New due-diligence standards for head-of-household filing status

By Jesse Palmer, CPA, Springfield, Mo.

Editors: Heidi Ridgeway, CPA, and Roby B. Sawyers, CPA, Ph.D.

Tax return preparers are subject to a variety of due-diligence standards. Under Section 10.34(d) of Treasury Circular 230, Regulations Governing Practice Before the Internal Revenue Service (31 C.F.R. Part 10), a practitioner may generally rely in good faith without verification upon information furnished by the client, but may not ignore the implications of information furnished to, or actually known by, the practitioner, and must make reasonable inquiries if the information as furnished appears to be incorrect, inconsistent, or incomplete. A similar requirement is found in AICPA Statement on Standards for Tax Services (SSTS) No. 3, Certain Procedural Aspects of Preparing Returns.

Over the years, Congress became increasingly concerned with taxpayers' taking certain credits for which they were not eligible. The Taxpayer Relief Act of 1997, P.L. 105-34, enacted a penalty under Sec. 6695(g) on paid tax return preparers who fail to comply with due-diligence requirements imposed under Treasury regulations to determine eligibility for, or the amount of, an earned income tax credit (EITC). The Protecting Americans From Tax Hikes Act of 2015, Division Q of P.L. 114-113, expanded the Sec. 6695 due-diligence requirements to preparers of returns that claim the child tax credit (CTC), the additional child tax credit, or the American opportunity tax credit. Most recently, the law known as the Tax Cuts and Jobs Act of 2017, P.L. 115-97, expanded the penalty's application to preparers of returns that claim the credit for other dependents or head-of-household filing status. The penalty for each such failure is $500, indexed for inflation ($520 for returns or claims for refund filed in 2019).

Sec. 6695 due-diligence standards

Regs. Sec. 1.6695-2 provides the due-diligence requirements that tax return preparers must follow to avoid the penalty and contains several examples reflecting these requirements. The primary requirement is the completion of Form 8867, Paid Preparer's Due Diligence Checklist, based on information provided by the taxpayer or otherwise reasonably obtained or known by the tax return preparer. The completed Form 8867 must be included with the tax return or claim for refund and contains general due-diligence questions that must be answered for any of the credits listed as well as head-of-household filing status. One question asks specifically, for returns claiming head-of-household filing status, whether the preparer determined the taxpayer was unmarried or considered unmarried on the last day of the tax year and provided more than half of the cost of keeping up a home for the year for a qualifying person.

When computing any of the specified credits, the tax return preparer must complete the applicable worksheet in the instructions to Form 1040, U.S. Individual Income Tax Return, and/or the instructions for Form 8863, Education Credits (American Opportunity and Lifetime Learning Credits), or a separate worksheet that provides the same information. The tax return preparer also must meet certain knowledge requirements. Similar to the general due-diligence standards described in Circular 230 and SSTS No. 3, a tax return preparer must not know, or have reason to know, that any information used in determining the taxpayer's eligibility to file as a head of household or in determining one of the applicable credits is incorrect.

Furthermore, the tax return preparer may not ignore the implications of information furnished to, or known by, the preparer, and must make reasonable inquiries if a reasonable and well-informed tax return preparer knowledgeable in the law would conclude that the information furnished is incorrect, inconsistent, or incomplete. The preparer must contemporaneously document any inquiries made and responses to those inquiries. The following example drawn from the regulation illustrates the knowledge requirement:

In 2019, S engages Preparer E to prepare S's 2018 federal income tax return. During Preparer E's standard intake interview, S states that S has never been married and that S's niece and nephew lived with S for part of the 2018 tax year. Preparer E believes S may be eligible to file as head of household and claim each of these children as a qualifying child for purposes of the [EITC] and the CTC, but the information furnished to Preparer E is incomplete. . . . Preparer E knows from prior social interactions with S that the children resided with S for more than one-half of the 2018 tax year and that the children did not provide over one-half of their own support for the 2018 tax year. To meet the knowledge requirement in [Regs. Sec. 1.6695-2(b)(3)], Preparer E must make ... reasonable inquiries to determine whether S is eligible to file as head of household and whether each child is a qualifying child for purposes of the [EITC] and the CTC ... including reasonable inquiries about the children's residency, S's relationship to the children, the children's income, the sources of support for the children, and S's contribution to the payment of costs related to operating the household, and Preparer E must contemporaneously document these inquiries and the responses. [Regs. Secs. 1.6695-2(b)(3)(ii)(E) and (F), Examples (5) and (6)]

Once the due-diligence requirements are met, the tax return preparer must retain a copy of the completed Form 8867, a copy of each completed worksheet required under the regulation, and a record of how and when the information was obtained, including the identity of any person furnishing the information, as well as a copy of any document that was provided by the taxpayer and relied upon to complete the Form 8867 and applicable worksheets. The Form 8867 instructions provide examples of documents that may be relied on for purposes of residency of a qualifying child to determine eligibility for head-of-household filing status and/or the credits, which include:

  • School records or statement;
  • Landlord or a property management statement;
  • Health care provider statement;
  • Child care provider records;
  • Placement agency statement; and
  • Social service records or statement.

This information must be retained for three years from the latest of the following dates:

  • Due date of the tax return (determined without regard to extensions);
  • Date the tax return or claim for refund was filed (if e-filed);
  • Date the tax return or claim for refund was presented to the taxpayer for signature (if not e-filed); or
  • In the case of a nonsigning tax return preparer, the date the portion of the tax return or claim for refund for which the nonsigning tax return preparer was responsible was submitted to the signing preparer.

The IRS can waive the Sec. 6695(g) penalty if the tax return 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, and the failure was isolated and inadvertent (Regs. Sec. 1.6695-2(d)).

As Congress continues to add to the list of due-diligence requirements, the potential penalty exposure grows as well. Given that the penalty under Sec. 6695(g) on paid tax return preparers who fail to comply with due-diligence requirements for the 2018 tax year could be as much as $2,080 for a single return, preparers need to be familiar with these requirements and ensure procedures are in place to identify clients subject to the enhanced due-diligence standards.

Member resources

Due Diligence in Tax Services practice guide (AICPA member login required)

2018 Paid Preparer’s Due Diligence Checklist (Tax Section member login required)

 

Contributors

Jesse Palmer, CPA, is a partner and director of Tax Quality Control at BKD LLP in Springfield, Mo. Heidi Ridgeway, CPA, is a director of Tax Practice Policy & Quality at Grant Thornton LLP in Chicago. Roby B. Sawyers, CPA, Ph.D., is a professor of taxation and accounting in the Department of Accounting, Poole College of Management, at North Carolina State University. All are members of the Tax Practice Responsibilities Committee. For more information on this article, contact thetaxadviser@aicpa.org.

 

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