Scenario 4 - No expenses

You have a new client named John Smith. After your first meeting with John and his wife, you learn:

• John has been married to Shelly Smith for 10 years
• They have two children aged 6 and 9
• The kids live with them full time
• John has a W-2 for $9,000
• Shelly has a cash-only home cleaning business
  • She made $6,663 according to bank statements
  • She has a notebook that lists her clients along with their addresses, cleaning fees, and service dates
  • She has not claimed any expenses for her business

What are some possible due diligence issues?

The information provided by John appears to be both inconsistent and incomplete – especially Shelly’s cleaning business. Some possible issues include:

1. Most businesses have expenses -- even if it is just a few dollars in cleaning supplies for a home cleaning business
2. The annual gross receipts from Shelly’s business appear to maximize EITC
3. Supporting a family of four probably on an income of $15,663 does not seem feasible

To meet your due diligence requirements, you need to ask more questions to determine if Shelly did incur allowable business expenses and that the income she reported is correct.

The tax code requires taxpayers to report all income and allowable expenses to determine their correct net profit from self-employment. If a taxpayer does not have complete records of their income and expenses, you may be able to guide your client through a reconstruction of their business income and expenses for the year. The reconstruction process can be an opportunity for you to educate your client on proper recordkeeping.

What steps should you take for due diligence compliance?

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

1. Make additional reasonable inquiries regarding Shelly's business to determine whether the information regarding both income and expenses is substantially correct. Ask your clients applicable questions and document their 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 another agency examines the tax return, she 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 these questions and documenting your client's reasonable answers should provide you with enough information to make a practical reconstruction of their records and satisfy your due diligence requirements.

What other questions could you ask?

Some supplies are essential to a cleaning business. How do you obtain them?

• If Shelly responds that her client provides the supplies, then it is reasonable to believe that she does not have expenses for supplies.
• However, if Shelly responds that she brings her own 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 do you use for work?

• If Shelly uses a personal vehicle for transportation, you should explain how to calculate expenses. Using her notebook record, you could reconstruct probable mileage expenses.
• If Shelly uses public transportation, she could use her notebook record to estimate the total 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 that the cash receipts align with the notebook.

Related

 

EITC Schedule C and record reconstruction training

Scenario 1 - No expenses

Scenario 2 - False business income

Scenario 3 - Overstated expenses

Scenario 5 - Rounded expenses

1099-NEC & 1099-MISC income treatment scenarios

EITC due diligence and self-employed taxpayers

Paid preparer due diligence training