Scenario 5 - Rounded expenses

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

• Is married to Lydia Laramie
• Lydia is a stay-at-home mom with their only child.
• Murray is a carpenter.
• His total income was $30,000.
• Has the following list of expenses:
  • Advertising, $10
  • Insurance, $500
  • Legal & professional, $200
  • Office expense, $50
  • Machine rental, $400
  • Small tools, $500
  • Supplies, $12,000
  • Cell phone, $300
  • Meals & entertainment, $1,427
  • Utilities, $3,012
  • Mileage of 15,000 total miles and 5,000 non-business miles

What are some due diligence issues?

Murray’s carpentry business has a few inconsistencies which include:

• Round numbers for gross receipts
• Round numbers for business expenses
• Records for income, but not for business expenses
• Income seems relatively low to support three people
• Income appears to maximize the EITC.
• In some states, a carpenter must be licensed.

What steps should you take for due diligence compliance?

Before you accept this new client, you must:

1. Make additional reasonable inquiries to determine if the business exists. Ask Murray applicable questions and document his responses.
2. Explain that tax law requires all income and allowable expenses be reported on his tax return.
3. Advise Murray that if the IRS or another agency examines the tax return, he will have to provide records for his income and the business expenses claimed on the return.
4. You may guide him through a reconstruction process to arrive at a substantially correct net profit for the business.

Asking these questions and documenting Murray’s answers should provide you with enough information to make a practical reconstruction of his business records and satisfy your due diligence requirements.

What other questions could you ask?

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

• Do you have a license?
  • If no, is it reasonable that the services provided do not require a license?
• How do you advertise your business (social media, flyers)?
• Do you have business cards?
• Are your services listed on any gig platforms? Which ones?
• How else do you get your customers?

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?
• Can a customer book services and pay online? Did you receive a Form 1099-K?
• Do you keep an appointment calendar or schedule each day?
• What records do you have to support the expenses reported here?

It is unlikely that all the expenses are round numbers. Are these 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? Do you have an account with a supplier who can provide an itemization of purchases?

Your current income seems too low to support three people. Do you have any other sources of income?

• If yes, please list.

Related

EITC Schedule C and record reconstruction training

Scenario 1 - No expenses

Scenario 2 - False business income

Scenario 3 - Overstated expenses

Scenario 4 - No expenses

1099-NEC & 1099-MISC income treatment scenarios

EITC due diligence and self-employed taxpayers

Paid preparer due diligence training