Expanded Due-Diligence Requirements for 2012 Returns

Editor: Valrie Chambers, Ph.D., CPA

Practice & Procedures

Tax practitioners are in the midst of a challenging tax season. In addition to the complexity of the late tax law changes, the IRS requirement for practitioners’ due diligence has risen to a new level. This item discusses Form 8867, Paid Preparer’s Earned Income Credit Checklist, extensive new due-diligence requirements for wage earners, and Schedule C, Profit or Loss From Business. Whether the tax practitioner does no returns, a few returns, or many returns with the earned income tax credit (EITC), he or she needs to be aware of the expanded due-diligence requirements because the IRS may apply similar procedures to other issues.

Expansion of Form 8867

Beginning with the December 2006 revision of Form 8867, the form had four parts to be completed by the tax practitioner and retained for three years in the file (not sent or e-filed to the government):

• Part I: EITC eligibility requirements for all taxpayers.
• Part II: EITC eligibility requirements for taxpayers with a child.
• Part III: EITC eligibility requirements for taxpayers without a qualifying child.
• Part IV: The preparer’s due-diligence requirements.

The fourth part consisted of four yes/no, preparer due-diligence questions:

• Line 20: Did you complete Form 8867 based on information provided by the taxpayer or reasonably obtained by you?
• Line 21: Did you complete the EIC worksheet found in the Form 1040, 1040A, or 1040EZ?
• Line 22: Did you comply with the knowledge requirements? (The form explains the “knowledge requirement.”)
• Line 23: Did you keep the following records? (Form 8867 or your own form or files; the EIC worksheets or your own worksheets; and a record of how, when, and from whom the information used to prepare the form and worksheets was obtained.)

The form then clarified what happened if the preparer answered “yes” to all four questions or if the preparer answered “no” to the questions. If all answers were “no,” the preparer had not complied with all the due-diligence requirements and may have had to pay a $100 penalty for each failure to comply. The form continued to be retained in the preparer’s file and not e-filed or mailed with the completed tax return.

Beginning last year (tax year 2011), Form 8867 had to be completed by the preparer and filed with Form 1040, 1040A, or 1040EZ. The form continued to contain the four parts as listed above. The preparer’s due-diligence requirement, however, was expanded to include not only records of how, when, and from whom the information used to prepare the form and worksheets was obtained but also “copies of any documents provided by the taxpayer and on which you relied to complete the form and the worksheets” had to be retained.

If the preparer checked “yes” to all Part IV questions, submitted Form 8867 in the manner required, and kept the records for three years, the IRS stated the preparer had complied with all the due-diligence requirements. If “no” was checked, the IRS stated the preparer had not complied with all the due-diligence requirements and might have to pay an increased penalty of $500 for each failure to comply.

Tax Year 2012 Form 8867

The preparer’s due-diligence requirements for the 2012 Form 8867, Part IV, has expanded to eight questions with detailed lists. The first two questions (lines 20 and 21) are similar yes/no questions: Did you complete Form 8867 based on current information provided by the taxpayer or reasonably obtained by you? Did you complete the EIC worksheet found in Form 1040?

The next two questions are new and allow a “Yes,” “No,” or “Does not apply” response (lines 22 and 23). These questions deal with a qualifying child of a nonparent taxpayer, tiebreaker rules, and possible consequences of another person claiming the child. Additionally, the “knowledge requirement” is covered over two questions. Line 24 is worded slightly differently but has the same information on compliance. The line 25 follow-up question asks if the preparer documented the additional questions that were asked and the client’s answers. Both have the response options of “Yes,” “No,” or “Does not apply.”

In an email sent to tax professionals on Feb. 4, the IRS reported that it was seeing a large number of returns in which information was missing from Form 8867. The IRS recommended that software developers ensure that lines 22 through 25 have entries before a return with Form 8867 is transmitted. The IRS also said that it was not rejecting returns with missing Form 8867 information, but that processing of those returns would be delayed.

2012 Form 8867 Document Requirements

If there is a qualifying child or children, the tax practitioner must check the box or boxes on what documents were relied upon and must keep copies of these documents for three years (line 26). The options for documenting the residency of the qualifying child(ren) are:

• School records or statements;
• Landlord or property management statement;
• Health care provider statement;
• Medical records;
• Child care provider records;
• Placement agency statement;
• Social services records or statements;
• Place of worship statement;
• Indian tribal official statement;
• Employer statement;
• Other (specify);
• Did not rely on any documents, but made notes in file; or
• Did not rely on any documents.

The document options for the disability of a qualifying child or children are a doctor statement; other health care provider statement; social services agency or program statements; other (specify); did not rely on any documents, but made notes in file; or did not rely on any documents.

2012 Form 8867 Schedule C Document Requirements

The practitioner should be aware that if the tax return claiming an EITC includes a Schedule C, he or she must document the business’s existence and the amount of Schedule C income and expenses reported (line 27). All documents from the list below that apply must be checked. Copies have to be maintained in the file for three years. The options are:

• Business license;
• Forms 1099;
• Records of gross receipts the taxpayer provided;
• Taxpayer summary of income;
• Records of expenses the taxpayer provided;
• Taxpayer summary of expenses;
• Bank statements;
• Reconstruction of income and expenses;
• Other (specify);
• Did not rely on any documents, but made notes in file; or
• Did not rely on any documents.

The preparer must complete the form and file it with the tax return. If the form preparer is not the signing preparer, then a completed Form 8867 must be given to the signing paid preparer either electronically or on paper. The penalty remains $500 for each failure to comply, with no total maximum dollar penalty amount. Starting with tax year 2012, the IRS will assert due-diligence penalties for failure to submit Form 8867 with any return claiming an EITC. The penalty is codified in Sec. 6695(g).

Outlook

As practitioners complete the 2012 tax filing season, they must remember to verify a taxpayer’s qualifications for claiming an EITC through documents the taxpayer has provided or through questions asked and answers received from the client. The IRS may, in the future, expand the due-diligence requirements to other issues related to the EITC. To prevent preparer penalties, proper documentation of a practitioner’s verification of a taxpayer’s qualifications for the EITC is essential.