The “Paid Preparer’s Due Diligence Checklist” (otherwise known as Form 8867) and the related due diligence regulation have historically been associated with the Earned Income Tax Credit and only occasionally required. Each will have a much more prominent role in most return preparers’ practices beginning in the 2019 filing season. In fact, as a result of several recent legislative changes, return preparers will likely find that the regulation’s due diligence is required for almost every Form 1040 return impacted by dependents.
The first factor expanding the required due diligence arises from the combined impact of the 2015 Protect Americans from Tax Hikes Act (the PATH Act) and the 2017 tax legislation (the TCJA). The PATH Act extended the section 6695 regulatory due diligence requirements to tax returns claiming the Child Tax Credit. The impact of this change (which increased the frequency of due diligence) will be compounded for the 2018 through 2025 tax years as a result of the TCJA’s significant expansion of the Child Tax Credit. For those tax years, the Child Tax Credit essentially replaces the dependency exemption for most taxpayers. Almost all individual taxpayers with qualifying dependents will be able to claim a Child Tax Credit because the credit does not begin phasing out until modified AGI reaches $400,000 for joint filers and $200,000 for all other filers. In addition, the TCJA expands the categories of dependents that qualify for the Child Tax Credit by creating a $500 credit for qualifying relatives. Prior to the TCJA, children under the age of 17 were qualifying children for child tax credit purposes. Under the TCJA, the taxpayer’s children ages 17 through 23, lineal ancestors, stepparents, aunts, uncles, nieces, nephews, certain in-laws, and certain other dependents who live with the taxpayer are qualifying relatives that may give rise to the child tax credit.
The second factor is required due diligence in new areas. The PATH Act expanded regulatory due diligence requirements to tax returns claiming the American Opportunity Credit and the Additional Child Tax Credit, and the TCJA expanded the associated due diligence requirements for claiming head of household filing status.
Under the final regulations promulgated under section 6695 on November 5, 2018, completing Form 8867 (based on information provided by the taxpayer) is an essential part of the due diligence process. There are, however, additional due diligence requirements that return preparers often overlook, including (1) completing the applicable worksheets prescribed by the Service or recording in one or more documents the method and information used to make the computations, (2) meeting the knowledge requirements concerning the basis for the benefits claimed on the return and contemporaneously documenting inquiries and responses related to meeting the knowledge requirements, and (3) retaining the documents used in preparing the return for three years. A return preparer who completes and files Form 8867 but fails to comply with the additional regulatory requirements may be subject to penalties.
Penalties for failure to be diligent are usually associated with the return preparer’s failure to meet the knowledge requirements. This provision states that a return preparer: (1) must not know that any information used to determine the taxpayer’s eligibility is incorrect, (2) must not have reason to know that any information used to determine the taxpayer’s eligibility is incorrect, (3) may not ignore the implications of information furnished to, or know by, the return preparer, (4) must make reasonable inquiries if the information appears to be incorrect, inconsistent or incomplete, and, arguably most important, (5) must contemporaneously document in his or her file any inquiries made and the responses to those inquiries.
As detailed below, the examples in the regulation focus on when information should appear incorrect, inconsistent, or incomplete to the return preparer and when a return preparer can rely on existing knowledge.
The regulation provides the following example of a situation where additional inquiries are required because the information provided by the taxpayer should appear incorrect to the return preparer.
W engages Preparer F to prepare her federal income tax return. During Preparer F’s standard intake interview, W states that she is 50 years old, has never been married, and has no children. W further states to Preparer F that during the tax year she was self-employed, earned $10,000 from her business, and had no business expenses or other income. Preparer F believes W may be eligible for the Earned Income Tax Credit. To meet the knowledge requirement, Preparer F must make reasonable inquiries to determine whether W is eligible for the Earned Income Tax Credit, including reasonable inquiries to determine whether W’s business income and expenses are correct, and Preparer F must contemporaneously document these inquiries and the responses.
The regulation does not explain why additional due diligence is required in this fact pattern. However, the fact pattern suggests that return preparers should suspect that the information provided by the taxpayer may be incorrect when a self-employed individual indicates that he or she did not incur any business expenses. In this example, the facts are particularly suspect because the taxpayer reports self-employment income in an amount that would maximize the taxpayer’s Earned Income Tax Credit. Therefore, the return preparer must make additional inquiries to confirm that the taxpayer has not omitted business expenses to maximize her Earned Income Tax Credit.
The regulation provides the following example of a situation where the information provided by the taxpayer appears to be inconsistent.
In 2018, Q, a 22 year-old taxpayer, engages Preparer C to prepare Q’s 2017 federal income tax return. Q completes Preparer C’s standard intake questionnaire and states that she has never been married and has two sons, ages 10 and 11. Based on the intake sheet and other information that Q provides, including information that shows that the boys lived with Q throughout 2017, Preparer C believes that Q may be eligible to claim each boy as a qualifying child for purposes of the Earned Income Tax Credit and the Child Tax Credit. However, Q provides no information to Preparer C, and Preparer C does not have any information from other sources, to verify the relationship between Q and the boys. To meet the knowledge requirement, Preparer C must make reasonable inquiries to determine whether each boy is a qualifying child of Q for purposes of the Earned Income Tax Credit and the Child Tax Credit, including reasonable inquiries to verify Q’s relationship to the boys, and Preparer C must contemporaneously document these inquiries and the responses.
In this example, the inconsistent information is clearly the taxpayer’s age in relationship to her children’s ages, and the return preparer must conduct additional due diligence to confirm the relationship. The regulation also provides an example that indicates additional due diligence is required when a 32-year-old taxpayer seemingly qualifies for the American Opportunity Tax Credit. The regulation does not explain why that fact pattern is inconsistent, but it may be that the Service believes a reasonable return preparer should question whether a 32-year-old taxpayer may not be qualified to claim the American Opportunity Credit because the taxpayer (a) has previously finished four years of higher education, (b) claimed the American Opportunity Credit (or the former Hope credit) for more than four tax years, or (c) is not pursuing a degree or other recognized educational credential.
The regulation provides the following examples of situations where additional inquiries are necessary because the taxpayer did not provide complete information.
In 2018, R, an 18 year-old taxpayer, engages Preparer D to prepare R’s 2017 federal income tax return. R completes Preparer D’s standard intake questionnaire and states that she has never been married, has one child, an infant, and that she and her infant lived with R’s parents during part of the 2017 tax year. R also provides Preparer D with a Form W-2 showing that she earned $10,000 during 2017. R provides no other documents or information showing that R earned any other income during the tax year. Based on the intake sheet and other information that R provides, Preparer D believes that R may be eligible to claim the infant as a qualifying child for the Earned Income Tax Credit and the Child Tax Credit. To meet the knowledge requirement, Preparer D must make reasonable inquiries to determine whether R is eligible to claim these credits, including reasonable inquiries to verify that R is not a qualifying child of her parents (which would make R ineligible to claim the Earned Income Tax Credit) or a dependent of her parents (which would make R ineligible to claim the Child Tax Credit), and Preparer D must contemporaneously document these inquiries and the responses.
In 2019, S engages Preparer E to prepare his 2018 federal income tax return. During Preparer E’s standard intake interview, S states that he has never been married and that his niece and nephew lived with him for part of the 2018 taxable year. Preparer E believes S may be eligible to file as head of household and claim each of these children as a qualifying child for purposes of the Earned Income Tax Credit and the Child Tax Credit, but the information furnished to Preparer E is incomplete. To meet the knowledge requirement, Preparer E must make reasonable inquiries to determine whether S is eligible to file as head of household and whether each child is a qualifying child for purposes of the Earned Income Tax Credit and the Child Tax Credit, including reasonable inquiries about the children’s residency, S’s relationship to the children, the children’s income, the sources of support for the children, and S’s contribution to the payment of costs related to operating the household, and preparer E must contemporaneously document these inquiries and the responses.
The second example above was modified in the final regulation to clarify that the Service believes additional due diligence is required in that fact pattern because the information is incomplete. This modification, combined with the first example, suggests that the Service believes additional due diligence is required whenever the facts indicate that the qualifying child or other qualifying relative might be a dependent of someone other than the taxpayer.
In certain circumstances a return preparer may satisfy the knowledge requirement based on existing knowledge without having to make additional inquiries. The following examples in the regulation illustrate some of these situations.
Returning to taxpayer Q above (a 22 year-old taxpayer, that has never been married and has two sons, ages 10 and 11), as part of preparing Q’s 2017 federal income tax return, Preparer C made sufficient reasonable inquiries to verify that the boys were Q’s legally adopted children. When preparing Q’s 2018 federal income tax return, Preparer C is not required to make additional inquiries to determine the boys’ relationship to Q.
Returning to taxpayer R above (an 18 year-old taxpayer, who has never been married, has one child, an infant, and lived with her parents during part of the 2017 tax year), Preparer D previously prepared the 2017 joint federal income tax return for R’s parents. Based on information provided by R’s parents, Preparer D has determined that R is not eligible to be claimed as a dependent or as a qualifying child for purposes of the Earned Income Tax Credit or Child Tax Credit on R’s parents’ return. Therefore, Preparer D is not required to make additional inquiries to determine that R is not her parents’ qualifying child or dependent.
Such pre-existing knowledge, however, must have been acquired in the context of the tax return preparer’s tax return preparation practice. The return preparer may not rely on pre-existing knowledge acquired from outside social interactions. The following example from the regulation illustrates this distinction.
Returning to taxpayer S above (never married and his niece and nephew lived with him for part of the 2018 taxable year), Preparer E knows from prior social interactions with S that the children resided with S for more than one-half of the 2018 tax year and that the children did not provide over one-half of their own support for the 2018 tax year. To meet the knowledge requirement, Preparer E must make the same reasonable inquiries to determine whether S is eligible to file as head of household and whether each child is a qualifying child for purposes of the Earned Income Tax Credit and the Child Tax Credit, including reasonable inquiries about the children’s residency, S’s relationship to the children, the children’s income, the sources of support for the children, and S’s contribution to the payment of costs related to operating the household, and preparer E must contemporaneously document these inquiries and the responses.
The above examples also reinforce the requirement to contemporaneously document the inquiries made and the responses to those inquiries. During the regulatory comment period, one commenter recommended that the Service permit return preparers to demonstrate satisfaction of the knowledge requirement through other forms of evidence, such as testimony that additional inquiries were made. The Service rejected this suggestion and reiterated that contemporaneous documentation is an important requirement for improving compliance and reducing the error rate in tax returns.
Section 6695(g) imposes a $500 penalty on return preparers for each failure to be diligent. Prior to recent changes, each failure to be diligent was a per-return penalty. After the PATH Act and TCJA expansion of section 6695(g), however, the regulation provides for a separate penalty for each credit or head of household status claimed on a return; thus, the Service may impose multiple penalties in connection with a single return. The Service’s position is illustrated by the following example from the regulation.
Preparer C prepares a federal income tax return for a taxpayer using the head of household filing status and claiming the Child Tax Credit and the American Opportunity Tax Credit. Preparer C did not meet the due diligence requirements under this section with respect to the head of household filing status and the Child Tax Credit claimed on the taxpayer’s return. … Unless the exception to penalty provided by Treas. Reg. 1.6695-2(d) applies, Preparer C is subject to two penalties under section 6695(g) for the failure to meet the due diligence requirements: one for the head of household filing status and one for the Child Tax Credit. … .
The regulation provides an exception to penalty at the Service’s discretion. The penalty will not be assessed if the return preparer can demonstrate to the satisfaction of the Service that, considering all the facts and circumstances, the return preparer’s normal office procedures are reasonably designed and routinely followed to ensure compliance with the due diligence requirements, and the failure to meet the due diligence requirements with respect to a tax return was isolated and inadvertent.
Form 8867, and the related due diligence required under Treas. Reg. § 1.6695-2, will likely be required on a significant number of individual tax returns for the 2018 and subsequent tax years. Return preparers must be alert to situations which require additional due diligence because the information provided by the taxpayer is incorrect, inconsistent, or incomplete. In these situations, the return preparer must make additional inquiries and must be sure to contemporaneously document the inquiries and responses to avoid the $500 penalty imposed under section 6695(g) for each failure to be diligent.
