Scenario 1 - No expenses

Your new client Dana comes in to have her tax return prepared. After meeting with her, you have learned that she:

• Has a babysitting business.
• Has two children ages 8 and 10.
• Wants to claim the EITC.
• Earned $14,000 from babysitting, but that she has no expenses.

What are some possible due diligence issues?

The information provided by Dana appears to be both inconsistent and incomplete, because it is unlikely that someone who operates this type of business:

1. Has no business expenses. Most businesses have expenses, even if it is just a few dollars here and there.
2. Has annual gross receipts from the business that are an exact round dollar amount, and that amount maximizes EITC.

To meet your 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.

Note: The Internal Revenue Code requires the taxpayer 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 expenses, 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. If Dana works out of her own home, it would be reasonable to pose the additional questions.

What steps should you take for due diligence compliance?

1. Make additional reasonable inquiries regarding the taxpayer's business to determine whether the information regarding both income and expenses is substantially correct. Ask your client applicable questions and document her responses.
2. Explain that tax law 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, she/he will have to provide records 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 answers should provide you with enough information to make a reasonable reconstruction of her records and satisfy your due diligence requirements.

What other questions could you ask?

• How did you compute your income?
• What types of records, if any, do you keep?
• How many children do you care for? Full-time, part-time?
• How much do you charge for full-time and part-time care? How are you paid (cash, card, payment app)? Did you receive a Form 1099-K?
• Do you keep a calendar or schedule of the children present each day?
• Are your services listed on any gig platforms? Which ones?
• Does the business require any licenses or permits? If so, do you have one? If not, do you have an exemption from having a license under state law?
• Did you watch the children in your own home or your daycare facility or in the client's home?
  • If Dana answers that she cares for the children in the client's home, it may be reasonable to assume she had no expenses after all. However, keep in mind there may be expenses for car & truck if Dana provides her own transportation to the client’s home.
  • If Dana answers that she watches the children in her home or her facility, you should follow-up with additional questions regarding common business expenses for individuals who provide childcare services in their home.
• Do you purchase food, diapers, toys, supplies, or other items necessary for the business?
  • If Dana answers no, you should consider the reasonableness of this response by asking what items the parents provide.
  • If Dana answers yes, you should follow-up with additional questions to help her establish the amount of her expenses. You can guide her through the reconstruction process or simply offer tips and ask her to return when she has completed the reconstruction.
    • 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 food, diapers, toys, supplies, etc. that you purchased for the babysitting business?

As part of business expenses, you may need to establish whether she is entitled to claim a portion of her house for business use.

• Was there a part of your home used exclusively for daycare?
• Was there a part of your home used regularly but not exclusively for daycare?
  • You may need to work with Dana to establish the portion of her home expenses that may be claimed as a business expense.

Record reconstruction techniques

Based on your client's answers, you could:

1. Use the calendar or schedule kept by the client to verify the number of children cared for.
2. Multiply the number of children by the charged rate to determine if the income figure appears correct.
3. Use a sample of grocery store receipts that Dana has or can produce from third party sources, or cancelled checks, credit card statements, etc. along with her testimony of how often she buys these items to calculate a reasonable estimate of expenses incurred. Personal grocery purchases should be subtracted.
4. Determine if Dana should be claiming expenses for business use of her home. If so, IRS Publication 587, Business Use of Your Home (Including Use by Daycare Providers) should be reviewed, and additional information will be needed to make that computation.

Related

EITC Schedule C and record reconstruction training

Scenario 2 - False business income

Scenario 3 - Overstated expenses

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