© by Greta P. Hicks, CPA

Effective for any returns prepared after 1-1-97, a $100 penalty was added to Internal Revenue Code Section 6695 for failure to be diligent in determining eligibility of taxpayers for earned income credit. Define due diligence? What is due diligence? How does a return preparer exercise due diligence? The search for the IRS definition of due diligence started with the Internal Revenue Code where the term "due diligence" is mentioned in five separate code sections, as follows:

Sec. 6695, Other assessable penalties with respect to the preparation of income tax returns for other persons. FAILURE TO BE DILIGENT IN DETERMINING ELIGIBILITY FOR EARNED INCOME CREDIT- Any person who is an income tax return preparer with respect to any return or claim for refund who fails to comply with due diligence requirements imposed by the Secretary by regulations with respect to determining eligibility for, or the amount of, the credit allowable by section 32 shall pay a penalty of $100 for each such failure.

Sec. 21. Expenses for household and dependent care services necessary for gainful employment.… In the case of a failure to provide the information required under the preceding sentence, the preceding sentence shall not apply if it is shown that the taxpayer exercised due diligence in attempting to provide the information so required.

Sec. 129. Dependent care assistance programs, Identifying information required with respect to service provider. … In the case of a failure to provide the information required under the preceding sentence, the preceding sentence shall not apply if it is shown that the taxpayer exercised due diligence in attempting to provide the information so required.

Sec. 5006. Determination of Tax on Distilled Spirits. Where there is evidence satisfactory to the Secretary that there has been access, other than as authorized by law, to the contents of casks or packages stored on bonded premises, and the extent of such access is such as to evidence a lack of due diligence or a failure to employ necessary and effective controls on the part of the proprietor…

Sec. 6323. Validity and priority (of Federal Tax Liens) against certain persons… Actual notice or knowledge…For purposes of this subchapter, an organization shall be deemed for purposes of a particular transaction to have actual notice or knowledge… if the organization had exercised due diligence. An organization exercises due diligence if it maintains reasonable routines for communicating significant information to the person conducting the transaction and there is reasonable compliance with the routine. Due diligence does not require an individual acting for the organization to communicate information unless such communication is part of his regular duties or unless he has reason to know of the transaction and that the transaction would be materially affected by the information.

Congress in IRC 6695 has given the IRS the authority to write the regulations to define due diligence. Until those regulations are complete, return preparers will need to look elsewhere for guidance. IRC 5006 and 6323 provide some hint to the definition of due diligence but added insight is gained from searching current IRS publications, notice and existing regulations.

Circular 230 And Due Diligence

Sec. 10.22 Diligence as to accuracy.

Sec. 10.34 Standards for advising with respect to tax return positions and for preparing or signing returns. Standards of conduct … Relying on information furnished by clients…

For More Information Read Due Diligence I.T. Temporary Regs. 35a.9999-1 Through 3.
Suggested Steps Leading To Due Diligence

Until the Secretary defines due diligence as it applies to IRC 6695, preparers must look to the above notices, announcements, temporary regulations, and code sections in order to piece together actions that a return preparer should take in order to have exercised due diligence with regards to earned income credit. Since actions, routines and controls seem to be the key words, here are some suggested actions the return preparer may want to take:

1. Design and employ necessary and effective controls. (Set up a system for interviewing clients and preparation of returns.)
2. Maintain reasonable routines (The preparer follows the systems, controls, and routines he/she has in place.)
3. Exercise reasonable compliance with the routine.
4. Communicate significant information to the client. (Explain the law to the client.)
5. Determine the correctness of oral or written representations made by preparer to the client. (Know the law.)
6. Document attempts to secure the necessary information from the client. (Show record of attempts to secure information and/or documents.)
7. Use the clients information unless the preparer knows or has reason to know that the information on the document is incorrect
8. Make reasonable inquiries of the client if the information as furnished appears to be incorrect, inconsistent, or incomplete.
9. Do not ignore the implications of information furnished to, or actually known by, the preparer.
10. Use the same care in processing the information provided by the client that a reasonably prudent preparer would use in handling client information.
11. Exercise care in using the required information to prepare the return.

To qualify for earned income credit, the primary facts the return preparer is to establish are:

1. Verify name of taxpayer and child
2. Verify accuracy of the social security numbers
3. The relationship of child to the taxpayer
4. Age of child
5. Taxpayer is citizen or resident alien
6. Child is resident of United States
7. Child lived in the taxpayer’s residence more than half the year
8. Taxpayer provided for the costs of the residence more than half the year

In the past, preparers have relied upon the oral evidence provided by the client. The new due diligence requirement appears to make it necessary to have a routine in place for requesting copies of documents from clients. Another key factor in determining due diligence is the asking for alternate documents when primary documents are not available. Until preparers are given better guidance, a combination of the following documents may be used as an argument to show that a preparer exercised due diligence in attempting to furnish the required information:

1. Birth certificate
2. Social Security card
3. School records
4. Insurance records
5. Day care records
6. Medical records
7. Rental contracts
8. Green Card

Bottom Line

To avoid the $100 return preparer penalty for failure to exercise due diligence and possible greater future problems, the preparer should be informed on current tax laws, advise the client of the laws, ask questions of the client, have a routine in place that requires the client to provide documents, and follow that routine. It is recommended that the preparer’s routine, procedure or system be in writing, such as in the form of a procedures manual, and that the preparer keep a record of the client interview and follow up questions and answers.

Just do the good job you’ve always done but now write down. Keep a paper trail and hope that you never need it.

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GRETA P. HICKS, CPA and former IRS manager, concentrates in solutions to IRS problems and advises business and tax professional on IRS policies and procedures. Ms Hicks is owner of TAX SOLUTIONS, Inc., a company providing educational materials and programs on solutions to IRS problems and is a nationally known speaker and writer on solutions to IRS problems. To arrange for consultation contact: Greta's web site: http://www.gretahicks.com

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