John & Shelly Smith, a married couple, come into your office to have their taxes prepared.
- They have two children, ages 6 and 9 that live with them full time.
- John's only income is from a W-2 in the amount of $9,000.
- Shelly is a stay at home mom who has a small business cleaning homes for extra income that made $6,663 this year. Shelly's customers all pay in cash. Shelly provides the following documentation:
- Bank statements that show cash deposits to substantiate the income, and
- A notebook that lists of her regular clients including name, address, cleaning fee, and dates cleaned.
- Shelly says that she does not have any expenses for her business.
What due diligence issues are present in this scenario?
In this example, the information provided by the taxpayer appears to be both inconsistent and incomplete, because it is unlikely that someone who operates this type of business:
- Has no business expenses. Most businesses have expenses, even if it is just a few dollars here and there.
- Has annual gross receipts from the business that maximizes EITC
Also, supporting a family of four does not seem feasible on just $15,663 of income.
To meet your EITC due diligence requirements you need to ask more questions of the client to determine if she did incur allowable business expenses and that the income she reported is correct.
The tax code requires the taxpayer to report all of the income and allowable expenses to determine their correct net profit from self-employment. If a taxpayer has no or minimal records of income and expense, you may be able to guide your client through a reconstruction of business income and expenses. If your client has some basic information, it may be enough to recreate their income and expenses. The reconstruction process can be an opportunity for you to educate your client on recordkeeping.
What steps must you take to comply with due diligence?
Before you decide to prepare the Smiths' return you must first:
- Make additional reasonable inquiries regarding Shelly's business to determine whether the information regarding both income and expenses is substantially correct. Ask your client applicable questions and document her responses.
- Explain that the IRS requires all income and allowable expenses be reported on the tax return.
- Advise your client that if the IRS or other agency examines the tax return, she will have to provide support for the income and expenses claimed on the return.
- You may guide your client through a reconstruction process to arrive at a substantially correct net profit from the business.
Asking the following questions and documenting your client's reasonable answers should provide you with enough information to make a reasonable reconstruction of her records and satisfy your due diligence requirements.
What additional inquiries might you make?
There are certain items that are essential to a cleaning business, how are those items obtained?
- If Shelly responds that her client provide the supplies, it is reasonable to believe that she does not have expenses as they relate to supplies.
- However, if Shelly responds that she brings her supplies and equipment to her client locations, you should follow-up with additional questions regarding the cost of common household cleaning supplies and depreciation of the equipment.
- Does she have receipts for the cleaning supply purchases? A single receipt could be used to estimate the annual cost.
What type of transportation does Shelly use to travel to her client locations?
- If Shelly uses a personal vehicle for transportation, you should explain how to calculate expenses. Using her notebook record, she could reconstruct mileage expenses.
- If Shelly uses public transportation, she could use her notebook record to reconstruct the cost of the fares.
Do you have a business license? Are you listed in the yellow pages? Do you have business cards? How do you get your customers?
- These answers can establish whether the business is legitimate.
- Expenses related to licensing and advertising can be deducted.
Supporting a family of four does not seem feasible on just $15,663 of income. Do you have any other sources of income? If yes, please list.
How did you determine the income figure?
- As the preparer you should confirm the cash receipts and notebook documentation are in agreement.