Most Recent Irs Due Diligence Regulations Under Irc § 6695(g) Continue to Pose Unique Challenges That Could Undermine Its Very Purpose

• Publication year: 2019
• Author: By Kevan P. McLaughlin

Most Recent IRS Due Diligence Regulations Under IRC § 6695(g) Continue to Pose Unique Challenges That Could Undermine Its Very Purpose

By Kevan P. McLaughlin¹

I. OVERVIEW

Few, if any, tax professionals would argue that due diligence requirements do not serve an important function in curbing problem-preparers and decreasing the risk of improper refunds to ineligible taxpayers. This is particularly true in the area of refundable credits because, unlike other credits that are limited to the amount of an individual's income tax liability, refundable credits may result in a payment to a taxpayer beyond their tax liability. This characteristic presents an avenue for problem preparers and taxpayers seeking to defraud the IRS, recent examples of which are aplenty.²

However, although a powerful tool in combatting unscrupulous tax return preparers, IRC § 6695(g) has transformed into something which is nearly unnavigable to many preparers and those advising them. Moreover, some of the penalty's structural problems may serve to undermine its very purpose. This concern is in part because of the current amount of the penalty, which in 2011 increased from $100 to $500 per return,³ and was further indexed to inflationary increases as a result of the Tax Increase Prevention Act of 2014.⁴ Moreover, the Protecting Americans from Tax Hikes Act of 2015 ("PATH Act") further extended the scope of the IRC § 6695(g) Earned Income Tax Credit ("EITC") penalty and due diligence requirements to other tax return items, including head of household filing status, the child tax credit (CTC)/additional child tax credit (ACTC) under IRC § 24, and the American opportunity tax credit (AOTC) under IRC § 25A(i).⁵

Thus, what once could be dismissed as only applying to EITC returns, and therefore avoided by declining such work, may not be so easily ignored after the PATH Act of 2015. Moreover, other tax practitioners, including tax attorneys, must be mindful of IRC § 6695(g)'s scope in that it applies to any "tax return preparer" as defined in IRC § 7701(a)(36). This could become a critical risk for other tax practitioners, like a tax attorney, if they become a non-signing tax return preparer after directly advising about a taxpayer's eligibility to file as head of household, or their eligibility for, or the amount of, the CTC, ACTC, AOTC, or EITC under IRC § 32.⁶

Taken together, a tax return preparer now faces up to a $2,000 penalty, per return, with inflationary adjustments. Moreover, pursuant to Treas. Reg. § 1.6695-2(c) a firm that employs a preparer could itself be vicariously penalized, also for up to a $2,000 penalty, per return, with inflationary adjustments. These increasing costs, scope, and structural features present unique challenges to return preparers, their advisers in matters of ethics, and possibly tax administration at large.

This article seeks to provide some background on the IRC § 6695(g) penalty, address recent revisions to the applicable regulation, and highlight other potential problems with the current due diligence penalty.

II. BACKGROUND ON IRC § 6695(G)

First enacted as part of the Taxpayer Relief Act of 1997, IRC § 6695(g) began as a $100 penalty on preparers who failed to comply with certain due diligence requirements when preparing return(s) that claim the EITC under IRC § 32.⁷ On December 22, 1997, the IRS published Notice 97-65.⁸ Therein the IRS first set out four specific due diligence requirements a preparer must satisfy. Largely unchanged even today, the four original requirements to avoid the imposition of the IRC § 6695(g) penalty were: (1) complete the Earned Income Credit Checklist as attached to Notice 97-65, or in the alternative, record the information necessary to complete the checklist elsewhere in the preparer's files; (2) complete the Earned Income Credit Worksheet as contained in the applicable Form 1040 instructions, or in the alternative record the computation and information necessary to complete the Computation Worksheet; (3) not know, or have reason to know, that any information

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used by the preparer in determining eligibility for, and the amount of, the EITC is incorrect; and (4) retain for three years the Eligibility Checklist and Computation Worksheet (or alternative records), and a record of how and when the information used to determine eligibility for, and the amount of, the EITC was obtained by the preparer.

On December 21, 1998, temporary regulations relating to the due diligence requirements were published,⁹ which became final on October 17, 2000,¹⁰ and generally mirrored Notice 97-65's four requirements. Since October 17, 2000, the four due diligence requirements imposed on preparers are:

1. Form 8867. A preparer must complete and submit Form 8867, Paid Preparer's Earned Income Credit Checklist.
2. Worksheet. A preparer must complete the Earned Income Credit Worksheet, as contained in the Form 1040 instructions or record the preparer's computation of the credit, including the method and information used to make the computation.
3. Knowledge. The preparer must not know or have reason to know that any information used by the preparer in determining eligibility for, and the amount of, the EITC is incorrect and make reasonable inquiries when required, documenting those inquiries and responses contemporaneously.
4. Document Retention. The preparer must retain, for three years from the applicable date, the Form 8867, the Worksheet (or alternative records), and the record of how and when the information used to determine eligibility for, and the amount of, the EITC was obtained by the preparer, including the identity of any person furnishing information and a copy of any document relied on by the preparer.

The IRC § 6695(g) penalty remained at $100 per return until 2011 with the passage of the United States-Korea Free Trade Agreement Implementation Act, which increased the penalty to $500 per return.¹¹ The penalty later became indexed to inflationary increases as a result of the Tax Increase Prevention Act of 2014 and IRC § 6695(h).¹²

More recently, the PATH Act of 2015 now extends the application of the IRC § 6695(g) penalty and due diligence requirements to other refundable tax credits, including the CTC and ACTC of IRC § 24(b), AOTC of IRC § 25A(a) (1), and head of household filing status as defined under IRC § 2(b).¹³ On December 5, 2016, final and temporary regulations,¹⁴ further cross-referenced to proposed regulations, were published to reflect these changes.¹⁵ On July 18, 2018, a notice of proposed rulemaking was published in the Federal Register to further reflect the most recent changes to IRC § 6695(g),¹⁶ which became effective as of November 7, 2018.¹⁷ Including minor grammatical revisions and one new example, the most recent guidance at Treas. Reg. § 1.6695-2 did give answers to a few common questions. For example, the regulation clarified that tax return preparers can make their contemporaneous documents in electronic files, whereas some preparers believed that only paper files were acceptable.¹⁸ However, the November 7, 2018 version of Treas. Reg. § 1.6695-2 continues to leave unanswered questions and present other unique challenges for tax return preparers.

III. ONGOING CONCERNS ABOUT IMPUTED OR EXISTING PERSONAL KNOWLEDGE

The knowledge requirement of the due diligence standard is arguably the most important protection against unscrupulous tax practitioners. Under that requirement, currently found at Treas. Reg. § 1.6695-2(b)(3)(i), a tax return preparer cannot know, or have reason to know, the information they use to determine credit eligibility (or head of household filing status) is incorrect. Moreover, a preparer cannot ignore incorrect, inconsistent, or incomplete information, and must make reasonable inquiries if a reasonable third-person preparer would conclude the information given to the preparer was also incorrect, inconsistent, or incomplete.

And further still, the preparer must contemporaneously document how and when they learned of the information used the prepare the return. The concern raised by many preparers, however, is what to do with their preexisting knowledge?

In practice the issue arises in one of two scenarios. First, the return preparer has a preexisting personal relationship with the taxpayer. This is particularly prevalent in tight ethnic communities. For example, a preparer may know that the biological parents of a child are deceased because of prior social interactions with the particular child's aunt. When the aunt later asks the preparer to help file her taxes, the preparer would have the preexisting personal knowledge and may not think to make, or document, any additional inquiries about the qualifying child, i.e., where are the child's parents? Furthermore, even if the preparer did think to ask the question, social insensitivity may prevent them from actually doing so.

The second scenario involves the preparer providing non-tax services and having some professional knowledge spillover. For example, a preparer may know that the biological parents of a qualifying child are deceased

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because they assisted in designating the qualifying child as the aunt's life insurance beneficiary as part of their larger professional offerings. When the child's aunt later asks the preparer to help file her taxes, the preparer would already have the preexisting professional knowledge and may not think to make any further inquiries. And even if they did think to make additional inquires, perceived professional incompetence may prevent them from actually doing so.

In either event the return preparer does not know, nor has any reason to know, the information about the aunt claiming the qualifying child is incorrect. To the contrary, the preparer knows the information to be absolutely true and correct, either through personal or professional interactions with the aunt. Nevertheless, Treas. Reg. § 1.6695-2(b)(3)(i) requires prepares to make additional inquires "if a reasonable and...