According to the IRS, roughly one-quarter of earned income tax credits (EITC) payments were issued improperly in 2018, costing the Department of Treasury approximately $16 billion each year. What’s more, the federal Office of Management and Budget has declared the EITC as a high-risk program, which subjects it to specific Treasury Department reporting requirements.
Refundable tax credits overall are subject to increased scrutiny by the IRS. In fact, the IRS withholds payments of the EITC and other refundable tax credits during tax season to double-check the accuracy of the information. Tax preparers must complete a due diligence checklist before they file tax returns that claim the credit.
Due Diligence Requirements
The tax law imposes strict due diligence requirements when clients claim one or more of the following tax credits on their returns: EITC); child tax credit (CTC) and additional child tax credit (ACTC); credit for other dependents (ODC); and the American opportunity tax credit (AOTC). Additionally, the Tax Cuts and Jobs Act (TCJA), which became effective in 2018, expanded the due diligence requirements to cover eligibility for filing as a head of household (HOH).
The IRS looks for returns with a high probability of errors completed by the same preparer and uses that information to select those to audit. Before filing season, the IRS conducts due diligence errors on the prior year’s returns. While the IRS may send a warning letter prior to auditing a return preparer and assessing penalties, they it is not required to do so.
During the audit, the IRS examiner will interview the tax preparer about their business practices. As part of the audit, you must meet the knowledge standard, which includes knowing the law, knowing the right questions to ask your clients, documenting the responses and obtaining all facts to prove your client truly qualifies for the tax credit and/or HOH filing status.
Specifically, tax practitioners must meet the following four diligence requirements:
- Compute the credits based on the facts
- Complete and submit Form 8867
- Retain the records
- Ask all the right questions
You must evaluate your client’s personal situation, information and eligibility. If you have a reason to doubt or question the correctness, consistency or completeness of any information used for these purposes, ask the client for additional information.
Understanding the Penalties
As a tax preparer, you must be aware of the stiff penalties for failing to meet due diligence requirements. Understand that both you and your clients are at risk. If the IRS examines a client's return and denies all or a part of one of the credits or HOH status, your client:
- Must pay back any amount in error with interest
- May be subject to the 20% accuracy-related penalty and the 75% fraud penalty
- May be banned from claiming one or more of the credits for the next two years if the IRS finds the error is due to reckless or intentional disregard of the rules
- May be banned from claiming one or more of the credits for the next 10 years if the IRS finds the error is due to fraud
If the IRS examines a return that you prepared for a client and finds that you didn’t meet all four due diligence requirements for each credit or the HOH, the possible consequences are:
- A $500 penalty, indexed for inflation, for each failure to comply with your due diligence requirements
- A minimum penalty of $1,000 if you prepare a client return and the IRS finds any part of the amount of taxes owed is due to an unreasonable position
- A minimum penalty of $5,000 if you prepare a client return and the IRS finds any part of the amount of taxes owed is due to your willful, reckless or intentional disregard of rules or regulations.
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Note: This content is accurate as of the date published above and is subject to change. Please seek professional advice before acting on any matter contained in this article.