What diligence means in today’s tax practice

How do you define “diligence”? When must a tax practitioner be diligent? A tax practitioner faces these questions daily. The Merriam-Webster Dictionary defines “diligence” as a “steady, earnest, and energetic effort: devoted and painstaking work and application to accomplish an undertaking.” The definition goes on to provide that in legal situations diligence means “the attention and care legally expected or required of a person.”

Tax practitioners are required to be diligent in the performance of their professional services. The diligence obligation is found in several professional standards, the Internal Revenue Code, and Treasury regulations, including:

• AICPA Code of Professional Conduct ET Section 0.300.060.02, which states, “Due care requires a member to discharge professional responsibilities with competence and diligence.” ET Section 0.300.060.05 goes on to provide, “Members should be diligent in discharging responsibilities to clients, employers, and the public. Diligence imposes the responsibility to render services promptly and carefully, to be thorough, and to observe applicable technical and ethical standards.”
• Section 10.22 of Treasury Circular 230, Regulations Governing Practice Before the Internal Revenue Service (31 C.F.R. Part 10), which provides in part: “A practitioner must exercise due diligence — (1) In preparing or assisting in the preparation of, approving, and filing tax returns, documents, affidavits, and other papers relating to Internal Revenue Service matters; (2) In determining the correctness of oral or written representations made by the practitioner to the Department of the Treasury; and (3) In determining the correctness of oral or written representations made by the practitioner to clients with reference to any matter administered by the Internal Revenue Service.”
• Rule 1.3 of the American Bar Association Model Rules of Professional Conduct, which states, “A lawyer shall act with reasonable diligence and promptness in representing a client.” It should be noted that many of the provisions of Circular 230 are loosely based on the ABA Model Rules of Professional Conduct. An in-depth discussion of the ABA rules, however, is beyond the scope of this column.
• Sec. 6694 and the regulations thereunder open the door to the diligence topic with respect to preparer penalties. Regs. Sec. 1.6694-2(b)(1) refers to the return preparer’s diligence in determining whether there is substantial authority for a position on a return and whether the more-likely-than-not standard is satisfied. The regulation contains a reference to the analysis found in Regs. Sec. 1.6662-4(d) (3)(ii) regarding the process to determine whether substantial authority or the more-likely-thannot thresholds are satisfied. Also, Regs. Sec. 1.6694-1(e)(1) requires that a return preparer “must make reasonable inquiries” with respect to a previously filed return when some of the information reported in that return appears to be incorrect or incomplete.
• On a granular level, Sec. 6695(g) provides for a penalty of $500 for each failure of a tax return preparer who fails to comply with the duediligence requirements imposed by regulations dealing with eligibility to file as a head of household or eligibility for child tax credits, the American opportunity tax credit, or the earned income tax credit (EITC). Regs. Sec. 1.6695-2 provides several examples of diligence situations; requires the completion of Form 8867, Paid Preparer’s Due Diligence Checklist; and requires the preparer to make reasonable inquiries if information provided by a taxpayer appears to be incorrect.
• In addition to the basic diligence requirement found in AICPA Code of Professional Conduct ET Section 0.300.060, members must also be aware of and follow the Statements on Standards for Tax Services (SSTSs). For example, SSTS No. 2.3.3 requires that “a member should make reasonable inquiries” to determine if conditions required to claim deductions are met. SSTS No. 2.3.6 goes on to explain that while a member has obligations with respect to diligence, the taxpayer has the ultimate responsibility for the information reported in the return.

Circular 230 issues

Section 10.22 of Circular 230 sets forth the rules governing diligence as to accuracy. This section provides that a person who practices before the IRS may, under certain circumstances, rely on information provided by the client and by third parties. However, the practitioner has diligence obligations to meet before accepting client or thirdparty information.

Circular 230 contains provisions that permit a practitioner to rely on the work of others. There is a presumption in Section 10.22(b) that a practitioner has performed adequate diligence if the practitioner relies on the work product of others and the practitioner used “reasonable care in engaging, supervising, training, and evaluating the person, taking proper account of the nature of the relationship between the practitioner and the person.” This provision basically permits a practitioner to rely on the work of employees if the engagement, supervision, training, and evaluation criteria are met. When hiring another practitioner for a specialized matter, the emphasis will be on the reasonable care taken in engaging the specialist.

Section 10.34(d) of Circular 230 expands on this, stating that a practitioner “generally may rely in good faith without verification upon information furnished by the client” when preparing returns or other documents for submission to the IRS. The subsection goes on to provide that “[t]he practitioner may not, however, 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 with an important fact or another factual assumption, or incomplete.” Simply stated, the practitioner can accept information provided by a client unless the practitioner has reason to believe the information is not complete and correct. If the practitioner thinks the information is incomplete or incorrect, the practitioner is required to make additional inquiries until the matter is clarified.

A somewhat similar provision is found in Section 10.37, which further expands Section 10.22 regarding written tax advice. When providing written advice, a practitioner must base the advice on reasonable facts and assumptions and must use reasonable efforts to identify and ascertain relevant facts. Specifically, Section 10.37(b) sets forth the rules for reliance on the advice of others. It states:

A practitioner may only rely on the advice of another person if the advice was reasonable and the reliance is in good faith considering all the facts and circumstances. Reliance is not reasonable when — (1) The practitioner knows or reasonably should know that the opinion of the other person should not be relied on; (2) The practitioner knows or reasonably should know that the other person is not competent or lacks the necessary qualifications to provide the advice; or (3) The practitioner knows or reasonably should know that the other person has a conflict of interest in violation of the rules described in this part.

These rules relating to reliance on another person often cause myriad problems, as discussed later.

IRS guidance

Sec. 6695 was originally enacted as part of the Tax Reform Act of 1976, P.L. 94-455. The section was amended by the Taxpayer Relief Act of 1997, P.L. 105-34, to include preparer penalties for failure to comply with the diligence requirements related to the EITC. Later amendments and regulations expanded the scope of Sec. 6695(g) to include head-of-household filing status, the child tax credit, the additional child tax credit, and the American opportunity tax credit, as well as raising the penalty from $100 to $500 per occurrence. While the IRS has issued regulations, guidance, and a required checklist for preparer diligence with respect to these issues, there has been little, if any, focus on other areas as far as the diligence process is concerned until recently.

The IRS issued News Release IR-2023-166 on Sept. 8, 2023, to announce a “sweeping effort to restore fairness to [the] tax system.” Among the issues identified as being in the IRS enforcement crosshairs was high-income taxpayers’ use of foreign bank accounts to avoid taxes. Subsequently, on Nov. 29, 2023, the Office of Professional Responsibility (OPR) released Issue No. 2023-12 in which it addressed “Practitioner Diligence Obligations and the Report of Foreign Bank and Financial Accounts” (FinCEN Form 114, commonly referred to as FBAR). The issue touched on the practitioner’s diligence obligations under Section 10.22(a) of Circular 230 and discussed the obligations of a practitioner who becomes aware of the existence of a client’s foreign account during the preparation of the client’s tax return. The issue noted that, while the practitioner does not have an obligation to prepare an FBAR unless specifically engaged to do so, the practitioner does have an obligation to advise the client of potential penalties for failure to file the FBAR. It should be noted that some practitioners have indicated that this OPR issue is a “stretch” in that the practitioner should not be held accountable for a matter that is outside the scope of the engagement.

Prior guidance on diligence

In Rev. Proc. 80-40, the IRS provided guidelines for application of the Sec. 6694(a) preparer penalty. The revenue procedure states that “a preparer is not considered to have negligently or intentionally disregarded a rule or regulation if the preparer exercises due diligence in an effort to apply the rules and regulations to the information given to the preparer to determine the taxpayer’s correct liability for tax.” The revenue procedure goes on to cite Marcello, 380 F.2d 499 (5th Cir. 1967), which held that “[n]egligence is lack of due care or failure to do what a reasonable and ordinarily prudent person would do under the circumstances.” The revenue procedure provides three factors to be considered with respect to the penalty: (1) the nature of the error causing the understatement; (2) the frequency of errors; and (3) the materiality of errors. It provides that the penalty will generally not be asserted if the preparer’s office procedures are such that errors would rarely occur. However, it goes on to provide that the normal office practice will not be relevant if an error is flagrant or there is a pattern of errors on one return or the same error on numerous returns. The revenue procedure reiterates the fact that the preparer may rely on information provided by the taxpayer but is required to make reasonable inquiries if the information furnished appears to be incorrect or incomplete.

Rev. Rul. 80-266 provided three simple illustrations of the diligence process with respect to entertainment expenses. In the first situation, a client told the return preparer that he had a certain amount of deductible entertainment expenses. The preparer inquired whether the taxpayer had the appropriate documentation, and the taxpayer represented that he did. Upon examination by the IRS, however, the taxpayer could not substantiate some of the expenses due to his failure to produce the required documentation. Since the preparer had inquired about the documentation and the taxpayer represented that his documentation was in order, the preparer was not subject to a penalty.

In the second situation, given the same facts, however, the preparer did not inquire about the documentation, and the taxpayer did not represent that the documentation was in order. In that case, the preparer would be subject to the penalty under Sec. 6694(a) since the requisite diligence was lacking.

The third scenario in the ruling adds a twist. In year 1, the preparer inquired whether the taxpayer had records to substantiate the deductions, and the taxpayer represented that he had the necessary documentation. The IRS examined the taxpayer’s return and disallowed a portion of the deduction since the taxpayer could not produce the required documentation. In preparing the taxpayer’s return for year 2, the taxpayer again represented that he had the required substantiation, but the preparer failed to make additional inquiries, knowing that a portion of the deduction had been disallowed in year 1. The IRS examined year 2 and again disallowed a portion of the deduction. The preparer was subject to the penalty under Sec. 6694 because he failed to make additional inquiries about the supporting documentation and therefore did not perform adequate diligence in the preparation of the return.

In Brockhouse, 749 F.2d 1248 (7th Cir. 1984), a preparer penalty was upheld by the Seventh Circuit. John Brockhouse was employed by an accounting firm and had the responsibility to prepare returns for a professional corporation and its sole shareholder. The bookkeeper for the corporation provided a trial balance that included loans payable by the corporation to a bank and to the shareholder. The trial balance also included interest expense, but the payee of the interest was not indicated.

In preparing the shareholder’s return, Brockhouse failed to inquire whether any of the interest was paid to the shareholder. Although the taxpayer had been sent a tax organizer, the taxpayer chose not to complete the questionnaire. Upon examination, the IRS found that approximately $15,000 of the interest paid by the corporation was in fact paid to the shareholder and was omitted from the shareholder’s return. The IRS asserted a preparer penalty against Brockhouse. The district court upheld the imposition of the penalty on the grounds that Brockhouse negligently failed to make the necessary inquiries about the corporation’s interest payments (Brockhouse, 577 F. Supp. 55 (N.D. Ill. 1983)). The appellate court upheld the imposition of the penalty.

Current diligence issues

Practice in today’s environment poses some unique issues when it comes to diligence. Let’s consider a few of the more common situations.

Example 1: Practitioner P has a corporate client, C Inc., that has been with her firm for many years. When P was planning the engagement to prepare C’s 2022 calendar-year Form 1120, U.S. Corporation Income Tax Return, C’s tax director told P that they had engaged A to prepare a study of C’s research and development (R&D) expenses for credit purposes. The tax director indicates to P in the November 2022 planning meeting that the anticipated credit is substantial in relation to C’s tax liability, and therefore C will not owe any tax in addition to the estimated payments already made. Without further communication, on April 15, 2023, P files an application for extension of time to file C’s return, showing the amount of the estimated payments as C’s tax liability and no additional tax due.

Over the course of the summer, P keeps inquiring when she will receive the R&D credit information needed for the return. After much delay, the tax director provides her with a draft Form 6765, Credit for Increasing Research Activities, on Oct. 11. The form shows a calculation of a large credit amount, but no further detail is provided. P requests the supporting detail behind the calculation of the credit but is told that it will not be available for several weeks, well beyond the extended due date of the return. As a result, P takes the amounts from the form and includes them in C’s return. The return is delivered to C, the authorization form is signed, and the return is e-filed on Oct. 15. Has P met her diligence obligations under the various professional standards?

From a diligence perspective, this example really contains two issues for practitioners’ consideration. The first is the filing of C’s extension without any current communication with the client’s tax director. Some practitioners are of the opinion that the filing of an extension without current communication with the client to confirm tax liability lacks the diligence required under Circular 230. A quick conversation with the tax director at the time the extension is being prepared to confirm the amount of tax liability and ensure that nothing occurred between the planning meeting and year end that had an impact on the tax liability would be the minimum amount of diligence required under applicable standards.

As far as the return is concerned, P had a responsibility to determine whether she could rely on A’s work in preparing the return. The fact that A did not (or would not) provide the detailed credit calculations prior to preparation of the return should cause concern. Also, P should make inquiries including, for example, an internet search to determine whether A is competent and possesses the necessary technical expertise to calculate the credit. There may also be a potential conflict of interest between C and A, especially if A’s credit calculation was performed on a contingent fee basis. Absent those inquiries, P is not performing adequate diligence in the preparation of the return.

One possible solution would be to explain to C’s tax director the potential exposure to penalties if the credit is found to be incorrect. A suggestion to file the return without claiming the credit and amending once the detailed report is available for review may be in order. At a minimum, disclosure of the credit calculation should also be considered if there is a reasonable basis, but not substantial authority, to claim the credit using A’s calculation.

Example 2: Practitioner T has an old school pal, D, who is a laborer. T has prepared D’s tax returns for many years and knows that D has never made more than $30,000 per year. When D shows up for the interview appointment for the preparation of his 2022 returns, T happens to look out the window at the parking lot and sees D getting out of a new electric sports car that T knows is in the $200,000 price range, as opposed to his normal old pickup truck.

While exchanging pleasantries during the interview, T comments on the new car and asks D how he came up with the money to buy an expensive vehicle like that. D responds that his Uncle i had made a gift of some cryptocurrency to D, and D decided to cash out of the cryptocurrency to purchase the car of his dreams. D assures T that there is no gain on the transaction since the cryptocurrency had gone down in price substantially since E made the gift. Since D represented that there was no gain, T is inclined to include the cryptocurrency sale on D’s return without gain. Should T be performing more diligence?

T knows that D does not possess any knowledge of tax laws. As such, D’s representation that there is no gain on the cryptocurrency sale because it decreased in value since the time of the gift may not be accurate. T has an obligation to make additional inquiries regarding the cryptocurrency gift before he can complete D’s return. At a minimum, did E file a gift tax return? Did E tell D what the tax basis of the cryptocurrency was in E’s hands at the time of the gift? Without obtaining information about the donor’s basis at the time of the gift, T cannot make an accurate determination whether D has a reportable gain. Completing D’s returns without making the additional inquiries would be a lack of adequate diligence. See IRS News Release IR-2024-18 for a reminder of the requirements to report transactions involving digital assets.

Example 3: S has been preparing tax returns for married clients J and K for several years. S has noted that J and K have had a nominal amount of investment income in prior years. When reviewing J and *K’*s 2022 tax information, S notices information indicating that J received a substantial amount of dividend and interest income from a bank that S recognizes as being a foreign-based institution. The tax organizer that S provided to J and K contains questions about ownership of foreign accounts and foreign trust distributions, but J and K do not complete the organizer. S asks J about the increased amount of dividend and interest income, and J replies that his rich aunt passed away during 2022 and J was the successor beneficiary of her trust. Is that inquiry sufficient to satisfy S’s obligations?

J’s response regarding the new investment income should lead S to make several additional inquiries in her diligence quest. Was J’s aunt a U.S. citizen or resident? Was her trust terminated, or is it still in existence? Is it a U.S. trust or a foreign trust? Does J have a copy of the trust agreement? Is the account generating the investment income held in the United States or at a foreign institution?

S has an obligation to determine whether J’s return should include “Yes” as the response to the questions regarding foreign accounts and foreign trusts on Schedule B of the 2022 return. Additionally, S may have to obtain sufficient information to complete Form 8938, Statement of Specified Foreign Financial Assets. The information requested about the trust may lead to the need for J to file Form 3520, Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts, or 3520-A, Annual Information Return of Foreign Trust With a U.S. Owner. The penalties for failure to properly report distributions received from a foreign trust or the ownership of a foreign trust are substantial. OPR’s Issue No. 2023-12, mentioned above, was intended to alert practitioners to their obligations with respect to FBARs. According to the alert, S has an obligation to notify J of his responsibility to file an FBAR if he does, in fact, have a foreign account with a balance that exceeds $10,000. The alert indicates that S does not have an obligation to prepare the FBAR unless specifically engaged to do so but does have an obligation to inform J of the potential penalties if he is required to file and fails to do so.

This column cannot cover the various diligence situations that arose from the employee retention credit (ERC). Much has already been written about those issues, and hopefully the IRS announcement of a withdrawal process for ERC claims that may have been overly aggressive will help to make some of these issues disappear (see IRS News Release IR-2023-193 (Oct. 19, 2023)).

In summary, to take a line from Sgt. Phil Esterhaus from the old Hill Street Blues television series: “Let’s be careful out there!”

Author’s note: The author is grateful for the editorial comments and assistance provided by Edward K. Dennehy, CPA, J.D., LL.M., of RSM US LLP’s Office of Risk Management, and Edward R. Jenkins, CPA, CGMA, a member of the AICPA Tax Practice Responsibilities Committee.

Contributor

James W. Sansone, CPA, is managing director, Office of Risk Management, with RSM US LLP in Schaumburg, Illinois, and a member of the AICPA Tax Practice Responsibilities Committee. For more information on this column, contact thetaxadviser@aicpa.org.