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Have You Done Your Due Diligence?

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Under rules dating back to 1997, tax return preparers were required to comply with special due diligence requirements when preparing returns claiming the earned income tax credit (EITC). However, in recent years, the due diligence requirements 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 credit (AOTC) to the due diligence requirements. And, beginning with 2018 returns, the Tax Cuts and Jobs Act further expanded the due diligence requirements to returns claiming head of household (HOH) tax status. In addition, tax reform expanded the CTC to include an additional credit for other dependents (ODC) who do not qualify for the regular credit, which is also subject to the due diligence requirements. The IRS issued final regulations that reflect the expanded due diligence requirements [Treas. Reg. Sec. 1.6695-2].

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 the 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 a 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.

Key questions. The latest version of Form 8867 requires preparers to answer key questions for each of the claims subject to the due diligence requirements.

EITC. To establish due diligence for a return claiming the EITC, a preparer must answer these questions:

  • Did you determine that the taxpayer is, in fact, eligible to claim the EITC for the number of children for whom the credit is claimed, or to claim the EITC if the taxpayer has no qualifying children?
  • Did you ask the taxpayer if the child lived with the taxpayer for over half the year, even if the taxpayer supported the child for the entire year?
  • Did you explain the rules for claiming the EITC when a child is the qualifying child of more than one person?

CTC. Key questions for child tax credit claims are:

  • Did you determine that each qualifying person is the taxpayer’s dependent who is a citizen, national or resident of the United States?
  • Did you explain that the taxpayer may not claim the CTC if the taxpayer did not live with the child for over half the year unless the child’s custodial parent released a claim to exemption for the child?
  • Did you explain the rule for claiming the CTC or ODC for a child of divorced or separated parents?

AOTC. For the AOTC, there is one key question:

  • Did the taxpayer provide required substantiation for the credit, including an information return (Form 1098-T, Tuition Statement) from the educational institution, or receipts for qualified tuition and related expenses?

HOH. Here again, there is one key question:

  • Did you determine that the taxpayer was unmarried or considered unmarried on the last day of the tax year, and provided more than half the cost of keeping up a home for a qualifying person?

The Cost of Noncompliance

Failure to comply with the due diligence requirements can be costly. The statutory penalty for noncompliance is $500 per failure adjusted for inflation. The inflation-adjusted penalty amount for 2019 returns is $530 (Rev. Proc. 2018-57). What’s more, the regulations provide that, unless an exception applies, a separate penalty applies for each claim on a return for which the due diligence requirements are not met. So, for example, if a preparer files a head of household return for 2019 claiming the EITC and CTCs without meeting the due diligence requirements, the potential penalty could be as high as $1,590.

Key exception: On the other hand, a due diligence slip-up may be excused if a preparer has adequate compliance systems in the 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.

Editor’s note: Check out the Intuit® Tax Pro Center’s variety of articles on compliance and IRS matters.