Logo

Due Diligence: An Area Demanding Caution

mug lach kathleenIt is critical for tax professionals to periodically pause and review the stringent guidelines tax return preparers must adhere to in order to avoid any IRS scrutiny on their return preparation. In particular, the due diligence standard has the IRS’ attention, most often in the context of the child tax and earned income credits, and now, eligibility to file as head of household.1 Penalties for failure to exercise due diligence in these areas may be harsh, running $500 for each failure to comply with the requirements.2

Preparers must complete Form 8867, the due diligence check list, each year, no matter if they have had the same client for years, to claim the Earned Income Credit, American Opportunity Tax Credit, the Child Tax Credit, the Credit for Other Dependents, and for Head of Household filing status. The checklist must be completed with current information provided by each client if they are going to claim the credit, and it is generally submitted electronically with the return. A preparer should keep a copy of the form (with client documents) and any supporting documentation in the client file in the event return is selected for audit, and the preparer has to defend the information on the return. Since this is an area of renewed IRS focus, it is in the best interest of the preparer to take the time to fully complete the checklist, and ask questions when the information provided is not consistent, or does not seem accurate. The form specifically asks if the preparer has interviewed the client, and if any information provided seems inconsistent. A key requirement is contained in number four of the form 3 :

• Did any information provided by the taxpayer or a third party for use in preparing the return, or information reasonably known to you, appear to be incorrect, incomplete, or inconsistent?

• Did you make reasonable inquiries to determine the correct, complete, and consistent information?

• Did you document your inquiries? (Documentation should include the questions you asked, whom you asked, when you asked, the information that was provided, and the impact the information had on your preparation of the return.)

The preparer must ask questions. If he knows his client has recently divorced, he should confirm where the children reside, the time spent in each household, and confirm the address for each child. It may be helpful to have school records in the file. If a client is reluctant to provide clarifying information or documentation, it may be a signal that there is an issue on the return. A preparer should take clear and concise notes on each file, ask for paperwork from the client, and keep it in the file. Taking these few extra steps, although time consuming, may prove well worthwhile if the IRS comes back to the preparer to defend the return.

In addition, penalties are applicable under Internal Revenue Code section 6695 for:

• Failure to furnish a copy of the return to the taxpayer
• Failure to sign the return
• Failure to furnish an identifying number
• Failure to retain a copy of the return or list
• Failure to file correct information returns
• Negotiating a check 4

The IRS is actively auditing returns which claim these credits, and in many instances reviewing the practices of the preparers, opening new preparer investigation cases. These cases can lead to multiple return audits within a tax preparation firm, with auditors asking for complete files and notes, and detailed questions on client contact and interviews.

Along with heightened scrutiny in the due diligence arena, preparers may be subject to penalties for taking “unreasonable” positions on a return. A preparer may be subject to a penalty of $1,000 or 50% of the income derived by preparation of the return for taking an “unreasonable” position, causing an understatement of tax.5 If the IRS determines that any understatement on a return was due to willful or reckless conduct by the preparer, the fine goes to $5,000, or 50% of the income derived from the engagement.6 In addition, under the willful and reckless standard, a preparer will in most cases be referred to the IRS Office of Professional Responsibility for review of his or her ability to represent taxpayers before the IRS.

When interviewing your client, all factors must be considered before making a recommendation on positions to take on the return. For example, if your client has rental property, you would not assume he is a real estate professional, even though he may hold himself out to be one. This is a hot area for IRS audit, particularly if there are losses associated with the rental, taken against ordinary income. Hobby losses are another area of heightened scrutiny. If a client is entitled to these deductions, there should be no issue if the return is selected for audit. The preparer, however, should be ready to defend any position on the return, and have back-up in the file for support.

Although the cautionary approach to return preparation may take more time when time is of a premium during filing season, in audit situations, the extra time and due diligence exercised by a preparer may be invaluable in the long run.


1. IRC §6695(g)
2. IRC §6695(g)
3. IRS, Form 8867
4. IRC §6695(a)-(f)
5. IRC §6694(a)
6. IRC §6694(b)


Kathleen M. Lach is a Partner in the Tax and Litigation Departments of Arnstein & Lehr LLP. She represents clients before a variety of different tax authorities, including the Internal Revenue Service, the Illinois Department of Revenue, and the Illinois Department of Employment Security.

© 2016 Abide Media