Small business - no documentation

[Kea]

New client has regular W-2 job (primary job). When I was going through the interview, he mentioned having a mobile DJ business. I told him he was required to report all income, but he could offset it with his business expenses. It seems he's done this since about 2005, but it didn't really take off until 2007. He's not previously reported this at all in 2005 or 2006.

He stated that it was a purely cash business. He didn't deposit the money or track it in any way. He estimates it probably around $5000 in 2007. No problem here - I just report the $5000. Even though there is no documentation, it has to be reported.

He also has lots of equipment that he has bought over the years, but most of it was purchased in 2007 (as the business grew). He has lighting, speakers, amps, CD players, mixers, speaker cables, etc. He also said he buys about 4-5 CD per month. However, all of this was purchased with cash. The equipment is probably worth $7-8K (he's getting me better estimates). He probably kept most of the receipts at the time, but he got divorced last year and "just left." He didn't even think about making sure he had his receipts and didn't know he would need them later.

I can't do anything about the 2005 - 2006 returns. I can't make him amend; he doesn't have any documentation; he would have to work with his ex. Not gonna happen. If he could recreate everything, he would probably have losses.

Even without the documentation, I can't let him not report the estimated income. I have no reason to believe that he didn't buy the equipment. But can I actually claim any of it if I know he doesn't have the receipts? For the items he had pre-2007, I could move them in at FMV from "personal" use to business use. Is it reasonable to deduct the other assets, using low-end reasonable estimates? If he sells equipment in the future, he has to show depreciation "allowed or allowable," so he might as well depreciate the equipment.

I would never allow a client to claim more for assets than reasonable. But now with the new preparer penalties, am I in trouble if I let him claim ANYTHING?

Thanks.

[JohnH]

Isn't it funny how clients often want to forget past unreported income, but still want to take any possible current period deductions based on those prior years? You could assume that all equipment purchased in the past would have been written off against income in the year purchased via a Sec 179 deduction. On an informal basis, that's essentially what has happened. That would leave you with a cleaner slate for the 2007 year forward.

Of course, any equipment purchased in 2007 could be either depeciated going forward or depreciated via a Sec 179 deduction for the 2007 year, provided the client can produce adequate documentation. In any case, I'd be reluctant to do anything to generate depreciation deductions for 2007 & beyond based on something that happened prior to 2007 without knowing that the associated income for the prior years had also been reported.

You gotta start somewhere.

[jainen]

>>he got divorced last year and "just left."<<

Document your advice that he must amend the prior years. Although you are not required to prepare the amendments, don't even take on 2007 unless he is ready to get serious about it. Tactfully remind him that there is at least one person with very adverse interests who knows he cheats on his taxes. (It's none of my business, but that's probably one of the reasons she kicked the bum out!) Speaking of financial malfeasance, it's a good idea to charge this new client up front. Tell him "purely cash" is acceptable.

In my opinion, he needs a whole lot more than "low-end reasonable estimates." It is not too much work to remember who his clients are, what dates he worked, and how much he charges. He also knows exactly what equipment he bought and what it cost. Have him reconstruct it on a calendar and then compile it in a proper P&L statement. Only meals and transportation require specific records, but don't take any other expenses he can't support like telephone, gifts, or supplies. And remember that most of his DJ stuff is listed property, so he needs to account for any personal use.

By the way, have you thought about how you are going to handle the community property issues?

[Kea]

While I've only just met this client, I have worked with his brother a couple of years. I really don't feel like he's trying to pull a fast one. In the previous years, he wasn't really considering a business - just more of a hobby. He wasn't making much money, and had lots of expenses. I honestly don't think he really ever realized it was something to report. He's young, and like most people (old and young) really doesn't understand the tax system. They only ever seem to know to keep the documents that get mailed to them. (How many stock sellers know they were supposed to keep their basis info?)

His biggest concern last night seemed to be on how complicated this was getting. He never seemed to be avoiding any of my questions. I explained clearly that not having documentation could not get you out of reporting income, but it could keep you from claiming expenses. He was OK with that. I'm not letting him take mileage and when I asked about other categories of expenses, he said there were none. So he's not trying to maximize his deductions. But since I know he has some significant expenses, I'm trying to give him the deductions I can. But I also know he can't document them. He does have the assets and because of the cost and nature of them, I am sure he bought them and that he did not receive them as gifts ($0 basis).

I wouldn't consider the items he purchased as listed items. From his descriptions, these are pretty specialized for professionals. But yes, I did ask about the personal use, and there is none.

I did drill into him the need for documentation of all income and expenses. He agreed that he would start keeping track of everything. He had a friend with him who also promised she would make sure he kept the documents. He seemed to think it was getting too complicated and maybe it wasn't worth having this business. But he's got most of the big expenses paid for now, and should start making money now. I discouraged him from giving up on the business just because he had to track the $.

Since he was divorced by the end of 2007 and the complications of it, I will probably treat his income / expenses as though he were divorced all year. I really don't see being able to separate the W-2 or DJ info and have him have the ex report that. I also doubt he would be able to get the ex to share her pre-divorce info. As for the pre-2007 assets, I will just count 1/2 the basis -- if I count it at all.

Thanks for the help.

[BulldogTom]

OK, from what you have stated, here is how you might want to proceed.

2005 and 2006 - activity is classified as a hobby. Advise that the returns need to be ammended to show the hobby income on the front of the 1040 and the expenses added to schedule A. Document your advice, let him make the decision to ammend or not, and move to 2007.

2007 the activity is now classified as a business. Take all the assets prior to 2007 purchase and add them to the depreciation schedule. Placed in service date is now the date the activity moved from a hobby to a business. Basis is lower of cost or FMV. Client can go to the supplier of the equipment and get a FMV estimate based on the age and condition of the used equipment. All equipment purchased after the business starting date is depreciated (sec 179?) in the normal manner. Help the client put some reasonable financial statement together that as best as possible reflects accurately the income and expense of the business. Put the client on notice that he must keep accurate records of the income and expense going forward. Help him set up something or do it for him (for a fee - of course). Next year, all is good.

My 2 cents.

Tom

Lodi, CA

[Kea]

Thanks Tom,

That's basically how I always handled these situations in the past. But now with the new preparer penalties, I want to do this in a clear / straightforward method that won't get me in trouble. In this case, I really don't think he's claiming anything fraudulently. He really just didn't know. Most clients that take on a new small business never seem to know what's involved before they start. I think he'll have better records next year.

Thanks!

[jainen]

>>new preparer penalties<<

Follow Tom's advice and you won't have to worry.

[Kea]

Thanks so much. I really appreciate everyone's advice.

[kcjenkins]

I agree with Tom. Also, for the equipment that he bought, if he does not know how to get receipts, and paid cash, I bet there is a store in town that sells used equipment, and he could get them to give him an estimate of what they would pay him for what he has. Let him get that, and you are safe to use those values, or even just a bit higher, as 'cost'. Also, have him take pics of all the equipment, which you could even keep in his file, as support for what he has and how it looks now.

[michaelmars]

here i go on my soapbox again but way overkill here in my opinion. report the $5m, thats a given. As for the expenses, he either purchased them, stole them, received them as a gift or found them. If we take the assumption he purchased them you can get the cost out of any music equipment catalog. Your only issue of debate is if he purchased them in 2007 or prior, perhaps the store or mfg has records if he filled out warrentee info. If you are too conservative to assume 2007 without real proof then assume 2005, get a fmv as stated above and take depr for 2007. As for mileage, if you are reporting the income from a job then take the mileage to/from the job, use mapquest! If the irs throws out the mileage then they do but your method is reasoned and logical and defendable.

don't forget all other expenses even if the client says there aren't any, he isn't a businessman obviously. Did you discuss where he makes his demo's etc, does he have a home studio, does he advertise, etc?

-Just my 2 cents