Due Diligence Update

By Joseph W. Schneid, CPA

Editor: Thomas J. Purcell III

The AICPA Tax Practice Responsibilities Com mittee is charged with providing guidance to CPAs in matters of high-quality professional performance. One area of focus for the committee is a CPA’s duty to exercise due diligence in tax return preparation. The AICPA standard is contained in Statement on Standards for Tax Services (SSTS) No. 3, Certain Procedural Aspects of Preparing Returns . In addition, CPAs must follow Circular 230, Regulations Governing Practice Before the Internal Revenue Service (31 C.F.R. Part 10), in respect to practice before the IRS, including income tax preparation.

Lately, the IRS has focused on due diligence as it applies specifically to preparation of returns claiming the earned income tax credit (EITC). This column discusses the tax professional’s due-diligence obligations under SSTS No. 3 and Circular 230. This column also focuses on due diligence in tax return compliance. While the same concepts apply to tax advice and research, a full discussion of due diligence in those areas is beyond the scope of this column.

SSTS No. 3 states, in part, that a CPA practitioner “may in good faith rely, without verification, on information furnished by the taxpayer. . . . 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” [emphasis added].

Example 1: The taxpayer provides an amount of taxes paid during the year that is much lower than amounts reported on prior returns prepared by the CPA. The CPA should inquire whether amounts are missing, or perhaps property subject to tax was sold or otherwise disposed of.

SSTS No. 3 continues, “[A] member should make appropriate inquiries to determine to the member’s satisfaction” whether adequate records are maintained when required to substantiate a deduction [emphasis added].

Example 2: The taxpayer uses his only vehicle for business and personal use. The CPA preparer sees the taxpayer in the vehicle regularly during the year, including at schools and shopping malls. The CPA should request satisfactory assurance that the taxpayer keeps detailed records of the business-use percentage of the vehicle. The CPA should not ignore his or her casual observations of the taxpayer in the community during the year when obtaining the information from the taxpayer.

Over the past 18 months, there have been significant developments in due diligence in tax practice. In October 2010, Douglas J. Milford and J. Edward Swails, past members of the Tax Practice Responsibilities Committee, published an article in The Tax Adviser providing comprehensive analyses and examples of due diligence in everyday tax practice (“Tax Return Due Diligence: Basic Considerations,” 41 The Tax Adviser 690 (October 2010)). It stands as a valid reference guide for tax practitioners in applying overall high-quality, due-diligence practices.

The IRS has occasionally announced actions against tax preparers, including CPAs, for failing to exercise due diligence. In announcing the disbarment of a CPA in July 2010 (IR-2010-82), Karen Hawkins, the director of the IRS Office of Professional Responsibility (OPR), said, “Practitioners who think OPR isn’t serious about due diligence should take heed. Practitioners may not ignore the implications of information already known, and must make reasonable inquiries if the information furnished by a client appears to be incorrect, inconsistent, or incomplete.” The IRS also recently cited Circular 230, Section 10.22, in announcing CPA disbarments (Announcements 2011-24 and 2011-41).

With respect to practice before the IRS, including preparing federal income tax returns, Section 10.22 of Circular 230 states a practitioner must exercise due diligence in preparing, approving, and filing returns, documents, affidavits, and other papers and in determining the correctness of oral and written representations made by the practitioner to the IRS and to clients. When relying on others, the practitioner must use reasonable care in engaging, supervising, training, and evaluating each person, keeping in mind the relationship of the person to the practitioner.

Regs. Sec. 1.6694-1(e) gives guidance on how practitioners may rely on information furnished by the taxpayer. For purposes of preparer penalties under the Code, the preparer may generally rely in good faith, without verification, on information provided by the taxpayer. However, as stated in both these regulations and SSTS No. 3, the preparer may not ignore implications of information actually known by or furnished to the preparer.

Example 3: The taxpayer client provides inflated amounts for medical expenses and travel costs. Based on the preparer’s knowledge of the client, the preparer has no reason to doubt the amounts provided. The preparer inquires about the existence of expense records and is reasonably satisfied that the taxpayer has sufficient records to support the travel and entertainment expenses. As a result, the preparer is not subject to penalty under Sec. 6694.

SSTS No. 1, Tax Return Positions, provides the standards an AICPA member is expected to follow when recommending a tax return position and when preparing or signing a tax return. SSTS Interpretation 1-1, “Reporting and Disclosure Standards,” provides illustrations of complying with SSTS No. 1, including exercising due diligence with respect to tax return positions. (For more on SSTS Interpretation 1-1, see Gardner, et al., “Interpretations of SSTS No. 1, Tax Return Positions.”)

The illustrations clearly require the practitioner to determine whether there is sufficient authority for taking a position on a return and to analyze law and applicable authority. The CPA must determine whether there is substantial authority for a tax return position and, if not, whether there is a realistic possibility the position would be sustained on its merits. The examples also demonstrate the need to inquire sufficiently to understand the facts applicable to a matter. Similarly, Sections 10.33 and 10.34 of Circular 230 state that a practitioner may not advise a client to take a position that lacks a reasonable basis or is unreasonable or a willful attempt to understate a tax liability. In so doing, the practitioner must establish relevant facts, evaluate assumptions, and apply the applicable law to the relevant facts.

IRS Preparer Letters

In preparation for the 2012 filing season, the IRS sent letters to approximately 21,000 members of the return preparer community nationwide. The letters included an enclosure outlining common issues preparers should be aware of on Schedules A, C, and E to Form 1040, U.S. Individual Income Tax Return. The letters also described current responsibilities of tax return preparers, the consequences of filing incorrect returns, and new tax return preparer requirements. For example, one enclosure states that, when preparing a Schedule C, the preparer should “ask . . . clients sufficient questions to determine that the expenses claimed are correct,” adding that taxpayers may not understand tax laws. The enclosure thus implies a level of inquiry by the practitioner that is higher than the standard expected under Regs. Sec. 1.6694-1(e).

EITC Due Diligence

The recently issued Regs. Sec. 1.6695-2(b) contains stricter procedures for preparing a return claiming the EITC. The new rules require that a due-diligence checklist (Form 8867, Paid Preparer’s Earned Income Credit Checklist) be completed and included with any return claiming the EITC. Most of the three-page form is much like a flowchart, with inquiries into the taxpayer’s eligibility to claim the EITC. The questions are yes/no, with plenty of guidance such as “stop” if the answer results in ineligibility. Part IV of the form is titled “Due Diligence Requirements” and focuses on the preparer’s documentation and recordkeeping requirements under the new regulations. It is important to note that the strict due-diligence rules found in the EITC regulations are higher than those expected of a practitioner or preparer under SSTS No. 3 or Regs. Sec. 1.6694-1(e).

For a complete review of these rules and a discussion of due diligence as it applies to EITC enforcement and education, see McGowan and Seetharaman, “EITC Due-Diligence Requirements: IRS Ramps Up Enforcement and Education Efforts,” 43 The Tax Adviser 34 (January 2012). For summaries of other recent developments, see Nellen, “Due-Diligence Reminders for the 2012 Filing Season,” Tax Insider (Jan. 12, 2012), and Nellen, “Due-Diligence Reminders for the 2012 Filing Season (Part 2),” Tax Insider (Feb. 9, 2012).

The AICPA Tax Section publishes many checklists for income tax preparation. Active use of these checklists is evidence that a practitioner employs an appropriate measure of due diligence in research and preparation of returns. The checklists are free to members of the Tax Section.

The Tax Practice Responsibilities Committee is developing a practice guide with examples of CPA tax practice due diligence. It should be available to members before the 2013 filing season.




Thomas Purcell III is a professor of accounting and professor of law at Creighton University in Omaha, Neb. Joseph Schneid is a principal at AKT CPAs and Business Consultants in Lake Oswego, Ore., and is a member of the AICPA Tax Practice Responsibilities Committee. For more information about this column, contact Mr. Schneid at jschneid@aktcpa.com.



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