Past due returns, lost business documentation

[AuditorTurnedGood]

All,
I have a bit of a sticky wicket with a client of mine. I took him on at the beginning of my practice, and he's been on and off the band wagon for about 3 years. He has delinquent Federal and State income tax returns from 2000 through present (with 04 and 05 taken care of from when I started) as well as S-Corp returns from those years and a few years of withholding returns. This is the client where I learned all we can do is lead a horse to water.
In any event, the client does not seem to have any documentation of the business expenses from 2000 through 2003. Can he take anything, or are we SOL on those years, and are going to have to pick up only the raw income (reported on forms 1099)? Don't want to get myself in any hot water here either. Thoughts? Thanks!!

ATG

[Burke]

If he has nothing, I don't see where you can deduct anything, unless you can get old bank records and hope the IRS might take them. And in those days, they sent YOU your cancelled checks. You will be lucky if the old bank is still around and not merged with some new entity. Good Luck.

[erchess]

Two Thoughts

Number one, if he really wants to he can probably reconstruct most of his expenses. He can pay his credit card company, his bank, and his major suppliers to give him back records. Of course if he prefers he can simply pay tax on his income and forget the deductions. That would certainly make life easier for you.

Number two, there is the old Cohan Rule. Except for certain specific types of expenses including mileage and charitable contributions which are by statute exempted from the rule, a client who has lost documentation through some understandable cause other than his own foolishness can reconstruct deductions where it is certain that he had to have spent something and the question is exactly how much. Ultimately if things go that far what will be allowed for each number is the least favorable to him believable value.

[Zee]

Based on your client's description, I would probably tell this client to go somewhere else. In my experience, this type of client just isn't worth keeping.

Erchess is correct, But, reconstruction of records is extremely time-consuming and it begs the question whether you will be paid for all your time & effort, or not.

Here's a brief description of the Cohan ruling:

http://www.unclefed.com/AuthorsRow/Daily/fwdgetaudited.html

[Uncle Sam]

Past Due Returns

Zee - nice article, however it did NOT mention that the Cohan Rule does NOT apply to entertainment expenses.

[erchess]

Getting Paid

The concern over getting paid can be addressed easily by getting an advance fee.

There remains the fact that people like this guy are pains to work with because they do not assign much importance to keeping their papers organized and meeting their tax obligations in timely fashion. I certainly would never work on one of these people at a time when I had something I really wanted to do in my personal life or when I had work I could do for a better client.

[JohnH]

I've done several reconstructions, and sometimes they turn out to be easier that it first appears. Still complicated, but manageable. This primarily works if you're fairly sure the business didn't have lots of unreported cash income (that is, the bank statements are a reliable indicator of income & expense transactions).

The first step is to obtain copies of the bank statements only (not the individual checks). Post the check numbers and amounts to an Excel spreadsheet. Then sort to identify any recurring amounts (loan payments, rent, lease payments, regular draws or net payroll amounts, etc) Generally obtaining a copy of only one check for each transaction for the same amount will be sufficient documentation to get you going.

If there are any statements available, such as credit card statements, utility bills, etc, then match up the amounts paid with the bills available. Use the same process if there are any canceled checks or check registers, no matter how spotty. Even a dozen or so matched transactions can sometimes be used to identify numerous other payees. Using the sort feature in Excel makes it very easy to flip between amount & date in order to quickly match up any known transsaction amounts. After doing this a few times, you get pretty good at jumping back & forth.

Next group the transactions by amount, largest to smallest, and figure out how many check copies would need to be obtained to identify a significant percentage of the total amounts paid. Sometimes you'll find that out of 1000 checks for example, you only need a couple of hundred copies at most to account for 70-80% of the amount paid out. This gets you pretty close to the point at which you're prepared to concede the 20% or so remaining as being non-deductible (or maybe even partially allocable to expenses).

Once you have a reasonable number of checks that you need copies of, you can negotiate with the bank for a reduced charge for the batch. In the end, if you have to pay $5 per check for 200 checks for example, then the $1,000 the client spends for this info will be more than offset by the tax savings. (What the client deosn't want to do is spend $5 each for a copy of every $20 check)

From there, you have to decide how much you want to dig to find documentation to back up the checks you classified as deductible expenditures. (You also have some supporting information in the 2 years you did prepare, so this may make it a little easier as well)

I'm not saying that this approach will work in your situation, but it is one way to go at it. Of course, you'll need a very tight engagement letter and lots of client cooperation during the process. If that isn't possible then maybe it's better to bail out. And it goes witohut saying that you'll need a sizable retainer before the first step.

[Zee]

JohnH -

Nice description of the tasks.

[S T]

I agree

John H - you are great at outlining tasks and how to approach situations
Thanks for all of your great advice for handling various situations

Guess, it is just a question for anyone of us, whether we want to tackle, how much time we want to spend, and how involved we want to become.

I don't always look to the $$ we can charge, it is more about the client and the potential client relationship.

Sometimes it is worth it and many times it is not.

Thanks very much for sharing

Sandy

[AuditorTurnedGood]

Thanks everyone for weighing in - it's all very good advice.

I am getting the money up front, and at this point the practice is a little slow, so I have the time, and could use the money. Though this client may be a pain, he has given me 5 very solid, long term client referrals.

Sounds like the consensus is to get all the statements we can get our hands on and go from there. Income is all 1099 (he's in real estate), so we're just looking at expenses, which in this industry is mostly adv. when you're the only person (which he was for these years).

Every time I post to the board I get very thoughtful responses. As someone who is still a little new to the field (my practice is 3 years old), I benefit greatly from those of you who have been doing this well for more years than I have. Thanks again!!

ATG

[JohnH]

(Zee & Sandy - thanks for the kind words. Guess this was fresh on my mind since I'm working on a similar situation right now).

ATG: You might consider:
1) Annual licensing fees & MLS membership charges should be easy to obtain from third-party records.
2) Most agents have a few attorneys & loan brokers they tend to recommend if the client asks. These people might have some documentation your client could obtain to support some deductions.
3) State licensing board might be able to provide his historical continuing ed info.
4) He may have forged working relationships with other agents who may be able to produce documentation from their own records on commission-splitting, cost-sharing, etc.

My first step would be to tell him to give me any bank statements he has. Then give him a list of the statements we need, tell him to order from the bank, and wait until he gets them for me. If he won't take that first step, probably no need going any further with him.

If he produces the missing statements, a simple columnar proof of cash will give you an idea of the amounts of money involved in total. A quick count of the number of checks written gives you a maximum number you'd need to obtain copies of, and a visual scan of the transaction amounts would give you a rough idea of how many checks copies you might realistically need out of that total number of checks written. Then you'd be in a pretty good position to tell him how much it might cost just to get the basic info in hand.

This also gives him an incentive to dig a little more in his files to see if he has any old statements & canceled checks stuffed away in a box or bag somewhere. For example, if check copies are $5 each and he writes 30 checks per month on average, then each bank statement with canceled checks he finds will be worth as much as $150 (assuming you needed copies of all the checks on that statement) From that point, it's a simple matter of his making a decision based on what he thinks his time is worth. Oftentimes it's better if they're missing all the info that if they're only missing part of it because that may mean it's all in one place - it's just a matter of motivating them to find that particular place.

[Burke]

Unless he is/was licensed as an Independent Broker, that means he had to be affiliated with a primary (supervising) broker-firm to sell real estate. That firm (or firms) would have records of expenses they charged to him if they had that sort of agreement where he had to contribute his pro-rata shares of things like E&O, office expense, etc., etc. They would also have a copy of his contract with them in which it details how the commission arrangement worked, and possibly the above expenses, if any. He most likely would have been required to pay dues to local, state and National Association of Realtors, including MLS and state licensing expenses as John mentioned.