Scenario 5 - Rounded Expenses

Murray and Lydia Laramie, a married couple, come in to have their taxes prepared. Murray tells you:

  • Lydia stays at home with their one child.
  • He is a carpenter.
  • He has records of his income that he received for the year.
  • Total income $30,000.
  • His expenses:
Expense Type Expense Amount
Advertising 100
Insurance   500
Legal & Professional 200
Office Expenses 50
Machine Rental 400
Small Tools 500
Supplies 12,000
Cell phone 300
Mileage of 15,000 total miles and 5,000 non-business miles.  


What due diligence issues are present in this scenario?

In this example, the information regarding the clients business appears inconsistent with the normal income and expense profile of this type of business. These inconsistencies include:

  • Businesses don't often have round numbers for gross receipts.
  • Businesses don't often have round numbers for business expenses.
  • Client states he has records for income, but not for business expenses.
  • The income seems relatively low to support three people.
  • The income allows the maximum credit.
  • In some states a carpenter should be licensed.

Further inquiries may be needed to determine if there are reasonable explanations for these inconsistencies.

What steps must you take to comply with due diligence?

Before you decide to prepare the Laramies' return you must first:

  1. Make additional reasonable inquiries to determine if the business is real. Ask your client applicable questions and document his responses.
  2. Explain that the IRS requires all income and allowable expenses be reported on the tax return.
  3. Advise your client that if the IRS or other agency examines the tax return, he will have to provide support for the income and expenses claimed on the return.
  4. 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?

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

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

The numbers listed here on the Schedule C are rounded and probably do not reflect actual business accounting numbers.

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 numbers 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?

The net income from the buisness is relatively low to support 3 people.

  • Do you have any other sources of support?


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