EITC Due Diligence Penalty Increases and Requirements Change

Legislation & Regulations

The tax preparer penalty relating to earned income tax credit (EITC) due diligence will increase to $500 under legislation signed by President Barack Obama on October 21 (United States–Korea Free Trade Agreement Implementation Act, P.L. 112-41). The IRS is also proposing that the requirements for EITC due diligence be made tougher.

EITC Due Diligence Penalty

Section 501 of the U.S.-Korea Free Trade Act increases the EITC due diligence penalty from $100 to $500. The Sec. 6695(g) penalty applies to each failure of a tax return preparer to exercise due diligence in determining taxpayer eligibility for, or the amount of, an EITC.

Congress believes increasing the penalty will deter EITC noncompliance (see H.R. Rep’t No. 239, 112th Cong., 1st Sess., p. 21 (October 6, 2011)); the IRS has estimated that between 23% and 28% of EITC claims are improper. The increased penalty amount will apply to returns required to be filed after December 31, 2011.

Proposed Requirements for EITCs

The IRS issued proposed regulations on October 6 that would impose new requirements for tax return preparers and their firms for returns claiming the EITC, including submission of information on taxpayers’ eligibility to the IRS (REG-140280-09).

Existing regulations (Regs. Sec. 1.6695-2) require preparers to complete Form 8867, Paid Preparer’s Earned Income Credit Checklist, or to otherwise record the information it requires for each return claiming the EITC and keep it in the preparer’s records. The checklist must be based on information provided by the taxpayer to the preparer or otherwise reasonably obtained by the preparer.

The proposed regulations would require preparers to submit Form 8867 with the tax return on which the EITC is claimed and would not allow any substitute for Form 8867. Return preparers would also be required to keep a copy of the form and of any document that the taxpayer supplied and that the preparer relied upon to complete Form 8867. Return preparers would be required to retain this information for three years from the return due date (without regard to any extension) or the date the return or claim for refund was filed, whichever is later.

The proposed regulations also would add a special rule subjecting firms to the same penalty as their preparers if:

• One or more members of the principal management or principal officers of the firm or its branch office participated in or knew of the failure to comply with due diligence;
• The firm failed to establish reasonable and appropriate procedures to ensure compliance; or
• The firm had such procedures but disregarded them through willfulness, recklessness, or gross indifference.

Under the current regulations, a return preparer can avoid the Sec. 6695(g) penalty with respect to a particular tax return or claim for refund if the preparer can demonstrate to the IRS’s satisfaction that his or her normal office procedures are reasonably designed and routinely followed to ensure compliance with the EITC due diligence requirements and that any failure to meet the due diligence requirements was “isolated and inadvertent.” However, under the proposed regulations, this defense would not be available to a firm (Prop. Regs. Sec. 1.6695-2(d)).

The proposed regulations would be effective for returns filed after the final regulations are published in the Federal Register for tax years ending on or after December 31, 2011.