checks. These documents are important to support the entries in the books and the tax return. These records will also help the taxpayer determine the value of inventory at the end of the year.
Schedule C should include current operating costs of running the business. To be deductible, a business expense must be both ordinary and necessary.
- An ordinary expense is one that is common and accepted in your field of business, trade, or profession.
- A necessary expense is one that is helpful and appropriate for your business, trade, or profession.
To be correct and complete, the Schedule C should include all allowable business expenses. The taxpayer's records should not include any personal expenses. The following is a brief list of some common business expenses. See the Schedule C instructions and IRS Publication 535, Business Expenses, Publication 946, How to Depreciate Property, and Publication 587, Business Use of the Home, for more information. Common business expenses include the following:
- Payroll or contract labor
- Interest on business loans
- Legal and professional fees
- Car and truck expenses
- Business use of the home - Most of your clients won't qualify as they do not meet the exclusive use requirement. Most day care providers will not qualify as the statute requires a license or proof of exemption from the license requirement.
- Travel, transportation, entertainment, and gift expenses. Specific recordkeeping rules apply to these expenses. For more information, see IRS Publication 463.
- Employment taxes. There are specific employment tax records a taxpayer must keep. For a list, see IRS Publication 15.
- Gross receipts. Gross receipts are the income received by the business. The taxpayer should keep supporting documents that show the amounts and sources of gross receipts. Documents that show gross receipts include the following.
- Cash register receipts
- Bank statement and deposit slips
- Receipt books
- Credit card charge slips
- Forms 1099-MISC
- Any format (calendar, income ledger, etc.) that the taxpayer consistently uses to record receipts of the business
- Purchases. Purchases are the items bought to resell to customers. Supporting documents should show the amount paid and that the amount was for purchases. Documents for purchases include the following.
- Canceled checks
- Cash register tape receipts
- Credit card sales slips
- Expenses. Expenses are the costs incurred (other than purchases) to carry on the business. The supporting documents should show the amount paid and that the amount was for a business expense. Documents for expenses include the following.
- Canceled checks
- Cash register receipts
- Account statements
- Credit card sales slips
- Petty cash slips for small cash payments
- Assets. Assets are the property, such as machinery and furniture owned and used in the business. Taxpayers must keep records to verify certain information about business assets. They need records to figure the annual depreciation and the gain or loss when assets are sold. The records should show the following information.
- When and how an asset was acquired
- Purchase price including purchase invoice, real estate closing statements, cancelled checks, etc.
- Cost of any improvements including invoices and cancelled checks
- Section 179 deduction taken
- Deductions taken for depreciation
- Deductions taken for casualty losses, such as losses resulting from fires or storms
- How the asset was used
- When and how the asset was disposed of, including sales invoice or closing statement
- Selling price
- Expenses of sale
To comply with their EITC due diligence requirements, a paid preparer should make adequate inquiries to be satisfied that the taxpayer is carrying on a business and that the income and expenses reported on the tax return are substantially correct and complete.
In the event of a loss of client records or due to poor recordkeeping, a paid preparer may need to help his client reconstruct the records. The reconstruction will demonstrate that the paid preparer exercised due diligence and it will also teach the client about recordkeeping.
The goal of record reconstruction is to use available documentation to develop a sound and reasonable estimate of the taxpayer's business income and expenses to support the Schedule C prepared. Although the taxpayer may not have formal books and records with supporting documentation, they may have partial records that can be used as a basis for reconstruction.
The knowledgeable tax preparer can guide their client on how to use these partial records to develop support for the Schedule C. This reconstruction can also provide support for the return in the case of an audit. Numerous court cases exist that support the use of reasonable estimates and reconstruction of income and expenses to determine a taxpayer's correct tax liability. However, if the tax preparer is not satisfied with the accuracy of the reconstructed records, he has the right to refuse to prepare the return.
The following is a table of helpful example options and tools to use in reconstructing records:
|Example source||How to use to reconstruct records|
|Appointment books or calendars||
An appointment book could be used to develop:
Using summary counts of the number of each kind of service rendered, the taxpayer could apply an average or standard cost to come up with an estimate of total receipts. The number of trips made and the locations traveled to could be combined with online map tools data to support total business miles driven.
|Online map tools||Online map tools can be used to reconstruct mileage calculations.|
|IRS standard allowances||The IRS provides standard expense allowances including per diem expenses for truck drivers and standard mileage rates.|
|Checkbook, cancelled checks, bank statements or credit card statements||These documents can be used to gain information about expenses incurred and what types of services were performed for clients. Using summary counts of the number of each kind of service rendered, the taxpayer could apply an average or standard cost to come up with an estimate of total costs and receipts.|
|List of regular clients||Using a list of regular clients, a taxpayer could reconstruct a reasonable calendar of services. Regular expenses could be extrapolated from that information. The taxpayer could apply an average or standard cost to come up with an estimate of total receipts.|
|Partial receipts or sales tax records||Partial receipts can lend information regarding what expenses were incurred for services. The taxpayer could apply an average or standard cost to come up with an estimate of total receipts.|
|Cell phone records and call history or computer logs||Cell phone records and call history can be used to develop a list of clients served during specific timeframes.|
|Prior year returns||Prior year returns can provide the basis for records if activities are similar from year to year.|
As a preparer you must make a decision whether you are comfortable that the information presented by your client is substantially correct.
If you are not satisfied with the taxpayer's records, you may:
- Request the taxpayer attempt to reconstruct his records on his own.
- Assist him with reconstructing his records.
- Suggest filing without an EITC claim.
- Refuse to prepare the Schedule C return altogether.
You have a professional responsibility to prepare returns that are accurate. The taxpayer is ultimately responsible for the figures computed through record reconstruction, and you should inform the taxpayer of possible repercussions of filing a false EITC claim whether with or without your assistance. However, as a tax preparer you must exercise due diligence and apply reasonableness as you may be subject to penalties and additional consequences.
- EITC Home Page on irs.gov
- EITC Central
- Due Diligence for CPE Module
- Tax Forum Presentations and other Educational Opportunities
- Tax Forum Due Diligence Videos