Scenario 3 - Overstated expenses

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

• Has a construction and remodeling business
• Earned $50,000 in gross income last year
• Is single with two children aged 7 and 9
• Wants to claim the EITC
• Has Forms 1099-MISC for his income
• Has the following list of expenses:
  • Advertising, $60
  • Contract labor, $7,200
  • Insurance, $150
  • Interest, $2,025
  • Legal & professional, $250
  • Office expense, $75
  • Machine rent, $750
  • Repairs, $1,975
  • Supplies, $2,972
  • Taxes, $4,222
  • Meals & entertainment, $1,427
  • Utilities, $3,012
  • Mileage of 25,721 total miles and 7,554 commuting miles

What are some possible due diligence issues?

The information provided by Charlie appears complete but some potential issues may include:

• The list of expenses is itemized but his income is not
• The expenses listed seem tailored to maximize the EITC
• Meals and entertainment require specific documentation
• Are the expenses listed ordinary and necessary business expenses?
• Do Charlie’s children qualify for the EITC?

Note: The tax code requires taxpayers to report all income and allowable expenses to determine their correct net profit from self-employment.

What steps should you take for due diligence compliance?

1. Make additional reasonable inquiries about Charlie’s business to determine whether his income and expenses are correct. Ask questions and document his responses.
2. Make additional reasonable inquiries to determine if the expenses claimed are allowable business expenses and that he has necessary documentation to support them.
3. Explain that the IRS requires he report all income and only allowable expenses.
4. Advise him that the IRS or another agency may examine his tax return and he will have to provide support for his income and expenses.

Taking steps like these, and documenting Charlie’s reasonable answers, should provide you with enough information to prepare a correct Schedule C and comply with due diligence requirements.

What other questions could you ask?

Are there any personal expenses included on this list?

• If Charlie answers no, you should ask for details on how he made sure personal expenses were not included in his list. Does he have separate bank accounts, checkbooks, or credit cards for the business?
• If Charlie answers yes, you should ask for the details behind the expense listed and determine whether they are deductible.

Are credit cards used for business purchases?

• If Charlie answers yes, you should follow-up with additional questions to determine if the interest expense includes only interest related to business expenses.

Is the repairs expense of $1,975 for a business vehicle?

• If Charlie answers yes, you should ask for a detailed list of the expenses. Since vehicle expense is being deducted using a mileage method, including the vehicle repair expense is overstating the cost to repair the vehicle.

Are any personal expenses included in supplies?

• If Charlie answers no, you should consider the amount of the supplies expense and if the dollar amount seems reasonable for the income reported.
• If Charlie answers yes, you should follow-up with additional questions to determine if the supplies expense includes only supplies related to the business.

Are any income taxes included in the taxes expense?

• If Charlie answers yes, you should follow-up with additional questions to determine if Charlie knows what types of taxes are deductible.

Does the utility expense include any amounts for residential or vacation properties?

• If Charlie answers yes, you should follow-up with additional questions to determine if the utility expense includes only properties related to the business.

Does the mileage amount you provided include any personal travel other than commuting?

• If Charlie answers no, you should document that no other personal travel was included and should ask if another vehicle is available for personal travel.

Do Charlie’s children live with him?

• If Charlie answers yes, follow-up with questions about childcare and what part of the year they live with him.
• If there is no information on the children's other biological parent, you need to ask about their involvement in childcare.

Related

 

EITC Schedule C and record reconstruction training

Scenario 1 - No expenses 

Scenario 2 - False business income

Scenario 4 - No expenses

Scenario 5 - Rounded expenses

1099-NEC & 1099-MISC income treatment scenarios

EITC due diligence and self-employed taxpayers

Paid preparer due diligence training