- Who is self-employed?
- How is self-employment reported on a tax return?
- Why are Schedule C's an EITC issue?
- What is due diligence?
- How does due diligence apply to Schedule C returns claiming the EITC prepared by paid tax preparers?
- What are the consequences for not meeting your due diligence and filing incorrect EITC returns?
- What Schedule C situations should raise a red flag for you as a tax preparer?
- What techniques can be used to obtain information from your client?
Who is self-employed?
- You are self-employed if you carry on a trade or business with a profit motive as a sole proprietor or as an independent contractor.
- An individual who performs services on a part-time basis or does occasional "odd jobs" and receives compensation for that work, may be self-employed. An individual doesn't need to have a business name, or have a formal business structure, to be self-employed. All self-employed individuals are required to report the income and related expenses from selling goods or performing services for others for money.
How is self-employment reported on a tax return?
- Income received from all sources in a self-employed taxpayer's business must be reported unless it is excluded by law. See IRC 61.
- All ordinary and necessary expenses incurred in a self-employed taxpayer's business must also be reported. See IRC § 1402(a).
- Form 1040, Schedule C, Profit or Loss From Business, is used to report the activity on the individual's tax return.
Why are Schedule C's an EITC issue?
- IRS estimates that 33.5% of the EITC claims, or approximately $21.9 billion were paid in error in 2023.
- Income reporting errors are among the top three common EITC errors that account for more than 60% of the dollars paid in error annually.
- The most common Schedule C errors on returns with EITC, which fall into the income categories are:
- Over-stated expenses and losses on the Schedule C to bring income down to qualify for EITC,
- Inflated Schedule C income to maximize the amount of EITC, and
- Bogus Schedule C income to qualify for or maximize the amount of EITC.
- In tax year 2021, approximately 8.4 million EITC returns reported at least one Schedule C. Most of these represent small, often home-based businesses. Approximately one-third of the annual tax gap is a result of under-reported income or overstated deductions on all Schedule C businesses.
What is due diligence?
Due diligence is a law that requires paid preparers of EITC returns to take additional steps to ensure that the return information impacting EITC eligibility is correct.
The due diligence regulations can be found at: Due Diligence Law and Regulations
Basically, due diligence requires you, as a paid preparer, to:
- Evaluate the information received from the client
- Apply a consistency and reasonableness standard to the information
- Make additional reasonable inquiries when the information appears to be incorrect, inconsistent, or incomplete
- Document additional inquiries and the client's response
How does due diligence apply to Schedule C returns claiming the EITC prepared by paid tax practitioners?
- Due diligence, IRC §6695(g), requires paid tax return preparers to make additional inquiries of taxpayers who appear to be making inconsistent, incorrect or incomplete claims related to their self-employment when the tax return includes the earned income tax credit.
- All additional inquiries made to comply with due diligence and the client's responses must be documented.
- The statute requires the paid preparer to be reasonable, well-informed, and knowledgeable in the tax law.
- Paid preparers generally can rely on the taxpayer's representations, but due diligence requires the paid preparer to take additional steps to determine that the net self-employment income used to calculate the amount of or eligibility for EITC is correct and complete.
- Paid preparers should ensure that the amount of net self-employment income reported is correct.
- Taxpayers sometimes want to over-report or under-report their income to qualify for or maximize the amount of EITC.
- The paid preparer should ask clients enough questions about their self-employment income to be satisfied that:
- the client is conducting a business,
- the client has records to support income and expenses, or can reasonably reconstruct income and expenses records, and
- the client has included all income and related expenses on Schedule C, Profit or Loss from Business (Sole Proprietorship).
What are the consequences for not meeting your due diligence and filing incorrect EITC returns?
Incorrect EITC returns may adversely affect both you and your clients. The consequences may include:
- Your clients may be subject to accuracy or fraud penalties and be banned from claiming EITC for a period of 2 or 10 years depending on the reason the EITC was disallowed.
- Paid preparers who fail to comply with due diligence requirements can be assessed a $600 penalty for each failure. The most common reason for assessing due diligence penalties is failure to meet the knowledge requirement. Refer to Internal Revenue Code section 6695(g) and Treasury Regulation 1.6695-2. (Search most recent year, Title 26, Part 1, Section 6695.2)
- Other return preparer penalties ranging from $1,000 to $5,000 may also be assessed for negligence or intentional disregard of the rules and regulations when preparing an EITC returns. See IRC § 6694.
The assessment of return-related penalties against a tax preparer may result in:
- Suspension of the preparer from participation in IRS e-File and preparer registration
- Injunctions barring the preparer from preparing tax returns
- Referral for criminal investigation
- Disciplinary action by the IRS Office of Professional Responsibility
It is important to note that all registered preparers are held to the ethical standards defined in Circular 230 and are subject to consequences if the standards are not upheld. This could include revocation of your preparer tax identification number (PTIN).
What Schedule C situations should raise a red flag for you as a tax preparer?
- Schedule C income in round numbers
- Schedule C cash businesses as the only income on a return claiming EITC
- Schedule C with little or no expenses when expenses would be expected
- Schedule C taxpayers with little or no records for income and expenses
- Any Schedule C income that brings the taxpayer to the maximum EITC
- Schedule C without a Form 1099 if the business activity and types of payments received requires one
What techniques can be used to obtain information from your client?
- Conduct a thorough and in-depth interview with your client about the business activity.
- Ask your client to describe daily and weekly activities can provide a great deal of information when the basic question/answer format does not seem to be creating a clear and consistent picture.
- Have a casual conversation about business practices may prove insightful.
- Take the time to educate your clients on the need for recordkeeping and the consequences of failure to keep records will help them to establish a good recordkeeping system so that they will have a much easier time of filing an accurate return the next filing season.
- Use Form 11652 PDF, 11652 (Spanish Version PDF), Questionnaire and Supporting Documentation Form 1040 Schedule C (Profit or Loss from Business), during IRS examinations of Schedule C, provides a starting point for addressing client's recordkeeping.
- Review supporting material if it is provided. If supporting materials is not provided you should inform your clients that the IRS may audit them. In that event, your client would need to provide receipts to support the figures. Taxpayer claims of having supporting documentation is not sufficient to meet tax preparer due diligence. You should inquire how income and expenses were computed and document the responses. If you feel the information is not accurate or the supporting material is sufficient, you may ask to see the supporting material.
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