Claiming the Earned Income Tax Credit? Be Prepared to Substantiate Earned Income

This post originally appeared on Forbes.EITC

Most taxpayers are – or should be – aware of the need to substantiate deductions claimed on a tax return. If you deduct business expenses, charitable donations and other expenses and are chosen for an audit, you may need to provide canceled checks, receipts or credit card statements to prove that you incurred the expense. A recent Tax Court case illustrated a situation in which a taxpayer needed to prove that she earned all of the income she reported on her tax return.

According to court records, Myriam Cadet filed a federal income tax return for 2012 and reported net income of $17,190 earned from her business of selling used clothing at a flea market. Although Cadet was married, her husband lived in Haiti and transferred funds to her monthly to support herself and their three children. On her return, Cadet claimed Head of Household filing status and personal and dependent exemptions for herself and the three children.

Although she reported self-employment tax of $2,111 and withholding from wages of $14, Cadet also claimed an Earned Income Tax Credit (EITC) of $5,891 and additional child tax credits of $2,085, resulting in a claim for a refund of an overpayment of $5,879.Cadet testified that all of her transactions were in cash and she did not maintain any written records of her purchases or sales of clothing. The only documentation she provided was one receipt indicating she paid $689 for booth rental.The IRS determined that Cadet had failed to substantiate her earned income and recalculated earned

Cadet testified that all of her transactions were in cash and she did not maintain any written records of her purchases or sales of clothing. The only documentation she provided was one receipt indicating she paid $689 for booth rental.The IRS determined that Cadet had failed to substantiate her earned income and recalculated earned income of $1,565, including $925 of wages reported on a W-2 and $640 income from her clothing sales after taking into account the deductible portion of her self-employment tax. They then disallowed the entire additional child tax credit and all but $79 of the earned income credit that Cadet had claimed for 2012, reducing her overpayment to $638.

 

The IRS determined that Cadet had failed to substantiate her earned income and recalculated earned income of $1,565, including $925 of wages reported on a W-2 and $640 income from her clothing sales after taking into account the deductible portion of her self-employment tax. They then disallowed the entire additional child tax credit and all but $79 of the earned income credit that Cadet had claimed for 2012, reducing her overpayment to $638.

Because both the EITC and the additional child tax credit are based on the taxpayer having earned income, taxpayers claiming those credits may be asked to provide proof of the existence and amount of that income.

Because Cadet could not provide evidence of her income from the sale of clothing, the IRS took the position, and the Tax Court agreed, that it appeared Cadet might be grossing up her business income enough to maximize her utilization of refundable credits. It’s a good reminder, especially to anyone claiming refundable credits, that deductions aren’t the only items on your tax return that may need to be substantiated.

[Photo credit: Lending Memo]

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