Scenario 2 - False business income | Internal Revenue Service

A client, Linda, comes into your office to have her tax return prepared. She tells you:

She has three children (ages 4, 6, and 8) that live with her and for whom she provides support.
She is not listing any childcare expenses.
She has a hairdressing business, which had gross receipts of $11,000.
The business is cash basis and there are no Form 1099(s) documenting the gross receipts.
She has no expenses listed for the hairdressing business.

What due diligence issues are present in this scenario?

In this example, the information regarding the client's business appears incomplete. It is also inconsistent with the normal income and expense profile of this type of business. These inconsistencies could include:

Cash businesses don't generally have round numbers for gross receipts, and the amount of gross receipts maximizes EITC.
A legitimate business almost always has some expenses.
A legitimate hairdresser would have a license. Keep in mind, some states do not require braiders to have licenses.
This type of business will generally have operating expenses such as equipment, supplies and advertising expenses.
Those who are working during the day usually need assistance in caring for their children.
There is no information on the children's other biological parent and his involvement.

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 Linda's return you must first:

Make additional reasonable inquiries to determine if the business exists. 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 records 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.
Make the appropriate inquiries in order to make sure that the client is entitled to claim the three children.

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 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?

What hair services do you provide?
Do you have a license for hair services? Is a license required? Note: Some states do not require braiders to have licenses.
Which social media platforms do you use to advertise your business?
Where is your business located?
How do your customers find out about you?

The numbers listed here on the Schedule C are rounded and probably do not reflect actual business gross receipts or income.

How are you paid (cash, card, payment apps)? Did you receive a Form 1099-K?
How did you compute your income? Do you have records to support this figure?
What kind of services do you offer?
How much do you charge for each service?
Do you use an online booking service or do clients call you directly to book?

Businesses almost always have expenses. Please explain why there are no expenses.

If there are expenses, they can be reconstructed using appropriate techniques and recorded on the Schedule C.

Do you purchase hair dryers, combs, brushes, dyes, sprays, supplies, or other items necessary for the business?

If the client 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 of simply offer tips and ask her to return when she is complete.
- Are the supplies always the same? Where are they purchased? How often are they purchased? How much are they?
- How do you pay for supplies? Do you have any receipts for the supplies that you purchased for the business? If you have a supplier, they may provide you with an itemized list.

Is there anyone else who lives in the home who is NOT listed on the tax return?

Do you have any other sources of support? Please list.

You did not list any dependent care expenses. Who cared for the child(ren) while you worked?

There is no information on the children's other biological parent(s). Please explain the extent of the other parent(s) involvement?

EITC Schedule C and record reconstruction training

Scenario 1 - No expenses

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