EIC, Am I over reacting to say this sounds

[AZ-Tax]

like a Red Flag, for the IRS will be wondering what this family lives off of?

One spouse max out her pre tax dependent care, HSA and 401k benefits to the point the spouse had $18K box 1 of W-2 w/no taxes withheld. Other spouse is SE grossed about $20K (paid no SE & Inc Tax during yr) and with business related expenses totaling about $15K. 2 kids and most likely will qualify for EIC.

They refinance last year (cash out about $10K) and is about 50% LTV based on most recent values.

[Koss]

Red Flag?

I don't see a serious problem with this picture...

You didn't say how much was put into the HSA and Dependent Care accounts, but those amounts are probably flowing out of the accounts, and thus are funds that the taxpayers are spending to support themselves.

The cash taken out with the refi also provides money to live on.

Keep in mind that under the current rules, they don't have to show that they are providing more than half of the economic support for their children. To meet the criteria for qualifying child, they only have to show that the children are not providing more than half of their own support.

If there is a red flag, it's not about EIC or dependency. It's the ratio of expenses to income on Schedule C.

But I can't comment on that without knowing what kind of business it is, and how long he's been in business...

I don't think the IRS would challenge their dependent exemptions, Child Tax Credit, or EIC.

If they have anything to be concerned about, it's substantiation of the Schedule C expenses, and potentially having to show a profit motive, and making sure that they've reported all income.

BMK

[RitaB]

I often wonder if IRS is paying attention

I have people like this, too. I always suspect there is unreported income. Just ask the questions you should, and prepare the return. No, I don't think it's a red flag. Of course, I really don't know what WOULD appear red to IRS, cause I swear I have people who might as well be filing Schedule "Hey Look, I Must Be Cheating", but everything sails right through.