EITC Due-Diligence Requirements: IRS Ramps Up Enforcement and Education Efforts

EXECUTIVE SUMMARY

To reduce the high number of invalid earned income tax credit (EITC) claims, the IRS is stepping up its enforcement efforts against preparers that either inadvertently or fraudulently prepare a large number of returns with improper EITC claims. Sanctions the IRS can impose against a preparer run from monetary penalties to injunctions barring a preparer from preparing returns. The regulations contain specific due-diligence requirements that preparers must meet when preparing returns with EITC claims. Due diligence requires preparers to make further inquiries of a client where it appears, based on the available evidence, that the client may not be entitled to a credit. The three most common EITC errors are claiming children who are not the taxpayer’s qualifying children, using an incorrect filing status, and over- or underreporting income. These three errors account for over 60% of all EITC claim errors. The rules for determining whether a child is a qualifying child involve age, relationship, residency, and marriage (joint return) tests. If two taxpayers are entitled to claim a child for EITC purposes, a tiebreaker test is applied to determine which taxpayer is entitled to claim the child.

---

The Justice Department sues another man and his accounting firm to stop him from preparing tax returns.1 This headline and similar IRS press releases are becoming more frequent. One of the most common reasons for such enforcement measures is earned income tax credit (EITC) due-diligence noncompliance by return preparers. The IRS considers tax professionals essential partners in helping individual taxpayers understand the complex EITC law and claim the EITC only when appropriate. The numbers of both EITC claims and erroneous refund payments are on the rise. The Treasury Inspector General for Tax Administration offers evidence that the EITC error rate is as high as 28%. This translates to over $13 billion erroneously paid out each year. 2 Accordingly, more EITC return preparers can expect to receive letters or personal visits from the IRS as the agency expands its EITC preparer compliance initiative. This article explains the basic EITC rules, the due-diligence requirements under Sec. 6695(g), and the proposed changes to the regulations under Sec. 6695(g). It also covers recent court cases and IRS initiatives and enforcement efforts, and highlights best practices to assist preparers with EITC compliance.

Basic EITC Rules

The Sec. 32 EITC provides a refundable credit to subsidize the wages of low-income taxpayers. To qualify for the EITC, a taxpayer must:

• Be a U.S. citizen or resident alien for the entire year and have a valid Social Security number;
• Have earned income;
• File married filing jointly, head of household, or single;
• Not be a qualifying child of another person; and
• Not have investment income over a threshold amount.

A taxpayer with no children can qualify for a limited EITC; however, taxpayers with one or more qualifying children can qualify for a larger credit. The requirements to be a qualifying child of a taxpayer for EITC purposes are discussed in more detail below.

The EITC is calculated by multiplying the taxpayer’s income by a percentage, determined under Sec. 32(b). The amount of the credit phases out above certain income levels.

What Is Due Diligence?

A preparer must exercise due diligence in preparing a return claiming an EITC. The due-diligence requirements a preparer must meet are provided in Regs. Sec. 1.6695-2(b). Preparers that do not meet the due-diligence requirements are potentially subject to penalties and other sanctions.

Eligibility Verification and Credit Computation Requirements

To meet the EITC eligibility verification and credit computation requirements, a preparer must:

• Complete Form 8867, Paid Preparer’s Earned Income Credit Checklist, or otherwise record in the preparer’s paper or electronic files the information necessary to complete an eligibility checklist (alternative eligibility record); or
• Complete the EITC worksheet in the Form 1040 instructions or otherwise record in the preparer’s paper or electronic files the preparer’s EITC computation, including the method and information used to make that computation (alternative computation record).3

Record Retention Requirements

Preparers must keep Form 8867 or the alternative eligibility record and the EITC worksheet or the alternative computation record in their files.4 Preparers must also keep a record of the details of how, when, and from whom the information used to prepare the return was obtained. Preparers must keep these documents or records, either on paper or electronically, for three years from the June 30 following the date the return or claim for refund was submitted to the taxpayer for signature.

Knowledge

In addition to the other requirements, the tax return preparer must not know, or have reason to know, that any information used by the tax return preparer in determining the taxpayer’s eligibility for, or the amount of, the EITC is incorrect.5 Preparers may not ignore the implications of information furnished by taxpayers or otherwise known by the preparer. Thus, preparers must probe further if the information furnished appears to be incorrect, inconsistent, or incomplete. Preparers must promptly document taxpayers’ responses to these inquiries.

Proposed Changes to the Due-Diligence Requirements

As part of its efforts to improve compliance with the due-diligence requirements, the IRS has issued proposed regulations that would modify the current rules. Prop. Regs. Sec. 1.6695-2(b)(1)(i) requires the tax return preparer to submit Form 8867 along with the return claiming the EITC credit, and Prop. Regs. Sec. 1.6695-2(b)(4)(ii) changes the date through which tax return preparers must retain the required records. The proposed retention date is three years from the later of the due date of the return (determined without regard to any extension of time for filing) or the date the return or claim for refund was filed. This revision to the retention date is designed to simplify the determination of the retention date for both the IRS and tax return preparers. Both of these new rules will apply to tax returns and claims for refund for tax years ending on or after December 31, 2011, that are filed after the date the final regulations are published.

Reasons for EITC Compliance Errors

In general, EITC compliance errors occur for such reasons as lack of knowledge about tax law, honest preparer mistakes, incorrect information from clients (intentional and unintentional), disregard of EITC due-diligence requirements, or a blatant disregard of tax laws in an effort to erroneously claim the EITC. Publication 4687 on EITC due diligence identifies three common errors that account for more than 60% of erroneous claims.6 The most common form of EITC noncompliance is the improper claiming of a qualifying child. This error occurs when taxpayers claim a child who does not meet the age, relationship, or residency requirements. The qualifying child requirements are discussed in more detail below.

The second most frequent mistake is when taxpayers file as single or head of household when they are married. According to the IRS, many times this error is caused by taxpayers’ failing to understand the nuances of the head-of-household filing status, but taxpayers also often improperly claim filing status of single or head of household intentionally to qualify for or boost the amount of EITC.7

The third most common error made by taxpayers is the improper reporting of income. Taxpayers sometimes over- or underreport income to either qualify for, or maximize the amount of, EITC. For example, in Webb,8 a single taxpayer was not entitled to the EITC even though she claimed her grandchildren as dependents and claimed to have earned income from a child-care business. The taxpayer did not prove that either grandchild was a qualifying child for purposes of Sec. 32(c)(3)(A) or that she had earned income within the meaning of Sec. 32(c)(2)(A). Her claim of earning income from her child-care business was supported only by her and her daughter’s testimony, which the court held to be “conclusory, general, vague, uncorroborated, and self-serving” (or, in the case of the daughter’s testimony, serving the mother’s interests). The taxpayer apparently claimed the child-care income because, aside from it, the only other income she reported was from interest, pensions, and annuities, which was not earned income for EITC purposes.

Eligibility Requirements for Qualifying Child

Sec. 152 provides that taxpayers may claim a dependency exemption under either the qualifying child or qualifying relative tests. To qualify for the higher amounts of earned income tax credit for a taxpayer with children, the children claimed for purposes of the credit must meet the “qualifying child” requirements under Sec. 152(a)(1) (other than the support test). These rules stipulate that such dependents must meet the age, relationship, residency, and marriage (joint return) tests.

Age test: At the end of the filing year, the child must be younger than the taxpayer (or the spouse if married filing jointly) and under 19.9 The child may be under 24 if a full-time student or any age if permanently and totally disabled. A child is permanently and totally disabled if both of the following apply: (1) The child cannot engage in any substantial gainful activity because of a physical or mental condition, and (2) a doctor certifies that the disability can be expected to result in death or has lasted or can be expected to last at least one year.

Relationship test: At the end of the filing year, the qualifying child must be the taxpayer’s son, daughter, adopted child, stepchild, foster child, or another descendent of such a child.10 The qualifying child also may be a brother, sister, stepbrother, stepsister or another descendant of such a relative. A cousin is not considered a qualifying child.

Residency test: The qualifying child must have the same principal place of abode as the taxpayer for more than half the year, and that place of abode must be in the United States.11

Marriage (joint return) test: An individual will not be a qualifying child if the individual is married as of the close of the taxpayer’s tax year unless the taxpayer is entitled to a dependency exemption deduction for the tax year with respect to the individual (or would be if the taxpayer had not released his or her claim to the dependency exemption under Sec. 152(e)).12 If the individual is married but not filing a joint return (or only filing a joint return as a claim for refund), this test will be met.

Tiebreaker Rule for Qualifying Child

If two or more taxpayers can claim a child as a qualifying child, the child will be considered the qualifying child of the taxpayer that is the child’s parent, or, if none of individuals claiming the child is the child’s parent, then of the individual with the highest adjusted gross income (AGI) for the year.13 If a child can be claimed as a qualifying child by both of the child’s parents, the child will be considered the qualifying child of the parent with whom the child resided for the longest period of time during the tax year. If the child resides with both parents for the same amount of time during the tax year, the child will be considered the qualifying child of the parent with the higher AGI. In performing proper EITC due diligence, a preparer may often need to make further inquiries to ensure that a client is not precluded from claiming a child for EITC purposes by the tiebreaker rule.

Qualifying Child Due-Diligence Examples

Due diligence requires that the preparer not only ask the right questions but also document the information as he or she proceeds. The following examples illustrate the types of additional questions a taxpayer might need to ask to meet the EITC due-diligence requirements and to determine whether a child is a taxpayer’s qualifying child.

Example 1: A client, C, is 18 years old and has never been married. She lives with her parents and has a 2-year-old daughter, D. C has earnings of $3,000 from a part-time job and wishes to claim the EITC. The preparer should first determine whether C’s parents should claim the client for the EITC. Since C is 18 years old, she meets the age requirement of a qualifying child, and she meets the relationship requirement since she is their daughter. However, the grandchild may also be the qualifying child for the grandparents for the EITC.

The preparer should ask when C moved in with her parents. Suppose her answer is “last November.” It may seem that C could claim the EITC with her daughter as a qualifying child. However, the preparer should also ask C whether her daughter lived with her all year. If she states D lived with C’s parents all year, then C may not claim D as a qualifying child for EITC purposes. The residency test requires the child to live with the taxpayer for more than six months of the year.

Example 2: Suppose C and her daughter, D, lived with C’s parents for the entire year. In this case, C does not qualify for the EITC because she is the qualifying child of her parents: She passes the age, relationship, support, and residency tests. D is also the qualifying child of C’s parents as she also meets the age, relationship, and residency tests. It does not matter whether or not C’s parents claim the EITC. The 18-year-old still may not claim the EITC because she is the qualifying child of another person.

Example 3: Next, suppose C and her daughter, D, did not move in with C’s parents until August. In addition, the 2-year-old daughter lived with C for the entire 12 months of the year. In this case, C may claim the EITC, with D as her qualifying child, as she meets the age, relationship, and residency tests.

Example 4: M has a 7-year-old child living with her while she and her husband are separated. The couple has been separated since March of the current year. M has provided more than half the support for the child and wants to claim the EITC.

The preparer should first determine whether M must use a married status (married filing jointly or married filing separately) or can qualify for head of household or single filing status. If she is legally separated or did not live with her spouse for the last six months of the year, she may be considered “unmarried” for head-of-household purposes. Since there is another parent involved, the preparer should also ask questions to determine if there is a possibility the father might claim the child as well.

The preparer should inform the client what happens in a duplicate claim situation and how the IRS applies the tiebreaker rules if she and her spouse both claim the child (separated parents may have qualifying child issues between them). In this case, the couple has been separated for more than the last six months of the year. In addition, the mother has provided more than half the cost of supporting the child for the year. Therefore, the client may file as head of household, claim her child as a qualifying child, and claim the EITC.

In today’s society, family situations are complicated and many times nontraditional. As a result, it is common for taxpayers to claim dependents with last names different from their own. In addition, the ages of dependents may appear inconsistent with the client’s age. In such cases, it is imperative for the preparer to ask questions and be sure the client is lawfully claiming the EITC.

Example 5: A 22-year-old client, E, has two sons, ages 10 and 11, and wants to claim the EITC. The preparer should first ask E to explain his relationship with the children. Suppose E says they are his girlfriend’s sons but that he pays all the bills. The preparer should ask the client if he was ever married to the mother. If he says no, then they cannot be his stepsons. The preparer should then ask if the children were ever placed in his home for adoption or as foster children by a court or authorized agency. If the client answers no, then they are not qualifying dependents for the EITC, as they do not meet one of the defined EITC relationships.

Example 6: Suppose the same 22-year-old client, E, says the children are his girlfriend’s sons and that he pays all the bills. When the preparer asks E if he was ever married to the mother, he answers yes, but they were divorced and he got custody of them. The children are his stepsons even though the parents are divorced. This is a qualifying relationship for EITC purposes. The preparer should then ask if the mother lived with them last year. If the client answers that she moved out in February, the preparer could eliminate the possibility that the mother could also claim the children. In this case the client may claim the qualifying children and the EITC.

A well-qualified preparer should ask these types of questions to make sure there are no problems with more than one person claiming the same qualifying child. With the high and growing rate of EITC errors, it is becoming more common for the IRS to require documentation proving that the children lived with the parents for the current tax year. Examples of documentation the IRS will accept include school, medical, social service, or day-care records. The letter must be on official letterhead and must include the name of the child, name of the child’s parent or guardian, the child’s address, and dates the child lived with the taxpayer during the year. For example, in Collier,14 the taxpayer was not entitled to EITCs for her grandchild for one year or for her niece and nephew for another year because she had not provided proof that the children lived with her for one-half of the years in question.15

EITC Sanctions and Penalties for Preparers

The IRS may assess return preparer penalties against the preparer and/or his or her employer or employees. To avoid the imposition of penalties, the employer of the tax preparer must provide adequate training for employees. If the IRS determines that an employer provided adequate training and direction and that the preparer failed to comply with that guidance, the penalty generally is imposed on the preparer. The most common preparer penalty for failure to meet the due-diligence standard is $500 under Sec. 6695(g).16

The $500 penalty may be applied for each return where the preparer did not meet the due-diligence standard. The next penalty that may be assessed against preparers is the greater of $1,000 or 50% of the income derived (or to be derived) by the preparer with respect to the return or claim under Sec. 6694(a). Preparers may be liable for this penalty when taking tax return positions that are deemed “unreasonable.” However, under Sec. 6694(a)(3), tax preparers may avoid these penalties if they had good cause and acted in good faith. If the understatement is due to willful or reckless conduct, the penalty rises to $5,000 or 50% of the income derived (or to be derived) by the preparer with respect to the return or claim under Sec. 6694(b).

Prop. Regs. Sec. 1.6695-2(a) would change “signing tax return preparer” to “tax return preparer.” Consequently, under the proposed regulations (which, when finalized, will apply to all years ending on or after December 31, 2011), all tax return preparers (whether an individual or firm) who determine eligibility for, or amount of, the EITC under Sec. 32 and who fail to satisfy the due-diligence requirements are subject to the penalty under Sec. 6695(g). Thus, a firm that employs a person to prepare for compensation a tax return or claim for refund may be subject to the penalty for its employee’s failure to comply with the due-diligence requirements. Because a firm might not have direct knowledge of an employee’s failure to comply with the due-diligence requirements, however, Prop. Regs. Sec. 1.6695-2(c) provides additional requirements that must be met before the penalty will be imposed on a firm.

In addition, the Sec. 6695(g) penalty will not be applied with respect to a particular tax return or claim for refund if the preparer can demonstrate 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 in Regs. Sec. 1.6695-2(b), and the failure to meet the requirements with respect to the particular return or claim for refund was isolated and inadvertent. However, this exception will not apply to a firm that fails to meet the requirements to avoid a penalty under Regs. Sec. 1.6695-2(b). Under the proposed regulations, this defense would no longer be available to firms.17

2- or 10-Year Ban

There are also potentially serious consequences for taxpayers who claim reckless or fraudulent EITC positions. If the IRS examines taxpayers’ returns and classifies them as either reckless or fraudulent, it may ban the taxpayers from claiming the EITC for either 2 or 10 years, respectively.

Sec. 32(k) imposes a disallowance period for any individual who makes a reckless or fraudulent claim of an EITC. Sec. 32(k)(1)(B)(ii) denies the credit for two tax years after the most recent tax year for which there was a final determination that the taxpayer’s EITC claim was due to reckless or intentional disregard of rules and regulations. Sec. 32(k)(1)(B)(i) denies the credit for 10 tax years where there is a final determination that the taxpayer’s EITC claim was due to fraud.

According to Service Center Advice (SCA) 200113028,18 the IRS has concluded that it does not need to assert a fraud or accuracy-related penalty to deny the EITC for a prolonged period as provided for in Sec. 32(k)(1)(B). In addition, the SCA concluded that a frozen EITC refund is an underpayment for purposes of the accuracy-related and fraud penalties.

Other Sanctions Against the Preparer

Publication 4687, EITC Due Diligence Brochure, outlines tax return preparers’ responsibilities and potential sanctions for the 2011 filing season. The brochure states that the assessment of return-related penalties against a preparer can result in imposition of the following sanctions:

• Disciplinary action by the IRS Office of Professional Responsibility (OPR);
• Suspension or expulsion of the preparer’s firm from participation in IRS e-filing;
• Injunctions barring the preparer from preparing tax returns; and
• Referral for criminal investigation.

For example, in Adams,19 a return preparer and her employees were barred from acting as return preparers because of misconduct under Sec. 6694 that included filing excessive earned income tax credit claims.

In Hunn,20 a permanent injunction was imposed against a preparer, prohibiting him from directly or indirectly preparing or filing or assisting in the preparation or filing of income tax returns and related documents, or preparing or filing any documents, including legal pleadings he called “statements of notice,” for any person other than himself. He also was ordered to notify his clients of the injunction and provide the government with a list of his clients and copies of the federal tax returns he had prepared. Among his many misdeeds, the court found that the preparer had significantly understated the income that his clients received and claimed the EITC for clients who were clearly not entitled to the credit. Likewise, in Brown,21 the court prohibited the return preparers and their accounting firm from acting as paid preparers, in part for their failure to exercise due diligence in determining their clients’ eligibility for the EITC.

The best strategy preparers can pursue to avoid incurring penalties due to inadvertent errors in conducting EITC due diligence is the enhancement of their tax knowledge. Accordingly, practitioners should make sure that they and their staff are properly educated and trained. Because of the need for proper documentation to prove compliance with the EITC due-diligence requirements, having a good system in place for the production and retention of necessary EITC documentation is critical for practitioners in dealing with IRS enforcement efforts of the due-diligence rules.22

IRS Programs That Promote EITC Due Diligence by Tax Preparers

According to a 2008 study by Treasury and the IRS on EITC initiatives, 24% to 28% of all EITC claims contain mistakes23 and cost the federal government $13 billion to $16 billion annually.24 To reduce EITC-related mistakes, the IRS has developed extensive online resources for preparers to comply with the EITC requirements. In addition, the IRS also implemented the EITC Compliance Program to reduce EITC errors. On its website, the IRS has identified four general treatments for preparers under the compliance program:

• Reaching out to new and experienced preparers;
• Visiting preparers that have highly questionable returns;
• Auditing for due-diligence compliance; and
• Barring noncompliant preparers from filing tax returns.

Reaching Out to New and Experienced Preparers

As explained in the Preparer Toolkit section of the IRS website,25 outreach and education are the first tier of the compliance program. The IRS targets preparers for outreach based on the number of returns filed that have a high probability of an EITC error. The IRS previously sent educational letters only to new EITC preparers (preparers who had only filed returns with EITC claims in the current year), but it now also sends them to experienced preparers.

The IRS will contact preparers by letter. The letters range from purely educational to more strongly worded compliance letters. These letters outline due-diligence responsibilities, highlight common errors, and point to EITC tools, information, and other resources. The compliance letters also talk about the cost of not improving the quality of EITC claims. There are five versions of the letter:

• You may have submitted inaccurate returns (Letter 4744);
• You may have submitted inaccurate returns and be subject to penalties (Letter 4745);
• You may have submitted inaccurate returns, and your overall accuracy is below that of your peers (Letter 4746);
• You may have submitted inaccurate returns, and it is your responsibility to improve your overall accuracy (Letter 4747); and
• You may have submitted inaccurate returns, your overall accuracy is below that of your peers, and you may be subject to penalties (Letter 4748).

The IRS includes a copy of Publication 4687 with each letter.

Visiting Preparers Filing Highly Questionable Returns

The next step in promoting EITC compliance is a visit from a team of IRS revenue and criminal investigation special agents. The agents will personally visit preparers who file returns with highly questionable EITC claims. During these visits, the agents will discuss the identified errors and offer guidance on improving accuracy. The agents will also answer any questions to promote compliance with the law. While the visits are educational, the agency will also closely monitor future returns and take any follow-up action. Such future actions may include comprehensive due-diligence audits, penalties, or possible injunctions.

Auditing for Due-Diligence Compliance

EITC due-diligence visits are at the heart of the EITC compliance program. The IRS identifies tax preparers for due-diligence audits based on a risk-based scoring system that analyzes certain factors and filing patterns for previously prepared returns. If a practitioner is selected for a due-diligence visit, he or she can first expect a detailed interview with the IRS. The agent will review at least 25 EITC returns plus the preparer’s corresponding due-diligence records. Specifically, the IRS is looking for written documentation that the preparer asked detailed questions of the client. Examiners will also review data intake questionnaires, checklists, and worksheets associated with the claims. The objective is to determine whether the practitioner complied with Sec. 6695(g).

The IRS will charge penalties when it finds during a visit that the preparer did not comply with the EITC due-diligence requirements. According to the IRS, due to its improved audit selection process, it penalizes over 90% of the preparers that its examiners visit for these audits.26

Barring Preparers Making Fraudulent EITC Claims from Filing Tax Returns

One of the chief goals of the IRS is to remove preparers who file false EITC claims from the tax preparation community. To accomplish this goal, the IRS has improved the process of referring cases to the Department of Justice. The objective is to get legal injunctions and bar preparers who repeatedly fail to meet the due-diligence requirements. The government can bar these preparers temporarily or permanently from preparing federal tax returns.  

The IRS reserves this treatment for the most severe cases of noncompliance, and injunctions are pursued if a preparer has a demonstrated history of noncompliance.27 Such a history includes a history of due-diligence violations and penalties, prior e-file warnings or suspensions, a high percentage of clients with denied EITC claims, and/or noncompliance related to personal or business tax returns. The newly streamlined process allows the IRS and the Department of Justice to move quickly and shut down targeted noncompliant preparers in an average of 10 months.

Due-Diligence Procedures for Accurate Reporting of Income

For 2011 tax returns, the maximum EITC is $5,751 for a taxpayer with three or more qualifying children. For many low-income families, this amount represents a large portion of their annual cashflow.28 To qualify for the EITC, taxpayers must have earned income that falls within certain limits. For example, single taxpayers with either two or three or more qualifying children maximize their EITC when income is between approximately $12,750 and $16,700. For single taxpayers with one qualifying child, the maximum EITC ($3,094) occurs when income is between $9,100 and $16,700. Accordingly, taxpayers may inadvertently or intentionally inflate or suppress their incomes to increase or qualify for the EITC. To deal with this form of noncompliance, the IRS has recently published due-diligence procedures that promote both accurate reporting of income and good recordkeeping in the area of miscellaneous reported income.

1099-MISC Income

The tax treatment of workers is quite different depending on whether they are classified as employees or independent contractors. Employees receive Form W-2 and may not deduct business expenses on Schedule C. Alternatively, independent contractors receive Form 1099-MISC and report their income and expenses on Schedule C as earnings from self-employment.

Preparers should understand the behavioral and financial factors used by the IRS to classify taxpayers as either employees or independent contractors. Moreover, preparers should ask questions to document and support the classifications indicated by taxpayers. The IRS recently provided a number of examples or scenarios to educate preparers on their responsibilities to properly identify earnings from self-employment that may qualify for the EITC.29

EITC Schedule C and Record Reconstruction Training

Tax preparers should exercise specific due-diligence procedures to ensure taxpayers accurately report their income from self-employment. Preparers should ask specific questions to make sure the client is actually running a business. For example, the preparer should inquire about how the business is run (e.g., how the business finds new clients). Other evidence for existence of a legitimate business may include an advertisement in the newspaper or Yellow Pages, a business license, an invoice, business cards, or a letter on business stationary.

As noted in Chief Counsel Advice (CCA) 200022051,30 in cases where the taxpayer reports net earnings from self-employment but cannot show that the business exists, the IRS may disregard these earnings in determining the taxpayer’s eligibility for the EITC. (In addition, the taxpayer is not liable for self-employment tax on those net earnings.) Similarly, the preparer should ask to see the client’s records to support the earnings on Schedule C.

Recent IRS Guidance on Recordkeeping

A common taxpayer misconception exists with respect to claiming business expenses. Taxpayers commonly believe they do not have to claim business expenses. They argue that their lack of documentation or receipts enables them to leave certain business expenses off the return. In fact, the Code requires that taxpayers report all business income and allowable expenses to determine net profit from self-employment.

Rev. Rul. 56-40731 addresses whether taxpayers may ignore allowable deductions in computing net earnings from self-employment. The revenue ruling requires every taxpayer (with the exception of certain farm operators) to claim all permissible deductions in computing net earnings from self-employment. As the IRS explains in CCA 200022051:

There are, therefore, two necessary elements for determining “net earnings from self-employment”: gross income derived from the trade or business and allowable deductions attributable to the trade or business that produced that gross income. Gross income from a trade or business does not itself constitute net earnings from self-employment; allowable deductions must be taken for expenses in order to arrive at net earnings from self-employment. A taxpayer normally reports both of these elements on a Schedule C.

The CCA goes on to state that, if a taxpayer fails to keep proper books and records, the IRS may disregard reported income and disallow the EITC if the taxpayer fails to claim all allowable expenses.

Another scenario addressed by recent IRS guidance on recordkeeping concerns the use of rounded expenses for both revenues and expenses on Schedule C. Rounded numbers for self-employed clients typically appear inconsistent with the normal income and expense profiles for self-employed workers.32 In such cases, preparers have due-diligence responsibilities to ask for and examine any and all business records for evidence to support these numbers. Finally, an important question for preparers to ask is whether the income seems adequate to support the taxpayer’s household. If it does not, the preparer should inquire whether the taxpayer has other sources of income.

Best Practices

Best practices to resolve or avoid qualifying child issues include five points. First, when interviewing clients, preparers should phrase questions in terms that the client understands and avoid the use of technical tax terminology. Second, preparers should understand when to apply the AGI rule. The AGI rule requires that a nonparent claiming a child as a qualifying child has an AGI higher than the AGI of either parent of the child. Third, the preparer should know the definition of “disabled” for tax purposes. Fourth, the preparer should explore any aspects of the relationship with the child that appear on their face questionable. Finally, the preparers should ask enough questions to ensure that the child meets the age, relationship, and residency tests. Similar best practices can avoid problems with filing status and income reporting issues and are summarized in the exhibit.

Conclusion

Especially for the 2011 filing season, tax preparers should be aware of the high priority the IRS is placing on due diligence by preparers for EITC-based returns. For the past several tax seasons the IRS has conducted many surprise office visits to ensure that preparers have maintained proper documentation in client files. Revenue agents have been primarily looking for signed Forms 8894 (permission to e-file) and 8867 (EITC checklist). They also have been checking for copies of certain taxpayer records such as Form W-2 and Social Security cards for dependents. Due-diligence audits are priorities for IRS examinations. By following best practices, preparers will assist clients in filing accurate returns and discharge their due-diligence responsibilities for EITC-based returns.

The first priority for practitioners is to gain a strong knowledge of the tax law. Almost all due-diligence penalties to date relate to the knowledge requirement. For example, preparers should be able to recite the qualifying child requirements for age, relationship, and residency off the tops of their heads. Beyond that, preparers should conduct thorough interviews with clients and document the answers at the time of the interview. It is not sufficient for preparers to rely on software alone. In addition to W-2s, Social Security cards, signed Forms 8879 and 8867, client files must now contain reasonable documentation to demonstrate that preparers exercised due diligence in complying with the law on all EITC-based tax returns.

Penalties for noncompliance include $500 for each instance of failure, as well as a possible $1,000 or $5,000 penalty under Sec. 6694. Moreover, taxpayers could lose eligibility for future participation in the EITC program for either 2 or 10 years. In more extreme cases, practitioners also run the risk of being barred from any further preparation of tax returns. Practitioners can avoid such adverse consequences and increase the quality of their tax practice by having a thorough understanding of the tax law and documenting their interviews with clients. Practitioners are also advised to stay abreast of the proposed regulations under Sec. 6695 discussed above.

Footnotes

¹ Dep’t of Justice, “Justice Department Sues Georgia Man to Stop Him from Preparing Tax Returns for Others,” Justice News (February 23, 2011).

² Treasury Inspector General for Tax Administration, Reduction Targets and Strategies Have Not Been Established to Reduce the Billions of Dollars in Improper Earned Income Tax Credit Payments Each Year (2011-40-023) (February 7, 2011).

³ Regs. Sec. 1.6695-2(b).

⁴ Regs. Sec. 1.6695-2(b)(4).

⁵ Regs. Sec. 1.6695-2(b)(3).

⁶ IRS Publication 4687, EITC Due Diligence Brochure (April 2011).

⁷ See IRS, “Handling the Most Common Errors.”

⁸ Webb, T.C. Memo. 2011-124.

⁹ Sec. 152(c)(3).

¹⁰ Secs. 152(c)(1) and (2).

¹¹ Sec. 152(c)(1)(B).

¹² Sec. 152(b)(2).

¹³ Sec. 152(c)(4).

¹⁴ Collier, T.C. Memo. 2011-126.

¹⁵ The taxpayer also failed to prove her relationship with the children. Id.

¹⁶ This penalty was $100 for returns required to be filed before January 1, 2012. As part of the United States-Korea Free Trade Agreement Implementation Act, P.L. 112-41, the amount was increased to $500 for returns filed after December 31, 2011.

¹⁷ Prop. Regs. Sec. 1.6695-2(d).

¹⁸ SCA 200113028 (3/30/01).

¹⁹ Adams, No. 3:06cv136 (W.D.N.C. 12/2/08).

²⁰ Hunn, No. CV06-1458-PCT-FJM (D. Ariz. 8/18/06).

²¹ Brown, No. 2:04cv-00337 (N.D. Miss. 8/24/05).

²² Regs. Sec. 1.6695-2(b)(4) on retention of records.

²³ Dep’t of Treasury and IRS, IRS Earned Income Tax Credit (EITC) Initiatives: Report on Qualifying Child Residency Certification, Filing Status, and Automated Underreporter Tests (2008).

²⁴ See IRS, “About EITC for Preparers.” 

²⁵ See IRS, “Welcome to the Tax Preparer Toolkit.”

²⁶ See IRS, “Auditing for Due Diligence Compliance.”

²⁷ See IRS, “Barring Non-Compliant EITC Return Preparers from Filing Tax Returns.”

²⁸ Holt, “Periodic Payment of the Earned Income Tax Credit,” Brookings Inst. Metro. Policy Program (June 2008).

²⁹ See IRS, “1099-MISC Income Treatment Scenarios.”

³⁰ CCA 200022051 (6/2/00).

³¹ Rev. Rul. 56-407, 1956-2 C.B. 564.

³² See IRS, “Scenario 5: Rounded Expenses.”

 

EditorNotes

John McGowan is a professor of accounting and Ananth Seetharaman is the Ernst & Young Distinguished Professor of Accounting, both in the John Cook School of Business at Saint Louis University in St. Louis, MO. For more information about this article, contact Prof. McGowan at mcgowanjr@slu.edu