A Valuable Lesson

[dyne]

I just prepared a tax return for a young man who operates a business. He presented to me business gross receipts of about $24,000 and 1099-Misc forms which totaled about $12,000. Generally the gross receipts reported to me includes the amounts reflected on the 1099-Misc or that was my assumption, which I now have come to realize can be wrong! In this case he had a list of personal expenditures which totaled about $20,000. He is entitled to EIC and when I began to prepare one of the EIC checksheets, I realized it was NOT obvious that he earned enough business profit, which was $5,000; to be able to provide for his own support. So, I prepared a Source and Application of Funds Computation as used by IRS which indicated that he omitted about $12,000 of gross receipts or overstated his business expenses by that amount. In further questioning of him I discovered that he was telling me that he had the $12,000 reported on the 1099-MISC plus $24,000 of OTHER business gross receipts. I now know better!

[JG EA]

Good reminder. Source and Application of Funds Computation - could you tell us where to get one of these?

[ChEAr$]

dyne's experience reminds me of a client once who had a day job and also a landscaping service after hours and on weekends. So I sent him my business income and expense worksheet so he could do all the summation work of income and expenses. Worksheet is keyed of course to schedule c items.

the second year I was amazed he did so well. I knew he was a hustler, but he must have been busy all year. How DID he find time to sire that new baby?

Third year, income is down slightly, but still a nice schedule c and se profit.

Fourth year while interviewing him I find out that he had been including in income his
landscaping receipts PLUS his W2 income!

Several 1040x's were in order.

[dyne]

I believe it was an IRS form RC ATL Aud 308 but it was eliminated back in 1984.I searched for it in Google and could not find it. IRS reasoning was that their Tax Auditors and Agents were expected to make the computation without the use of a form to encourage them to use their intelligence. The only thing I remember which seemed unusual about it was that an increase in a business inventory was an application (expenditure) but a decrease was NOT a source. The theory being that an increase in a business inventory was an additional expenditure since it was paid but not included in the cost of good sold or the schedule C profit. However the decrease in a business income WAS included in the cost of goods sold and reflected in the schedule C profit. Now after putting it in writing, I am not sure that it makes sense. Does anyone else have a better explanation?

[AZ-Tax]

Wooow, looks like I probably should clarify the wording on .....

my Business Tax Organizer and make sure the SE does NOT include any W-2 income if applicable.

[JohnH]

I believe it was an IRS form RC ATL Aud 308 but it was eliminated back in 1984.I searched for it in Google and could not find it. IRS reasoning was that their Tax Auditors and Agents were expected to make the computation without the use of a form to encourage them to use their intelligence. The only thing I remember which seemed unusual about it was that an increase in a business inventory was an application (expenditure) but a decrease was NOT a source. The theory being that an increase in a business inventory was an additional expenditure since it was paid but not included in the cost of good sold or the schedule C profit. However the decrease in a business income WAS included in the cost of goods sold and reflected in the schedule C profit. Now after putting it in writing, I am not sure that it makes sense. Does anyone else have a better explanation?

Just a quick thought here, assuming I understand the question. Since the S&AF was designed to catch cheating, it assumed that the taxpayer was fudging the numbers. It forces the auditor to make that assumption by biasing the analysis toward the negative. Thus the taxpayer had to justify anything unusual, even it it turned out to be explainable.

An increase in inventory is believable because it has the effect of increasing profit, so those numbers are acceptable on the surface since someone who's cheating would be unlikely to show a higher profit than necessary. However, a decrease in inventory could be the result of either a legitimate decrease or by the taxpayer pulling items out of inventory for personal use or off-the-books sales. So the analysis throws up a red flag on an inventory decrease and requires the taxpayer to offer an explanation. Doesn't mean they did anything wrong, but puts the burden of proof on the taxpayer. What do you think?