Have you done your due diligence?

Under rules dating back to 1997, tax return preparers have been required to comply with special due diligence requirements when preparing returns claiming the earned income credit (EIC). However, in recent years, the due diligence requirements have expanded to other tax claims.

Starting in 2016, the Protecting Americans From Tax Hikes (PATH) Act added returns claiming the child tax credit (CTC) or American Opportunity education tax credit (AOTC) to the due diligence requirements. And, beginning with 2018 returns, the 2017 Tax Cuts and Jobs Act further expanded the due diligence requirements to returns claiming head of household (HOH) tax status. In addition, the Tax Cuts and Jobs Act expanded the CTC to include an additional child tax credit (ACTC) and credit for other dependents (ODC) who do not qualify for the regular credit, which is also subject to the due diligence requirements. The IRS has issued final regulations that reflect the expanded due diligence requirements [Treas. Reg. Sec. 1.6695-2].

Key Point: Guidance on the IRS website makes it clear that not meeting your due diligence requirements can have tough consequences for you, your firm, and your client (Consequence of Not Meeting Your Due Diligence Requirements, 12/29/2020).

Basic rules: A paid tax return preparer must complete Form 8867, Paid Preparer’s Due Diligence Checklist, for each return subject to the due diligence requirements. Form 8867 must be submitted with the taxpayer’s return. However, checking off boxes is not enough to satisfy the due diligence requirements.

Knowledge. The tax return preparer’s completion of Form 8867 must be based on information provided by the taxpayer, or otherwise reasonably obtained or known by the preparer. Moreover, the preparer must not know, or have reason to know, that any information used in determining the taxpayer’s eligibility to file as head of household or in determining the taxpayer’s eligibility for, or the amount of, any credit claimed on the return is incorrect.

Records. A tax return preparer must retain a copy of the completed Form 8867 and supporting records, including copies of documents provided by the taxpayer; a record of how, when, and from whom the information used to complete Form 8867 was obtained; and record of any additional questions asked of the taxpayer and the taxpayer’s answers. As a general rule, these records must be retained for three years from the later of the return due date or the date the return was filed.

The high cost of noncompliance. Failure to comply with the due diligence requirements can be costly—for you, your firm, and your client.

The preparer penalty for noncompliance is $500 per failure adjusted for inflation. The inflation-adjusted penalty amount for 2021 returns filed in 2022 is $545 per failure [Rev. Proc. 2020-45]. What’s more, a separate penalty applies for each claim on a return for which the due diligence requirements are not met [IRC Sec. 6695(g)]. So, for example, if a preparer files a head of household return for 2021 claiming the EITC, child tax credits, and an AOTC education credit without meeting the due diligence requirements, the potential penalty could be as high as $2,180.

The IRS can also assess separate penalties against a preparer’s firm if management knew of or participated in failure to comply with the due diligence requirements. Separate penalties can also be assessed if the firm failed to establish proper procedures to ensure compliance with the due diligence requirements or disregarded those procedures [Treas. Reg. Sec. 1.6695-2(c)].

The IRS guidance makes it clear that a preparer who fails to comply with the due diligence requirements can also face other consequences, including:

• Other civil return preparer.
• Suspension or expulsion from IRS e-file.
• Disciplinary action by the IRS Office of Professional Responsibility.
• An injunction barring the preparation of tax returns.
• Criminal penalties for filing false returns.

Key exception: On the other hand, a due diligence slip up may be excused if a preparer has adequate compliance systems in place. The penalty will not apply to a particular return if the tax return preparer can show that, considering all the facts and circumstances, the preparer’s normal office procedures are reasonably designed and routinely followed to ensure compliance with the due diligence requirements, and the failure to comply was isolated and inadvertent [Treas. Reg. Sec. 1.6695 (d)].

Failure to meet the due diligence requirements will also have adverse consequences for clients. If the IRS denies HOH filing status or credits claimed on the return, the client must pay back any amount refunded in error plus any additional assessment. In addition, the client will have to file Form 8862, Information to Claim Certain Credits After Disallowance, to renew any credit claims.

The consequences will be more severe if the client’s credit claims were reckless or fraudulent. A client can be banned from claiming the credits for two years if the improper credit claims were due to reckless or intentional disregard of the rules, or for 10 years if the credit claims were fraudulent [IRC  Sec. 24(g), 25A(b), 32(k)].

Editor’s note: This article was originally published on Feb. 5, 2020, and republished with all new content on Feb. 23, 2022. Check out the Intuit® Tax Pro Center’s variety of articles on compliance and IRS matters.