Does this raise a red flag???

[peggysioux]

Taxpayer is a cash basis taxpayer and has electrical business (schedule C). He brings in a P&L where his COGS ($72,005) is $15,000 more than his earned income ($57,662) from business. Then he has all his general expenses to add to his loss. He has had a loss on this business the previous two years, but the losses were due to overall expenses; his COGS were less than his earned income in previous years. I know if all expenses are legitimate, than loss can be taken; but was just wondering how other tax preparers handle.

Thanks!

[outwest]

Bet a lot of people will agree there are problems..

Here's what strikes me:

1. 3 Years of losses? What is he living on?
2. Not even collecting enough to pay the parts?

Here's what I would do:
Let's bring in the 1099s and run a tape on them. Remind him that even without a 1099, all income is taxable.
Is this P&L from quickbooks? Let's get a backup and look through it.

Once upon a time, I had a towing client that had just enough income to pay the house mortgage. I mentioned the IRS might wonder how they pay car payments, groceries, etc. I also noted that the IRS suspects many tow truck operators would take cash under the table, though I wouldn't think they would do that. None the less, it would probably be good for them to double check the books before we filed the return.

They came back with more income that had been "inadvertantly" overlooked. Next year, they didn't come back at all. Good result for all.

[oceanlovin'ea]

Inventory

Is it possible that he has bought extra supplies and has them in his garage, shed or wherever he stores extra parts. He may have gotten a really good deal on some parts and stocked up. If so, those things are inventory, not COGS.

He can only deduct as supplies or COGS the parts he buys and uses during the year.

That might be causing a problem. Just a thought.

Linda F

[taxmandan]

Red Flag

Sounds like he forgot to get you all of the income he earned, maybe asking for the bank statements would help you help him get more accurate income numbers. Yes, definately a red flag, theIRS would be looking for the missing income. What does he live on if he loses money on the business? Why stay in business if you can't make some profit? Now if by "cash basis" you mean the hip pocket bank, make sure he signs your engagement letter that explains that it's his responsibility to report ALL income and the information on the return is his responsibility, not yours.

[JohnH]

Cash basis definition

For some taxpayers, CASH BASIS means "If I'm paid in CASH, that's a good BASIS for not reporting it."

[Uncle Sam]

Red Flag

Since other posters discussed the missing income - I wish to bring up something else.
If the income is not understated - then how about jobs in progress that have to be picked up and capitalized ("Inventoried" until sold)?
A number of things don't make sense here-and I think the customers' job contracts should be examined and compared to the job costs. It's possible paid items are being charged to jobs that shouldn't be, and are really non-business related.

[veritas]

Don't forget

about bartering. Electricians like this almost as much as dentists.

[Snaggletoof]

All sorts

I think you've got to get to the bottom of the problem before completing this return.

Of all the possibilities mentioned, let's assume he is trying to report all income and is not padding his expenses with non-business costs.

Then the most likely culprit is he is growing rapidly and needs to use the percentage-of-completion method for recognizing revenue. If he doesn't do this, he could be honestly showing more job cost than cash receipts. I think this is what Uncle Sam may be referring to when he suggests "inventorying" the jobs in progress.

[Uncle Sam]

Red Flag

Snaggletoof - that's EXACTLY what I was referring to.

[peggysioux]

Does this raise a red flag??

I spoke with the taxpayer again and he stated the income is correct, but he did not receive payment on several jobs until 2007, but material was purchased in 2006 and work was done in 2006; thus the discrepancy. He stated he got behind in his billing. He does have another business which is showing a profit. Any additional thoughts?

[BOB W]

I like to present a tax return that is reasonable "at first glance".

Late collection of unpaid invoices can be a normal operating circumstance which is profound when collection crosses over the year end. Usually, it is what it is, cash basis accounting.

I like to use prepaid expenses ( an asset account) when I see how odd the COGS looks. No "RED FLAGS" are needed around here either. Bottom line is that I am matching the expense with the income by making an end of the year adjustment to the COGS and creating an asset account "prepaid expenses".

[taxmandan]

In the OP you said he had losses for the past two years also. I would still look closely for unreported income, you know: the 2005 income received in January 2006, which he didn't list as '06 income "cause it was from 2005." Of course it's not on the '05 return, "cause I didn't get paid until 2006."

Daniel

[Luis Mopeo]

I like to present a tax return that is reasonable "at first glance".

Late collection of unpaid invoices can be a normal operating circumstance which is profound when collection crosses over the year end. Usually, it is what it is, cash basis accounting.

I like to use prepaid expenses ( an asset account) when I see how odd the COGS looks. No "RED FLAGS" are needed around here either. Bottom line is that I am matching the expense with the income by making an end of the year adjustment to the COGS and creating an asset account "prepaid expenses".

I disagree with the position of reporting based on an attempt to make the return look good at first glance. I believe the return should represent reality, no matter how ugly it might look. If the COGS amount is legitimate, you put it down as COGS. It's a bad idea to pretend the goods are still in inventory just so the reality of the situation doesn't look "odd." That's the kind of thing that can come back and bite you in the hinder.

What happens if the client gets in hot water with the IRS? How are you going to explain to a revenue agent why you prettied up the tax return?

As to the original situation, nobody knows for sure, but if computers could give off a foul odor, this one would. If someone's losing money year after year, it doesn't make sense that they'd be slow on billing. That goes against human nature. If the client has another business that's profitable, there's less tax to pay if there are losses to offset the taxable income.

It just doesn't make sense that a person wouldn't care that they're losing a bunch of money.

I had a client with an "auto parts" business that had consistent losses that offset other income. I got a story about why their expenses were higher than their income. It was all timing. The next year they had a similar loss. I got the same story. I cut them loose. Later I got a call from a mortgage company trying to verify income for a refinance. I didn't give him any information, but he gave me some. Their numbers didn't make sense to him either, which didn't surprise me because they were giving him completely different numbers than they had given me.

Give them a chance to explain it and take steps to verify. If it's legit, the reasons will jump out at you. If the reasons don't jump out at you, be very careful.

[BOB W]

I disagree with the position of reporting based on an attempt to make the return look good at first glance. I believe the return should represent reality, no matter how ugly it might look. If the COGS amount is legitimate, you put it down as COGS. It's a bad idea to pretend the goods are still in inventory just so the reality of the situation doesn't look "odd." That's the kind of thing that can come back and bite you in the hinder.

What happens if the client gets in hot water with the IRS? How are you going to explain to a revenue agent why you prettied up the tax return?

Luis> I cannot disagree with your position, report it like it is. But the IRS allows "job completion method", under certain conditions, and all I'm doing is the same thing, somewhat.

As far the return goes, the prepaid expenses gets deducted next year. If the IRS wants to give the T/P the deduction on his '06 return( if audited), well Good for the client> Bad for the IRS. I'm just saying no damage is done to anybody.

Getting back to this particular client is another issue. Multiple years of losses is beyond reasonableness and I agree with many posters that futher inquiry should be done. At least verify the amount of money that was supposedly not collected in 2006 that will be collected in 2007. Then see if the year as a whole makes sense. If not, there are other problems with this account.

[gailtaxed]

Yes the IRS allows the job completion method as one way of reporting income. Just a caveat, however- even if using the job completion method, AMT requires using the percentage of completion method for AMT purposes if I am not mistaken.