Tax Return Due Diligence: Basic Considerations

By Douglas J. Milford, CPA, J.D., and J. Edward Swails, CPA, J.D.


  • Due diligence, in the context of tax return preparation, is the diligence or care that a reasonable preparer would use under the same circumstances. It is an objective standard.
  • Under the general due diligence standards set out in the regulations, the preparer can on most occasions rely in good faith and without verification on information provided by the client or third parties and contained in previously filed returns. However, in some situations the preparer will be required to make further inquiries to verify the accuracy and completeness of the information provided to meet the due diligence requirements.
  • The Code and regulations provide for enhanced due diligence requirements with respect to claims for the earned income tax credit. Preparers are required to exercise due diligence in determining whether a client has met the requirements for reporting foreign bank and other financial accounts.

In the popular movie The Verdict, a critical plot point is the question of a hospital’s due diligence and negligence. A patient at the hospital was in a vegetative state, and the family was suing the hospital over whether its behavior and the circumstances surrounding the administration of anesthesia were appropriate. There is further controversy over the documentation as to whether the admitting nurse “did the right thing” in checking into whether the patient had eaten anything outside the appropriate time frame for safely administering anesthesia. Did the hospital do the right thing? What would a normal and prudent medical staff do under the circumstances? What was the role of documentation in the determination of the hospital’s liability?

While the situation may not have the same drama as The Verdict, a tax professional may be asked the same types of questions if something goes awry and there is a mistake on a return or an understatement of tax. With the perspective of hindsight, did the tax return preparer do the right thing? What exactly is the right thing to do in determining a tax return position? Did the preparer apply the law appropriately to the facts? Did he or she have all the relevant facts? What effort is required of a reasonable and prudent preparer to obtain the pertinent facts? What should the preparer document in the client’s file?

In fact, this scenario is far from hypothetical: The IRS asks tax return preparers these questions every day. CPAs recognize that they serve an important role in the effective administration of the tax system. At the same time, they are also advocates for clients and are motivated to assist their clients in achieving an optimal tax result. There are also time and budget constraints on the entire process. Until recently, CPAs were part of a largely self-regulated profession. However, more attention is being paid to the concept of preparer due diligence and its impact on “unreasonable” tax positions. It is the authors’ view that if tax professionals do not understand these rules and proactively adapt to them in a practical manner, additional external regulation may be used to discourage inappropriate tax positions and collectively reduce the tax gap. The CPA’s role as an advocate for the client can still be effective and valuable while stopping short of having to audit, or make a skeptical inquiry of, every client assertion made in the course of return preparation.

Discussion and Examples

There may be as many ways to prepare tax returns as there are tax return preparers. 1 There is no universally accepted standard as to the steps that preparers must take when preparing a return. When the return is completed and ready for submission to the IRS, the preparer signs a declaration under penalties of perjury that the return is—to the best of the knowledge and belief—true, correct, and complete. The preparer bases that declaration on all information about which he or she has any knowledge. When issues arise in connection with the preparation of a return, the issue often comes down to whether the preparer exercised due diligence when preparing it. When a preparer is found to have failed to exercise due diligence, possible outcomes include a dissatisfied client, penalties asserted against the client and the preparer, other professional sanctions such as those related to the preparer’s licenses and Circular 230, 2 and actions for damages pursued by the client or, more accurately most of the time, the former client.

Dictionary definitions of “due diligence” suggest that it means the diligence or care that a reasonable person or, in this context, a reasonable tax return preparer would use under the same circumstances. 3 While court cases relating to disciplinary or malpractice actions against preparers often refer to a preparer’s due diligence, they do not appear to define the term in any manner that is unique to tax preparers. Furthermore, the cases do not appear to create bright lines that are useful to preparers in planning return preparation engagements or resolving difficult issues that may arise during those engagements. It is clear, however, that the courts apply an objective test of reasonableness. Although sometimes argued, it generally is not relevant that the preparer subjectively believed a position to be reasonable. This potential trap provides a compelling reason to double check one’s preliminary conclusions on a position with a colleague for another objective perspective.

The regulations also use the term “diligence” and generally describe due diligence as synonymous with the concept of acting with reasonable care and in good faith. While the regulations do not provide exhaustive guidelines on what constitutes due diligence in the preparation of a return, they address the issue generally and also provide some details in connection with the reliance on client information, the work of other preparers, and prior-year returns. Against this backdrop, one can extrapolate the level of effort expected to satisfy the due diligence standard in other common situations.

A fundamental precept of the preparer regulations has to do with the concept of reliance by the preparer. The general rule is that the preparer may rely in good faith and without verification upon information furnished by the taxpayer. The preparer is not required to audit, examine, or review books and records, business operations, documents, or other evidence to independently verify information provided by the taxpayer; however, the preparer may not ignore the implications of information furnished by the taxpayer. The preparer must make reasonable inquiries if the information as furnished appears to be incorrect or incomplete. 4

Example 1: A, a return preparer, asks her client, B, to complete an organizer to help her in the preparation of his 2009 Form 1040. B completes the organizer page on securities transactions, including information that he bought 200 shares of Z Corp. for $2,000 on January 14, 2009, and sold them for $2,200 on April 17, 2009.

Unless she has some reason to suspect that the information provided in the organizer is incorrect or incomplete, A has acted with appropriate due diligence when preparing B’s Schedule D using this information without further inquiries. Specifically, unless she has reason to suspect that the information in the organizer is incorrect or incomplete, she can prepare the return with appropriate due diligence even though she does not examine trade confirmations or brokerage statements.

Example 2: F ’s firm prepares a corporate tax return for M, a medical practice. F also prepares the individual income tax return for M’s sole shareholder, S. M’s books and records include loans to the corporation from S and a bank. F then prepares S ’s tax return without including any interest income paid by M to S. Based on these specific background facts known to F, he did not make any further inquiries as to whether M had paid any interest to S.

On these and similar fact patterns, courts have found that the information provided to F would lead a reasonable, prudent preparer to seek additional information related to the interest paid on the loans, so F is negligent in not making further inquiries leading to an understatement of tax by the shareholder. 5

As an additional requirement to the general rule concerning reliance on information, the regulations provide that for provisions of the Code or regulations requiring that specific facts and circumstances exist (for example, that the taxpayer maintain specific documents) before a deduction or credit may be claimed, the preparer must make appropriate inquiries to determine the existence of the required facts and circumstances. 6 While the regulation requires the preparer to make such inquiries, absent some reason to suspect that the client’s representation as to the required circumstances is incorrect or incomplete, the preparer generally may rely on that representation that the circumstances have been satisfied. The most critical exception to this general rule—the special regime applicable to the earned income credit—is discussed in the following example.

Example 3: G asks H to prepare an organizer to assist her in preparing his 2009 Form 1040. H, who travels in connection with his Schedule C business, states in the organizer the amount he incurs for lodging and other travel expenses while away from home. The organizer also summarizes the requirement in Sec. 274(d) and the regulations thereunder for documentation such as receipts to support these deductions, and it asks the client to check a box to indicate that he has complied with this requirement. H checks this box. Unless G has reason to suspect that H ’s travel expense amount is incorrect or that his response about documentation is incorrect, she has exercised appropriate due diligence when she computes a deduction for travel expenses based on the information provided.

Specifically, as a part of preparing the return, G is not required to verify the accuracy of the amounts in the documentation against the number in the organizer or even to ask H to produce the receipts or other documentation to verify their existence unless she has reason to question the information provided in the organizer or H’s statement that they exist. While this is clearly the general rule, the IRS has suggested that there may be important exceptions. In what circumstances would the IRS conclude that preparers did not go far enough in their due diligence when they relied on incorrect information provided by a taxpayer? In Rev. Rul. 80-266, 7 the IRS reviewed three scenarios related to the dynamics of a preparer’s diligence regarding entertainment expense documentation. The following examples recap the ruling’s conclusions.

Example 4: J was engaged to prepare a tax return for K. In reviewing a position related to entertainment expenses, J asked K if she had records showing the time, place, and business purpose of the expenses within the requirements of Sec. 274(d). K told J that she had such records. J prepared the returns taking the deduction. Upon examination, the IRS disallowed a portion of the deduction because K could not substantiate the claimed deduction.

Because in this scenario J made the appropriate inquiries as to whether K had appropriate documentation to substantiate the deduction under the regulations and there were no other factors indicating a need to inquire further, the revenue ruling concluded it was proper to prepare a return claiming the deduction.

Example 5: Unlike in Example 4, J completely fails to inquire about the existence of the required records, and K does not make any statements about having the required documentation.

In this scenario, the IRS concluded that J did not demonstrate that his normal office practice should prevent the Sec. 6694(a) preparer penalty.

Example 6: The facts are the same as in Examples 4 and 5, except that the IRS has previously examined K and in that examination could not substantiate her entertainment expenses. It is assumed that J knows this had happened.

In this situation, the ruling concludes that J should have made further inquiries to reconcile the inadequacy of the records in the recent examination to reasonably conclude that the taxpayer now has adequate records. The preparer could not ignore the implications of the taxpayer’s recent examination history where the specific issue of entertainment documentation was the determining factor.

The regulations apply essentially identical reliance standards to information provided by third parties. Thus, the preparer can generally rely in good faith and without verification upon information and advice furnished by another adviser, another tax return preparer, or other party, including another adviser or tax return preparer at the preparer’s firm. 8

In this regard, the regulations specifically state that the preparer may rely in good faith on the advice of, or schedules or other documents prepared by, the taxpayer, another adviser, another tax return preparer, or another party (including another adviser or preparer at the preparer’s firm) who the preparer has reason to believe was competent to render the advice or other information. The advice or information may be written or oral, but in either case the burden of establishing that the advice or information was received is on the preparer. The regulations also provide that the preparer is not considered to have relied in good faith if (1) the advice or information is unreasonable on its face; (2) the preparer knew or should have known that the other party providing the advice or information was not aware of all relevant facts; or (3) the preparer knew or should have known (given the nature of the return preparer’s practice), at the time the return or claim for refund was prepared, that the advice or information was no longer reliable due to developments in the law since the time the advice was given. 9

Example 7: L has been retained to prepare the 2009 Form 1120, U.S. Corporation Income Tax Return, for M Corp. She is told that M hired N&O, a reputable CPA firm in her community, to perform a tax analysis of M’s research activities for 2009 and that as part of that engagement N&O prepared a Form 6765, Credit for Increasing Research Activities, for use in connection with the client’s 2009 return. Assuming that none of the exceptions to the general rule are applicable (the form is not unreasonable on its face, etc.), L can prepare M’s return with appropriate due diligence by using the Form 6765 without additional verification. Specifically, unless one of the exceptions set forth in the regulation is implicated, L can prepare the return using the Form 6765 without examining N&O’s workpapers or the M business records that N&O may have reviewed during the course of its engagement.

Two additional points can be made in this scenario. First, if the Form 6765 constitutes a “substantial portion” of the M return, N&O would meet the definition of a nonsigning preparer of this tax return position and may be subject to penalty risk for potential understatement penalties. 10 In addition, because L maintains the primary responsibility for the overall substantive accuracy of M’s Form 1120, she would be required to exercise due diligence related to the third-party-prepared Form 6765 in order to avoid her own penalty risk as the tax return signer. 11

Second, while beyond the scope of this article, research credit controversies frequently involve a taxpayer’s general responsibility to keep adequate books and records to support a deduction or credit. 12

Practice tip: It generally would be an appropriate and value-added service for CPAs to educate clients on the specific requirements and the IRS’s point of view in this area in order to avoid surprises upon examination, even if not required by professional standards to do so.

In the course of preparing tax returns, preparers frequently encounter tax returns that the taxpayer previously has filed. The regulations offer specific guidance for these situations, providing that a preparer may rely in good faith without verification upon a tax return that has been previously prepared by a taxpayer or another tax return preparer and filed with the IRS. For example, a preparer who prepares an amended return (including a claim for refund) need not verify the positions on the original return. The preparer, however, may not ignore the implications of information furnished or actually known to the preparer. He or she must make reasonable inquiries if the information being furnished appears to be incorrect or incomplete. The preparer must confirm that the position being relied upon has not been adjusted by examination or otherwise. 13

Example 8: Q is preparing the 2009 Form 1120 for P Corp. She did not prepare its 2008 Form 1120, and she asks for a copy of it. She reads the return and notes that it contains a schedule showing that P Corp has $1 million in net operating loss carryover and $850,000 of alternative minimum tax net operating loss carryover to 2009. Q does not note any errors in the return, has no reason to question the accuracy of these numbers, and confirms that the items have not been adjusted by examination or otherwise. In fulfilling her duty to exercise due diligence in the course of preparing the 2009 return, it is not necessary for Q to perform any further procedures with respect to the carryover numbers. Specifically, it is not necessary for her to review the workpapers supporting the 2008 return as a predicate to preparing a 2009 return utilizing the carryover.

Example 9: S is preparing R Corp.’s 2009 Form 1120. She did not prepare R’s 2008 Form 1120, and she asks for a copy of it. In reading the return, she notes that there is no deduction for repairs and maintenance on line 14. Curious, she investigates and determines that through an oversight, the deduction—$75,000—was omitted from the return. S does not note any other errors in the return, has no reason to question the accuracy of any other item, and confirms that the items have not been adjusted by examination or otherwise.

In fulfilling her duty to exercise due diligence in the course of preparing a Form 1120X, Amended U.S. Corporation Income Tax Return, for 2008 to report the omitted deduction, it is not necessary for S to perform any procedures with respect to any other item on the 2008 tax return. Specifically, it is not necessary for her to review the workpapers supporting the other items on the 2008 tax return as a predicate to amending the return. Note that the client may wish to engage S to review other items on the 2008 tax return (for the client’s peace of mind), but that should not obscure the point that because S has no reason to question the accuracy of any other items on the return, she has no professional obligation to verify their accuracy as an integral part of preparing the amended return.

As noted above, the concept of due diligence is implicated when a preparer seeks to qualify for the exception to the penalty that applies when the preparer demonstrates that the understatement was due to reasonable cause and that the preparer acted in good faith. The regulations indicate that all the facts and circumstances are to be considered in determining whether the preparer acted in good faith and specifically enumerate a number of the factors to be considered.

One of the enumerated factors is the nature of the error causing the understatement—that is, whether the “error resulted from a provision that was complex, uncommon, or highly technical, and a competent tax return preparer of tax returns of the type at issue reasonably could have made the error.” 14 The benchmark here is a preparer of tax returns “of the type at issue.” No guidance is provided as to how returns are to be categorized into types; however, this provision strongly suggests that preparers may be held to different standards depending on the types of return they typically prepare.

Example 10: T exclusively has individuals as clients. One of her clients has an unincorporated sole proprietorship (Schedule C) with an inventory, and that inventory is accounted for using the LIFO method. This is T ’s only client using LIFO. The regulations suggest that in the event T takes appropriate steps to understand the LIFO rules but nonetheless makes an error in preparing the client’s LIFO computations, she may be held to a different, presumably lower, standard than another preparer who has numerous business enterprise clients using LIFO.

Another factor is the materiality of the error. The regulations state that “[t]he reasonable cause and good faith exception generally apples if the understatement is of a relatively immaterial amount.” 15 No guidance is provided as to what standard is to be used to determine materiality for this purpose.

Example 11: U has a corporate client that spent money in 2008 to replace a component on a machine used in its trade or business. The component somewhat increased the functionality of the machine; consequently, the issue arises whether the cost of the component should be capitalized and depreciated or can be deducted as a repair. Based on the preparer regulation, it appears that the due diligence required of U in addressing the issue would be very different if the amount in question were $5,000 rather than $500,000.

Another factor the regulations focus on is the preparer’s normal office practice. The regulations provide that the inquiry here is whether

[t]he tax return preparer’s normal office practice, when considered together with other facts and circumstances, such as the knowledge of the tax return preparer, indicates that the error in question would occur rarely and the normal office practice was followed in preparing the return or claim for refund in question. Such a normal office practice must be a system for promoting accuracy and consistency in the preparation of returns or claims for refund and generally would include, in the case of a signing tax return preparer, checklists, method for obtaining necessary information from the taxpayer, a review of the prior year’s return, and review procedures. Notwithstanding these rules, the reasonable cause and good faith exception does not apply if there is a flagrant error on a return or claim for refund, a pattern of errors on a return or claim for refund, or a repetition of the same or similar errors on numerous returns or claims for refund. 16

Example 12: V, a CPA firm, has a written tax department policy that preparers must complete a technical issues checklist for any individual client with prior-year AGI of over $200,000. G prepares an individual return for a client with prior-year AGI of $250,000 but does not complete the checklist. The return she prepares erroneously treats an item in a manner contrary to the manner indicated on the checklist.

G’s failure to complete the checklist may be a factor that weighs against her in evaluating whether she acted with reasonable cause and in good faith, and in that regard she may have a harder time avoiding the penalty than a preparer who demonstrates that she followed office protocol and the relevant checklist. 17

Enhanced Due Diligence: Earned Income Credit

Against this backdrop of more general due diligence considerations for income tax preparers, it is worth noting the specific due diligence requirements under Sec. 6695(g) in order to claim the earned income credit (EIC). Sec. 6695(g) and Regs. Sec. 1.6695-2 provide a penalty for each failure to determine the eligibility or amount of the EIC under Sec. 32. A preparer claiming the EIC must complete Form 8867, Paid Preparer’s Earned Income Credit Checklist, or otherwise record the information as prescribed by the IRS in the preparer’s workpapers. The eligibility checklist or alternative eligibility record must be based on information provided by the taxpayer or “otherwise reasonably obtained by the preparer.” A knowledge standard is provided for the EIC similar to that discussed above: “know or have reason to know” that any information (aided by the required checklist) related to eligibility for or amount of the EIC is incorrect. Preparers are required to maintain copies of the worksheets and records.

A reasonable cause exception to the penalty is provided if the preparer can demonstrate to the satisfaction of the IRS that, considering all the facts and circumstances, his or her normal office procedures are reasonably designed and routinely followed to ensure compliance with the due diligence requirements of the regulation and that the item in question was “isolated and inadvertent.”

These EIC provisions have recently been cited in support of similar and more specific due diligence requirements for other positions. 18 In order to determine the value of these additional steps outside the EIC, it may be helpful to analyze their impact and determine whether they have led to improved administration or compliance.

Due Diligence and Foreign Bank Accounts

An area of increased IRS focus is undisclosed foreign bank and other financial accounts. Historically, the principal tool of paid preparers for documenting due diligence in the area has been some form of statement in connection with the tax return organizer that lays out the requirements for the tax return and Treasury Form TD F 90-22.1, Report of Foreign Bank and Financial Accounts (FBAR), filing requirements and asks the client to check a box confirming that he or she has disclosed in the organizer all accounts that might be required to be reported on an FBAR. 19 Karen Hawkins, director of the IRS Office of Professional Responsibility, indicated in a 2010 speech that reliance on the organizer may not be sufficient for a preparer to establish due diligence. 20 This expression of concern was not accompanied by any concrete guidance as to when additional steps may be required of the preparer.

In the authors’ view, in many cases a preparer should be able to prepare a return with the appropriate degree of due diligence merely by confirming that the client has completed the organizer. Based on what the client presented in the organizer and all other information that the preparer knows about the client, a reasonable preparer would have no reason to suspect that the information provided is not complete or accurate. In other instances, it might be reasonable for the IRS to challenge whether the facts that the preparer knows (or could reasonably infer from the organizer or otherwise might know about the taxpayer) might trigger a need for the preparer to do more in terms of due diligence than merely rely on the taxpayer’s assertion in the organizer that he or she had no foreign bank or other financial accounts subject to FBAR.

Example 13: W, a paid preparer, is preparing a tax return for X, an expatriate employee of Y Conglomerate. X is a recent college graduate who works in Italy. X’s tax return organizer indicates that he is paid $60,000 a year and earned $30 (after conversion from euros) in interest from a bank in Italy. X checks a box in the organizer stating that he did not have a foreign bank account balance of in excess of $10,000 at any point during the year. Absent some reason to question the accuracy of the information in X’s organizer, it is the authors’ view that W may rely on the organizer without further inquiry.

Example 14: Z prepares the tax return of E, an expatriate employee of G who works in Italy. E is the president of G’s European operations and earns $480,000 per year. 21 E’s tax return organizer does not indicate any interest from a bank or brokerage account, U.S. or otherwise, and he checks a box in the organizer stating that he did not have a foreign bank account balance in excess of $10,000 at any point during the year. In addition, based on recollections of consultations with E and information in the organizer, Z is aware that during the tax year E purchased an apartment in Rome as his principal residence.

It is the authors’ view that E’s scenario is likely to be the sort that the IRS had in mind in questioning the preparer’s ability to rely solely on the organizer. That is, we would be concerned that the IRS would conclude that based on the information known to Z, she would have reason to ask (1) how E could conduct his affairs in Italy during the year without some kind of a bank account that had at least $10,000 in it at some point during the year, and (2) because E was known to be living in Italy, whether that bank account was a foreign account. In addition, Z should consider the lack of any Form 1099 or other reporting in the organizer that would suggest the existence of a substantial U.S. account. What would the result be if E denied the existence of a foreign bank account and the organizer contained Form 1099 reporting for a U.S. brokerage account showing substantial amounts of investment income, as one might expect from an account holding several hundred thousand dollars?

Example 15: The facts are the same as in Example 14. Z is uncertain how E could conduct his affairs in Italy without an Italian bank account that had at least $10,000 in it at some point during the year. She makes further inquiries, receives a reasonable explanation that satisfies her that E has no FBAR responsibility, 22 and documents that resolution. In the authors’ view, Z has performed adequate due diligence with respect to E’s foreign accounts.

Example 16: M, a sole practitioner in St. Louis, has prepared P’s return for several years. She sends to P’s house in St. Louis an organizer for 2009 along with an engagement letter requesting a retainer of $1,300. He returns the organizer from London, indicating that he relocated there during the year. He also sends M a check for €1,000 drawn on a U.K. money market mutual fund. P includes a note of apology for sending his fee in euros, indicating that he no longer has a dollar-denominated checking account. He also returns the organizer, which does not indicate any interest or dividends from any account outside the United States, and he checks the box in the organizer indicating that he did not have any foreign financial accounts.

There may be reasons why P’s responses are consistent with the check. For example, he may have closed his U.S. account and opened his U.K. account in 2010. Nonetheless, based on the information given, M should not ignore the apparent inconsistencies in favor of placing exclusive reliance on the organizer.

The Profession

Members of the AICPA are subject to the Statements on Standards for Tax Services (SSTS), and many states’ licensing rules as a practical matter require all CPAs licensed by them to follow the SSTS. 23 The principal guidance on tax return due diligence is contained in SSTS No. 3, Certain Procedural Aspects of Preparing Returns. While the provisions of SSTS No. 3 largely overlap the provisions of the preparer regulations, SSTS No. 3 covers all returns prepared by a member and is therefore relevant to the preparation of state, local, non-U.S., and U.S. federal tax returns.

The operative provisions of SSTS No. 3 are as follows:

In preparing or signing a return, a member may in good faith rely, without verification, on information furnished by the taxpayer or by third parties. However, a member should not ignore the implications of information furnished and should make reasonable inquiries if the information furnished appears to be incorrect, incomplete, or inconsistent either on its face or on the basis of other facts known to the member. Further, a member should refer to the taxpayer’s returns for one or more prior years whenever feasible. 24

If the tax law or regulations impose a condition with respect to deductibility or other tax treatment of an item, such as taxpayer maintenance of books and records or substantiating documentation to support the reported deduction or tax treatment, a member should make appropriate inquiries to determine to the member’s satisfaction whether such condition has been met. 25

When preparing a tax return, a member should consider information actually known to that member from the tax return of another taxpayer if the information is relevant to that tax return and its consideration is necessary to properly prepare that tax return. In using such information, a member should consider any limitations imposed by any law or rule relating to confidentiality. 26

The explanation in SSTS No. 3 may be helpful to members. Among its useful observations are the following:

Even though there is no requirement to examine underlying documentation, a member should encourage the taxpayer to provide supporting data where appropriate. For example, a member should encourage the taxpayer to submit underlying documents for use in tax return preparation to permit full consideration of income and deductions arising from security transactions and from pass-through entities, such as estates, trusts, partnerships, and S corporations. 27

The source of information provided to a member by a taxpayer for use in preparing the return is often a pass-through entity, such as a limited partnership, in which the taxpayer has an interest but is not involved in management. A member may accept the information provided by the pass-through entity without further inquiry, unless there is reason to believe it is incorrect, incomplete, or inconsistent, either on its face or on the basis of other facts known to the member. In some instances, it may be appropriate for a member to advise the taxpayer to ascertain the nature and amount of possible exposure to tax deficiencies, interest, and penalties, by taxpayer contact with management of the pass-through entity. 28

A member should make use of a taxpayer’s returns for one or more prior years in preparing the current return whenever feasible. Reference to prior returns and discussion of prior-year tax determinations with the taxpayer should provide information to determine the taxpayer’s general tax status, avoid the omission or duplication of items, and afford a basis for the treatment of similar or related transactions. As with the examination of information supplied for the current year’s return, the extent of comparison of the details of income and deduction between years depends on the particular circumstances. 29


The preparer regulations and SSTS No. 3 can be useful to preparers seeking to understand their obligations when preparing tax returns. Although these authorities are general, they address many of the recurring issues encountered by those who prepare tax returns as part of their professional practices.

Within these guidelines, it is clear from the increased penalty risk and IRS emphasis on transparency that there is an opportunity for tax professionals to serve in an educational role for clients— specifically, to remind clients of the requirements for claiming tax positions, the client’s ultimate responsibility for the position, the burden of proof, and the risks related to the position. There is plenty of room to be an advocate for a reasonable, albeit uncertain, client position without subjecting the client or the preparer to undue penalty risk. If the profession does not step up to this challenge, it is quite likely that there may be additional and unwelcome attempts to impose regulation on our relationships with our clients.

The views expressed in this article are those of the authors and are not the official views of Ernst & Young LLP.


1 This article uses “tax return preparer,” generally shortened to “preparer,” as the term is defined in Sec. 7701(a)(36), and therefore includes those who review returns for compensation.

2 Circular 230, Regulations Governing the Practice of Attorneys, Certified Public Accountants, Enrolled Agents, Enrolled Actuaries, Enrolled Retirement Plan Agents, and Appraisers Before the Internal Revenue Service (31 C.F.R., Part 10).

3 See, e.g., “due diligence” as defined in Black’s Law Dictionary, 5th ed. (1979), or the FindLaw online law dictionary at

4 Regs. Sec. 1.6694-1(e)(1).

5 Brockhouse, 749 F.2d 1248 (7th Cir. 1984).

6 Id. Regs. Sec. 1.6694-1(e)(3), Example (1), illustrates this requirement: “During an interview conducted by Preparer E, a taxpayer stated that he had made a charitable contribution of real estate in the amount of $50,000 during the tax year, when in fact he had not made this charitable contribution. E did not inquire about the existence of a qualified appraisal or complete a Form 8283, Noncash Charitable Contributions, in accordance with the reporting and substantiation requirements under Code section 170(f)(11). E reported a deduction on the tax return for the charitable contribution, which resulted in an understatement of liability for tax, and signed the tax return as the tax return preparer. E is subject to a penalty under section 6694.”

7 Rev. Rul. 80-266, 1980-2 C.B. 378.

8 Regs. Sec. 1.6694-1(e)(1).

9 Regs. Sec. 1.6694-2(e)(5).

10 Regs. Secs. 1.6694-1(b) and 301.7701-15.

11 Id.

12 Sec. 6001.

13 Regs. Sec. 1.6694-1(e)(2).

14 Regs. Sec. 1.6694-2(e)(1).

15 Regs. Sec. 1.6694-2(e)(3) (emphasis added).

16 Regs. Sec. 1.6694-2(e)(4).

17 The AICPA’s Tax Division provides technical checklists and other practice aids to its members.

18 National Taxpayer Advocate, 2009 Annual Report to Congress (December 31, 2009).

19 As a general rule, each U.S. person who has a financial interest or signature or other authority over any foreign financial accounts, including bank, securities, or other types of financial accounts, in a foreign country must file an FBAR if the aggregate value of these financial accounts exceeds $10,000 at any time during the calendar year. A detailed discussion of the FBAR rules is outside the scope of this article. For more on FBAR issues, see Dudley, “IRS Focuses on the FBAR,” 40 The Tax Adviser 815 (December 2009).

20 “Preparers cannot blindly rely on tax organizers, [Hawkins] warned, when it is logical and obvious for preparers to ask the client certain questions, such as about the existence of foreign bank accounts.” Coder, “IRS Moving Forward on Implementing Preparer Review Recommendations,” 2010 TNT 15-5 (January 25, 2010).

21 Thus, it would be a fair inference that if he is paid on a monthly or semimonthly basis, his net cash pay might be in excess of $10,000 per deposit.

22 For example, Z might find credible E ’s representation that he maintains a noninterest-bearing account denominated in euros with a U.S. bank where his pay is deposited, which he uses for his larger European disbursements, and a small noninterest-bearing account with an Italian bank, which he uses for smaller routine disbursements while in Italy.

23 See, e.g., 20 MO Code Regs. §2010-3.010(1).

24 SSTS No. 3, ¶2.

25 SSTS No. 3, ¶3.

26 SSTS No. 3, ¶4.

27 SSTS No. 3, ¶7.

28 SSTS No. 3, ¶8.

29 SSTS No. 3, ¶9.


Douglas Milford is an executive director at Ernst & Young LLP in Clayton, MO. Edward Swails is an executive director at Ernst & Young LLP in Washington, DC. For more information about this article, contact Mr. Milford at or Mr. Swails at

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James M. Greenwell Wins 2014 Best Article Award

The winner of The Tax Adviser’s 2014 Best Article Award is James M. Greenwell, CPA, MST, a senior tax specialist–partnerships with Phillips 66 in Bartlesville, Okla., for his article, “Partnership Capital Account Revaluations: An In-Depth Look at Sec. 704(c) Allocations.”



How Legal Marijuana Businesses Are Treated Federally

This article examines the tax problems that these businesses face and warns that professionals may provide services to them at their peril.