Due-Diligence Hazards for Tax Practitioners: The List Keeps Growing

Navigating the landscape of what is reasonable and sound is often a challenge for tax practitioners. When it comes to issues such as rental property income and worker classification, preparers and taxpayers are sometimes falling short, according to Stephen Whitlock, director of the IRS’s Office of Professional Responsibility. Speaking at the IRS Nationwide Forum in National Harbor, Md., on Tuesday, Whitlock reviewed compliance areas where his office sees room for improvement in following the rules of Circular 230, Regulations Governing Practice Before the Internal Revenue Service (31 C.F.R. Part 10), regarding reliance on client information. Separately, practitioners offered a few insights and suggestions for pursuing due diligence in the “real world.”

Rental real estate is a common noncompliance area. A 2008 U.S. Government Accountability Office report showed that at least 53% of the taxpayers who reported income from properties misreported that income in tax year 2001, translating to an estimated $12.4 billion of net misreported income. “There’s no reason to think that’s changed,” Whitlock said. A large part of noncompliance is misreporting expenses. Taxpayers are also claiming material participation in the rental “business” so they won’t be subject to the limits on what would otherwise be deemed passive income. “Courts have repeatedly taken a dim view on rough estimates” of time spent as a material participant, Whitlock warned.

With new clients, practitioners have an opportunity to educate them on the rules, he noted. But “if they’ve been in business for a while, you’ve got some real issues.” The preparer needs to go beyond what the client says or provides, Whitlock said, and ask questions like, “Did you really spend $10,000 in plumbing last year?”

Offers in compromise (OICs) can be another trouble spot for some practitioners. Whitlock urged the audience to make sure clients know the eligibility rules to participate and make sure prerequisites are met. “Practitioners should manage clients’ expectations when seeking to compromise tax debts,” he advised. To qualify for an OIC, an individual must have made all estimated tax payments, received at least one bill for a tax debt included in the offer, filed all required tax returns, and, if the individual is a business owner with employees, made all required federal tax deposits for the current quarter. “Delaying the collection process is not a legitimate use of the OIC program,” Whitlock observed. Even filing an incomplete application may be considered a Circular 230 violation, he said.

Not surprisingly, the byzantine worker classification regime can also trip up practitioners. A common misperception, the director said, is that a small business with a corporate officer and no nonofficer employees does not have employment tax filing or payment obligations. While the general rule under Sec. 3121(d)(1) is that a corporate officer is an employee of the corporation, there are exceptions to that rule, Whitlock pointed out, such as when an officer does not perform any services and is not paid remuneration. The IRS classification settlement programs can offer relief, but “make sure your client actually does qualify and understand their scope and limitations,” he advised.

Other common tax preparation issues that present due-diligence concerns include foreign account reporting, hobby income, education and child tax credits, and the Patient Protection and Affordable Care Act, according to veteran practitioners Terry Bakker and James Holmes, speaking at a separate IRS Forum session.

Bakker encouraged preparers to use engagement letters and document everything. Engagement letters “have saved me more often than not,” she said, citing an example of a client who had provided false information for his Schedule C, Profit or Loss From Business. The examiner was going to assess a penalty against Bakker as well as the client: “He said, ‘you should have known he was lying to the IRS.’ ” But Bakker said after she presented the engagement letter that stated she was not responsible for auditing the figures the client provided, as well as the organizer with figures in the client’s handwriting, the auditor backed off.

During the client interview, Bakker, a 28-year veteran in the field, noted she does not use a computer but rather takes notes on everything. She also does the return on paper first. “You should never abdicate responsibility to software,” she said. “You have to know what the return is.”

Holmes and Bakker urged practitioners to recognize their expertise limits and hire someone else to handle an issue that they are not comfortable managing themselves, and learn about it in the process. “You can get your education without violating competence” standards, she said.

Practitioners can also review their responsibilities for tax services in this AICPA practice guide.

—Ann Marie Maloney (amaloney@aicpa.org) is an AICPA communications manager–tax.