Temporary (TD 9799) and identical proposed regulations (REG-102952-16) have been released by the IRS to implement the expanded due diligence rules imposed on tax preparers as part of the Protecting Americans from Tax Hikes Act of 2015. The PATH Act expanded the preparer due diligence requirements that originally applied to returns claiming an Earned Income Tax Credit (EITC), first added by Taxpayer Relief Act of 1997, to apply to returns claiming the Child Tax Credit (CTC), Additional Child Tax Credit (ACTC) and American Opportunity Tax Credit (AOTC).

A preparer who prepares a return that claims the EITC, the CTC/ACTC and/or the AOTC faces a per return, per credit penalty if the credit was improperly claimed and the preparer failed to meet the due diligence requirements imposed by the statute and related regulations. [IRC §6695] The penalty is indexed annual for inflation, with the penalty for 2016 tax returns amounting to $530 per credit per return.

As the preamble to the temporary regulations notes, if a preparer erroneously prepared return claiming all three credits and it is found none applied and the preparer failed to meet the due diligence for each, a penalty of $1,590 would apply to the return. [Reg. §1.6695-2T(a)]

Pursuant to the statute, each failure to comply with the due diligence requirements set forth in regulations prescribed by the Secretary results in a penalty. The section 6695(g) requirements apply to each credit claimed, meaning more than one penalty could apply to a single return or claim for refund. The temporary regulations provide examples to show how multiple penalties could apply when one return or claim for refund is filed.

Each credit is tested separately. In the first example the preparer failed to perform due diligence for either credit and ends up with two penalties:

Example 1. Preparer A prepares a federal income tax return for a taxpayer claiming the CTC and the AOTC. Preparer A did not meet the due diligence requirements under this section with respect to the CTC or the AOTC claimed on the taxpayer’s return. Unless the exception to penalty provided by paragraph (d) of this section applies, Preparer A is subject to two penalties under section 6695(g): one for failure to meet the due diligence requirements for the CTC and a second penalty for failure to meet the due diligence requirements for the AOTC.

But if the preparer does meet the due diligence requirements for some, but not all, of the disallowed credits, the penalty applies only to those credits for which there was a due diligence failure:

Example 2. Preparer B prepares a federal income tax return for a taxpayer claiming the CTC and the AOTC. Preparer B did not meet the due diligence requirements under this section with respect to the CTC claimed on the taxpayer’s return, but Preparer B did meet the due diligence requirements under this section with respect to the AOTC claimed on the taxpayer’s return. Unless the exception to penalty provided by paragraph (d) of this section applies, Preparer B is subject to one penalty under section 6695(g) for the failure to meet the due diligence requirements for the CTC. Preparer B is not subject to a penalty under section 6695(g) for failure to meet the due diligence requirements for the AOTC.

A preparer subject to the due diligence requirements must complete Form 8867 and submit it with the tax return claiming the credits. The Form has been updated to include checklists of required steps and information for each credit. As the preamble to the temporary regulations describe these changes:

The Form 8867 has been revised for the 2016 tax year and is a single checklist to be used for all applicable credits (EIC, CTC/ACTC, and/or AOTC) on the return or claim for refund subject to the section 6695(g) due diligence requirements. The Form 8867 was streamlined to eliminate unnecessary redundancy with other forms and schedules. These changes were intended to reduce burden while increasing the utility of the Form 8867 as a checklist for tax return preparers to more accurately determine taxpayer eligibility for credits, thereby reducing errors and increasing compliance by preparers and taxpayers. The temporary regulations clarify § 1.6695-2(b)(1)(ii) to illustrate that the completion of Form 8867 can be based on information provided by the taxpayer to the preparer or otherwise reasonably obtained or previously known by the preparer.

Completion of Form 8867 must “be based on information provided by the taxpayer to the tax return preparer or otherwise reasonably obtained or known by the tax return preparer.” [Temporary Reg. §1.6695-2T(b)(1)(C)(ii)]

A preparer preparing a return on which the credit is claimed must handle computation of the credits by complying with one of two procedures found at Temporary Reg. §1.6695-2T(b)(2)]:

(2) Computation of credit or credits. (i) When computing the amount of a credit described in paragraph (a) of this section to be claimed on a return or claim for refund, the tax return preparer must either—

(A) Complete the worksheet in the Form 1040, 1040A, 1040EZ, and/or Form 8863 instructions or such other form including such other information as may be prescribed by the IRS applicable to each credit described in paragraph (a) of this section claimed on the return or claim for refund; or

(B) Otherwise record in one or more documents in the tax return preparer's paper or electronic files the tax return preparer's computation of the credit or credits claimed on the return or claim for refund, including the method and information used to make the computations.

(ii) The tax return preparer's completion of an applicable worksheet described in paragraph (b)(2)(i)(A) of this section (or other record of the tax return preparer's computation of the credit or credits permitted under paragraph (b)(2)(i)(B) of this section) must be based on information provided by the taxpayer to the tax return preparer or otherwise reasonably obtained or known by the tax return preparer.

The temporary regulations detail the knowledge requirement as follows [Temporary Reg. §1.6695-2T(b)(3)]:

(3) Knowledge—(i) In general. The tax return preparer must not know, or have reason to know, that any information used by the tax return preparer in determining the taxpayer's eligibility for, or the amount of, any credit described in paragraph (a) of this section and claimed on the return or claim for refund is incorrect. The tax return preparer may not ignore the implications of information furnished to, or known by, the tax return preparer, and must make reasonable inquiries if a reasonable and well- informed tax return preparer knowledgeable in the law would conclude that the information furnished to the tax return preparer appears to be incorrect, inconsistent, or incomplete. The tax return preparer must also contemporaneously document in the files any inquiries made and the responses to those inquiries.

Several examples have been added to address what represents due diligence in these circumstances.

The first set of examples deal with confirming that a proper relationship exists between the taxpayer and her two sons to allow her to claim them as dependents, a necessary requirement to claim either the EITC or the CTC. An important part of the second example is the concession that information obtained in a prior year can be used to fulfill the due diligence requirement for the current year.

Example 1. In 2018, Q, a 22 year-old taxpayer, engages Preparer C to prepare Q’s 2017 federal income tax return. Q completes Preparer C’s standard intake questionnaire and states that she has never been married and has two sons, ages 10 and 11. Based on the intake sheet and other information that Q provides, including information that shows that the boys lived with Q throughout 2017, Preparer C believes that Q may be eligible to claim each boy as a qualifying child for purposes of the EIC and the CTC. However, Q provides no information to Preparer C, and Preparer C does not have any information from other sources, to verify the relationship between Q and the boys. To meet the knowledge requirement in paragraph (b)(3) of this section, Preparer C must make reasonable inquiries to determine whether each boy is a qualifying child of Q for purposes of the EIC and the CTC, including reasonable inquiries to verify Q’s relationship to the boys, and Preparer C must contemporaneously document these inquiries and the responses.

Example 2. Assume the same facts as in Example 1 of this paragraph (b)(3)(ii). In addition, as part of preparing Q’s 2017 federal income tax return, Preparer C made sufficient reasonable inquiries to verify that the boys were Q’s legally adopted children. In 2019, Q engages Preparer C to prepare her 2018 federal income tax return. When preparing Q’s 2018 federal income tax return, Preparer C is not required to make additional inquiries to determine the boys relationship to Q for purposes of the knowledge requirement in paragraph (b)(3) of this section.

The following two examples involve the issue of confirming that a taxpayer who lives with her parents and has a child is not herself a qualifying child of her parents, a condition that would preclude claiming the EITC and CTC. Again, the second example notes that information obtained in the initial year can be used to provide evidence of due diligence in a later year:

Example 3. In 2018, R, an 18 year-old taxpayer, engages Preparer D to prepare R’s 2017 federal income tax return. R completes Preparer D’s standard intake questionnaire and states that she has never been married, has one child, an infant, and that she and her infant lived with R’s parents during part of the 2017 tax year. R also provides Preparer D with a Form W-2 showing that she earned $10,000 during 2017. R provides no other documents or information showing that R earned any other income during the tax year. Based on the intake sheet and other information that R provides, Preparer D believes that R may be eligible to claim the infant as a qualifying child for the EIC and the CTC. To meet the knowledge requirement in paragraph (b)(3) of this section, Preparer D must make reasonable inquiries to determine whether R is eligible to claim these credits, including reasonable inquiries to verify that R is not a qualifying child of her parents (which would make R ineligible to claim the EIC) or a dependent of her parents (which would make R ineligible to claim the CTC), and Preparer D must contemporaneously document these inquiries and the responses.

Example 4. The facts are the same as the facts in Example 3 of this paragraph (b)(3)(ii). In addition, Preparer D previously prepared the 2017 joint federal income tax return for R’s parents. Based on information provided by R’s parents, Preparer D has determined that R is not eligible to be claimed as a dependent or as a qualifying child for purposes of the EIC or CTC on R’s parents’ return. Therefore, for purposes of the knowledge requirement in paragraph (b)(3) of this section, Preparer D is not required to make additional inquiries to determine that R is not her parents’ qualifying child or dependent.

The fifth example looks at the requirements to confirm the right to claim a niece or nephew as a qualifying child to qualify for the EITC and CTC:

Example 5. In 2018, S engages Preparer E to prepare his 2017 federal income tax return. During Preparer E’s standard intake interview, S states that he has never been married and his niece and nephew lived with him for part of the 2017 tax year. Preparer E believes S may be eligible to claim each of these children as a qualifying child for purposes of the EIC and the CTC. To meet the knowledge requirement in paragraph (b)(3) of this section, Preparer E must make reasonable inquiries to determine whether each child is a qualifying child for purposes of the EIC and the CTC, including reasonable inquiries about the children’s parents and the children’s residency, and Preparer E must contemporaneously document these inquiries and the responses.

The importance of verifying items, such as the correctness of an assertion that there are no expenses related to a business when claiming the EITC, are outlined in the next example:

Example 6. W engages Preparer F to prepare her federal income tax return. During Preparer F’s standard intake interview, W states that she is 50 years old, has never been married, and has no children. W further states to Preparer F that during the tax year she was self-employed, earned $10,000 from her business, and had no business expenses or other income. Preparer F believes W may be eligible for the EIC. To meet the knowledge requirement in paragraph (b)(3) of this section, Preparer F must make reasonable inquiries to determine whether W is eligible for the EIC, including reasonable inquiries to determine whether W’s business income and expenses are correct, and Preparer F must contemporaneously document these inquiries and the responses.

The final example deals with the American Opportunity Tax Credit and points out that the adviser needs more than just a Form 1098-T. As well, if the Form 1098-T only contains information about amounts billed, the adviser will need to get information about amounts paid. That is important because the IRS has granted the option to colleges an and universities to continue to report amounts billed rather than paid on Forms 1098-T for 2016 and 2017 tax years, despite a 2015 law change requiring the institutions to report amounts paid. Thus, while the institutions have been given relief, that relief was not extended to preparers:

Example 7. Y, who is 32 years old, engages Preparer G to prepare his federal income tax return. Y completes Preparer G’s standard intake questionnaire and states that he has never been married. As part of Preparer G’s client intake process, Y provides Preparer G with a copy of the Form 1098-T Y received showing that University M billed $4,000 of qualified tuition and related expenses for Y’s enrollment or attendance at the university and that Y was at least a half-time undergraduate student. Preparer G believes that Y may be eligible for the AOTC. To meet the knowledge requirements in paragraph (b)(3) of this section, Preparer G must make reasonable inquiries to determine whether Y is eligible for the AOTC, as Form 1098-T does not contain all the information needed to determine eligibility for the AOTC or to calculate the amount of the credit if Y is eligible, and contemporaneously document these inquiries and the responses.

Preparers must also maintain specific records for a period of three years from the latest of a) the due date without regard to extensions for the filing of the return in question, b) for a paid preparer electronically filing the return and signing the return, the date the return was filed, c) for a return signed by the preparer not filed electronically, the date the return was presented to the taxpayer for signature or d) for a nonsigning preparer, the date the nonsigning preparer submitted the return to the signing preparer. [Reg. §1.6695-2(b)(4)(ii)]

The records to be retained are the Form 8867 itself [Reg. §1.6695-2(b)(4)(i)(A)], a copy of each completed worksheet or similar document for each applicable credit [Temporary Reg. §1.6695-2T(b)(4)(i)(B)] and “record of how and when the information used to complete Form 8867 and the applicable worksheets…was obtained by the tax return preparer, including the identity of any person furnishing the information, as well as a copy of any document that was provided by the taxpayer and on which the tax return preparer relied to complete Form 8867 and/or an applicable worksheet.” [Temporary Reg. §1.6695-2T(b)(4)(i)(C)]

The penalty can apply to the preparer and the firm that employs the preparer. As the preamble to the temporary regulations note:

Section 1.6695-2(c) provides that a firm that employs a tax return preparer subject to a penalty under section 6695(g) is also subject to a penalty if certain conditions apply. Under this rule, a firm will be subject to a penalty if and only if one or more members of principal management (or principal officers) of the firm or branch participated in, or prior to the time the return was filed, knew of the failure to comply with the due diligence requirements; the firm failed to establish reasonable and appropriate procedures to ensure compliance with the due diligence requirements; or, through willfulness, recklessness, or gross indifference (including ignoring facts that would lead a person of reasonable prudence and competence to investigate or ascertain) the firm disregarded its own reasonable and appropriate compliance procedures. A firm subject to a section 6695(g) penalty under this section is not eligible for the exception to the penalty in §1.6695-2(d). Under this exception, the penalty will not be applied if the tax return preparer can demonstrate to the satisfaction of the IRS that, considering all of the facts and circumstances, the tax return preparer’s normal office procedures are reasonably designed and routinely followed to ensure compliance with the due diligence requirements, and the failure to meet the due diligence requirements with respect to the particular tax return or claim for refund was isolated and inadvertent.

These expanded rules mean that a much larger number of returns handled by most CPA firms will be subjected to enhanced due diligence requirements, as well the potential for penalties. As the above paragraph notes, this is going to require firms to develop procedures to specifically insure that all required information is obtained by all preparers in the firm (both signing and non-signing) to ensure that the requirements are met.