Tax return due diligence: basic considerations.

• Author: Milford, Douglas J.

In the popular movie The Verdict, a critical plot point is the question of a hospital's due diligence and negligence. A patient at the hospital was in a vegetative state, and the family was suing the hospital over whether its behavior and the circumstances surrounding the administration of anesthesia were appropriate. There is further controversy over the documentation as to whether the admitting nurse "did the right thing" in checking into whether the patient had eaten anything outside the appropriate time frame for safely administering anesthesia. Did the hospital do the right thing? What would a normal and prudent medical staff do under the circumstances? What was the role of documentation in the determination of the hospital's liability?

While the situation may not have the same drama as The Verdict, a tax professional may be asked the same types of questions if something goes awry and there is a mistake on a return or an understatement of tax. With the perspective of hindsight, did the tax return preparer do the right thing? What exactly is the right thing to do in determining a tax return position? Did the preparer apply the law appropriately to the facts? Did he or she have all the relevant facts? What effort is required of a reasonable and prudent preparer to obtain the pertinent facts? What should the preparer document in the client's file?

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In fact, this scenario is far from hypothetical: The IRS asks tax return preparers these questions every day. CPAs recognize that they serve an important role in the effective administration of the tax system. At the same time, they are also advocates for clients and are motivated to assist their clients in achieving an optimal tax result. There are also time and budget constraints on the entire process. Until recently, CPAs were part of a largely self-regulated profession. However, more attention is being paid to the concept of preparer due diligence and its impact on "unreasonable" tax positions. It is the authors' view that if tax professionals do not understand these rules and proactively adapt to them in a practical manner, additional external regulation may be used to discourage inappropriate tax positions and collectively reduce the tax gap. The CPA's role as an advocate for the client can still be effective and valuable while stopping short of having to audit, or make a skeptical inquiry of, every client assertion made in the course of return preparation.

Discussion and Examples

There may be as many ways to prepare tax returns as there are tax return preparers. (1) There is no universally accepted standard as to the steps that preparers must take when preparing a return. When the return is completed and ready for submission to the IRS, the preparer signs a declaration under penalties of perjury that the return is--to the best of the knowledge and belief--true, correct, and complete. The preparer bases that declaration on all information about which he or she has any knowledge. When issues arise in connection with the preparation of a return, the issue often comes down to whether the preparer exercised due diligence when preparing it. When a preparer is found to have failed to exercise due diligence, possible outcomes include a dissatisfied client, penalties asserted against the client and the preparer, other professional sanctions such as those related to the preparer's licenses and Circular 230, (2) and actions for damages pursued by the client or, more accurately most of the time, the former client.

Dictionary definitions of "due diligence" suggest that it means the diligence or care that a reasonable person or, in this context, a reasonable tax return preparer would use under the same circumstances. (3) While court cases relating to disciplinary or malpractice actions against preparers often refer to a preparer's due diligence, they do not appear to define the term in any manner that is unique to tax preparers. Furthermore, the cases do not appear to create bright lines that are useful to preparers in planning return preparation engagements or resolving difficult issues that may arise during those engagements. It is clear, however, that the courts apply an objective test of reasonableness. Although sometimes argued, it generally is not relevant that the preparer subjectively believed a position to be reasonable. This potential trap provides a compelling reason to double check one's preliminary conclusions on a position with a colleague for another objective perspective.

The regulations also use the term "diligence" and generally describe due diligence as synonymous with the concept of acting with reasonable care and in good faith. While the regulations do not provide exhaustive guidelines on what constitutes due diligence in the preparation of a return, they address the issue generally and also provide some details in connection with the reliance on client information, the work of other preparers, and prior-year returns. Against this backdrop, one can extrapolate the level of effort expected to satisfy the due diligence standard in other common situations.

A fundamental precept of the preparer regulations has to do with the concept of reliance by the preparer. The general rule is that the preparer may rely in good faith and without verification upon information furnished by the taxpayer. The preparer is not required to audit, examine, or review books and records, business operations, documents, or other evidence to independently verify information provided by the taxpayer; however, the preparer may not ignore the implications of information furnished by the taxpayer. The preparer must make reasonable inquiries if the information as furnished appears to be incorrect or incomplete. (4)

Example 1: A, a return preparer, asks her client, B, to complete an organizer to help her in the preparation of his 2009 Form 1040. B completes the organizer page on securities transactions, including information that he bought 200 shares of Z Corp. for $2,000 on January 14, 2009, and sold them for $2,200 on April 17, 2009.

Unless she has some reason to suspect that the information provided in the organizer is incorrect or incomplete, A has acted with appropriate due diligence when preparing B's Schedule D using this information without further inquiries. Specifically, unless she has reason to suspect that the information in the organizer is incorrect or incomplete, she can prepare the return with appropriate due diligence even though she does not examine trade confirmations or brokerage statements.

Example 2: F's firm prepares a corporate tax return for M, a medical practice. F also prepares the individual income tax return for M's sole shareholder, S. M's books and records include loans to the corporation from S and a bank. F then prepares S's tax return without including any interest income paid by M to S. Based on these specific background facts known to F, he did not make any further inquiries as to whether M had paid any interest to S.

On these and similar fact patterns, courts have found that the information provided to F would lead a reasonable, prudent preparer to seek additional information related to the interest paid on the loans, so F is negligent in not making further inquiries leading to an understatement of tax by the shareholder. (5)

As an additional requirement to the general rule concerning reliance on information, the regulations provide that for provisions of the Code or regulations requiring that specific facts and circumstances exist (for example, that the taxpayer maintain specific documents) before a deduction or credit may be claimed, the preparer must make appropriate inquiries to determine the existence of the required facts and circumstances. (6) While the regulation requires the preparer to make such inquiries, absent some reason to suspect that the client's representation as to the required circumstances is incorrect or incomplete, the preparer generally may rely on that representation that the circumstances have been satisfied. The most critical exception to this general rule--the special regime applicable to the earned income credit--is discussed in the following example.

Example 3: G asks H to prepare an organizer to assist her in preparing his 2009 Form 1040. H, who travels in connection with...