Business Income and Expense Questions and Answers

We have adopted new security measures for verifying refunds which require your client to send additional information to confirm the information you reported on their tax return. The Illinois Department of Revenue is committed to protecting everyone’s tax dollars and wants to make sure we are sending your client the correct refund amount.

By law, your client is required to keep adequate business records. Your client’s system of records should include enough information to correctly determine gross receipts, business expenses incurred, and the purchase price of assets acquired for use in the business. These records should also include inventory purchases, payroll, and other transactions occurring in the course of operating the business.

Your client’s books and records should include supporting documents. Supporting documents include sales slips, paid bills, invoices, receipts, deposit slips, and canceled checks. These documents are important to support the entries in the books and the tax return. These records will also help your client determine the value of inventory at the end of the year.

Source: IRS Schedule C and Record Reconstruction Training and Publication 583.

Gross receipts ‐ Gross receipts are the income received by the business. Your client should keep supporting documents that show the amounts and sources of gross receipts. Documents that show gross receipts include the following:

• Cash register receipts
• Bank statement and deposit slips
• Receipt books
• Invoices
• Credit card charge slips
• Forms 1099-MISC and 1099-K
• Any format (calendar, income ledger, etc.) that you consistently use to record receipts of the business

Purchases - Purchases are the items bought to resell to customers. Supporting documents should show the amount paid and that the amount was for purchases. Documents for purchases include the following:

• Canceled checks
• Cash register tape receipts
• Credit card sales slips
• Invoices

Expenses ‐ Expenses are the costs incurred (other than purchases) to carry on the business. The supporting documents should show the amount paid and that the amount was for a business expense. Documents for expenses include the following:

• Canceled checks
• Cash register receipts
• Account statements
• Credit card sales slips
• Invoices
• Petty cash slips for small cash payments

Assets - Assets are the property, such as machinery and furniture owned and used in the business. Your client must keep records to verify certain information about business assets. Your client needs records to figure the annual depreciation and the gain or loss when assets are sold.

The records should show the following information:

• When and how an asset was acquired
• Purchase price including purchase invoice, real estate closing statements, cancelled
  checks, etc.
• Cost of any improvements including invoices and cancelled checks
• Section 179 deduction taken
• Deductions taken for depreciation
• Deductions taken for casualty losses, such as losses resulting from fires or storms
• How the asset was used
• When and how the asset was disposed of, including sales invoice or closing statement
• Selling price
• Expenses of sale

Source: IRS Schedule C and Record Reconstruction Training and Publication 583.

Schedule C should include current operating costs of running the business. To be deductible, a business expense must be both ordinary and necessary.

• An ordinary expense is one that is common and accepted in your field of business, trade, or profession.
• A necessary expense is one that is helpful and appropriate for your business, trade, or profession.

To be correct and complete, the Schedule C should include all allowable business expenses. Your client’s records should not include any personal expenses. The following is a brief list of some common business expenses. See the Schedule C instructions and IRS Publication 535, Business Expenses, Publication 946, How to Depreciate Property, and Publication 587, Business Use of the Home, for more information.

Common business expenses include the following:

• Advertising
• Supplies
• Insurance
• Payroll or contract labor
• Utilities
• Interest on business loans
• Legal and professional fees
• Repairs
• Taxes
• Utilities
• Car and truck expenses
• Depreciation
• Business use of the home ‐ Most of your clients won’t qualify as they do not meet the exclusive use requirement. Most day care providers will not qualify as the statute requires a license or proof of exemption from the license requirement.
• Travel, transportation, entertainment, and gift expenses. Specific recordkeeping rules apply to these expenses. For more information, see IRS Publication 463.
• Employment taxes. There are specific employment tax records a taxpayer must keep. For a list, see IRS Publication 15.

Source: IRS Schedule C and Record Reconstruction Training

In general, to be considered a “business activity,” the activity must be for profit and every effort must be made to show positive income.

If your client is claiming expenses from a hobby that earns income, you must report these expenses on the Schedule A, not on the Schedule C.

In making the distinction between a hobby or business activity, take into account all facts and circumstances with respect to the activity. No one factor alone is decisive. You must generally consider these factors in determining whether your client’s activity is a business engaged in making a profit:

• Whether your client carries on the activity in a businesslike manner and maintain complete and accurate books and records.
• Whether the time and effort your client puts into the activity indicate your client’s intent to make it profitable.
• Whether your client depends on income from the activity for his/her livelihood.
• Whether your client’s losses are due to circumstances beyond his/her control (or are normal in the startup phase of your client’s type of business).
• Whether your client changes his/her methods of operation in an attempt to improve profitability.
• Whether your client or his/her advisors have the knowledge needed to carry on the activity as a successful business.
• Whether your client was successful in making a profit in similar activities in the past.
• Whether the activity makes a profit in some years and how much profit it makes.
• Whether your client can expect to make a future profit from the appreciation of the assets used in the activity.

Source: IRS Frequently Asked Questions

Common occupations that require a professional license from the Illinois Department of Financial and Professional Regulation (IDFPR) include:

• Acupuncturist
• Barber
• Cosmetologist
• Esthetician
• Hair Braider
• Home Inspection
• Massage Therapist
• Nail Technician
• Private Security Contractor
• Real Estate Appraiser

Click here for a full list of occupations regulated by the IDFPR.

If your client's occupation requires a professional license (such as a hair stylist or daycare provider) and your client did not have an active license for the tax year, you may only include the income or loss you are able to document through books and records in the calculation of your client's Illinois Earned Income Credit. For more information about acceptable books and records documentation, see "What are examples of supporting documents?"

If your client cannot provide the requested support, we will not issue the refund requested. No further action is needed or will be taken on the account.

An amended federal and state tax return may be filed to correct the amount of business income or loss included in the Adjusted Gross Income (AGI) reported on his/her return.

Either the information provided did not support the amounts claimed on the Schedule C or your client did not provide all the information requested.

In order to allow your client’s Illinois Earned Income Credit, complete, accurate, and legitimate documentation which supports all amounts claimed on the Schedule C, both income and expenses, is required.

If you and your client do not agree with our determination and cannot provide the information requested, file Form IL‐1040‐X, Amended Individual Income Tax Return, along with any required documentation to support your client’s figures. If we deny your client’s claim, your client may file a written protest against the denial and request an administrative hearing. An administrative hearing is a formal proceeding conducted pursuant to the rules adopted by the Department and is presided over by an administrative law judge. An attorney representing the Department will be present. Your client may represent themselves or have an attorney there to represent them. See the Form IL‐1040‐X Instructions for more information.

EITC 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.

Basically, EITC 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, and
• Document additional inquiries and the client’s response.

Source: IRS Schedule C and Record Reconstruction Training

• EITC 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 EITC due diligence and the client’s responses must be documented.
• The statute also requires the EITC return preparer to be reasonable, well‐informed, and knowledgeable in the tax law.
• Paid tax return preparers generally can rely on the taxpayer’s representations, but EITC 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.

Tax 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.
• As a paid preparer, you should ask sufficient questions of clients claiming self‐employment income to be satisfied that:

1. The client actually conducts a business,

2. The client has records to support income and expenses, or can reasonably reconstruct income and expenses records, and

3. The client has included all income and related expenses on Schedule C, Profit or Loss from Business (Sole Proprietorship).

Source: IRS Schedule C and Record Reconstruction Training

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 Earned Income Tax Credit was disallowed. If you are ineligible for the EITC with the IRS, you are also not eligible for the Illinois Earned Income Credit.
• Return preparers who fail to comply with EITC due diligence requirements can be assessed a $500 penalty by the IRS 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.
• Other return preparer penalties ranging from $1,000 to $5,000 may also be assessed by the IRS 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 the US Treasury Department’s Circular 230 and are subject to consequences if the standards are not upheld. This could include revocation of your PTIN.

Source: IRS Schedule C and Record Reconstruction Training