In Chief Counsel Email 201846005 the IRS discusses the potential issues with imposing the due diligence penalty under IRC §6695(g) against the 25% owner of an S corporation. The issue related to the risk of hazards of litigation in such a pursuit. But the email gives information on the application of this penalty.

Under IRC §6695(g), a tax preparer may be penalized for failing to exercise due diligence in his/her preparation of returns if certain information is not obtained for taxpayers claiming certain benefits. Originally the penalty was limited to claims for the earned income tax credit, but Congress has expanded the penalty to cover claims for the child tax credit, additional child tax credit and American opportunity tax credit. In the Tax Cuts and Jobs Act Congress branched out beyond credits to impose the requirements on preparers of a return where the taxpayer claims head of household filing status.

IRC §6695(g), after amendment by the Tax Cuts and Jobs Act, reads as follows:

(g) Failure to be diligent in determining eligibility for certain tax benefits

Any person who is a 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—

(1) eligibility to file as a head of household (as defined in section 2(b)) on the return, or

(2) eligibility for, or the amount of, the credit allowable by section 24, 25A(a)(1), or 32,

shall pay a penalty of $500 for each such failure.

The IRS has issued regulations, found at Reg. §1.6695-2, that provide for the procedures for the preparer to follow. Under Reg. §1.6695-2(b)(1) the preparer must properly complete IRS Form 8867, Paid Preparer’s Due Diligence Checklist, as noted below:

(1) Completion and submission of Form 8867

(i) The tax return preparer must complete Form 8867, Paid Preparer's Due Diligence Checklist, or complete such other form and provide such other information as may be prescribed by the Internal Revenue Service (IRS), and

(ii) The tax return preparer's 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.

As well, Reg. §1.6695-2(b)(3)(i) provides the following knowledge requirements:

(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 to file as head of household or 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 preparer’s paper or electronic files any inquiries made and the responses to those inquiries.

For the year this issue arose, prior, virtually identical, temporary regulations governed in this area. The email notes that, generally, merely holding an equity interest in a tax preparation S corporation would not make the shareholder a preparer subject to this penalty:

Temporary regulation § 1.6695-2T(b)(3) provides generally that 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. We think that this specific knowledge requirement would present a legal hazard for assessing the penalty provided for under section 6695(g) directly on the SSN of the 25% co-owner of the S-Corp. However, we do not have enough facts in our possession to make a recommendation in your specific case.

But the S corporation itself, as the party hiring the preparer who presumably violated the due diligence rules, could be liable under the regulations. Reg. §1.6695-2(c) provides:

(c) Special rule for firms.

A firm that employs a tax return preparer subject to a penalty under section 6695(g) is also subject to penalty if, and only if --

(1) One or more members of the principal management (or principal officers) of the firm or a branch office participated in or, prior to the time the return was filed, knew of the failure to comply with the due diligence requirements of this section;

(2) The firm failed to establish reasonable and appropriate procedures to ensure compliance with the due diligence requirements of this section; or

(3) The firm disregarded its reasonable and appropriate compliance procedures through willfulness, recklessness, or gross indifference (including ignoring facts that would lead a person of reasonable prudence and competence to investigate) in the preparation of the tax return or claim for refund with respect to which the penalty is imposed.

The email points out that the S corporation itself, rather than the shareholder, may be appropriate party to penalize in this fact situation.

The S-Corp may be a tax return preparer within the definition of section 7701(a)(36) if it employs a person who prepares a tax return for compensation. The S-Corp may be the proper person on which to assess the penalty under section 6695(g) pursuant to Treasury regulation § 1.6695-2(c) if one of the requirements set forth in that section are met. We do not have enough facts in our possession to make a recommendation as to whether the S-Corp in your case meets these requirements. In addition, there are likely legal hazards with assessing the penalty provided for under section 6695(g), pursuant to Treasury regulation § 1.6695-2(c), directly on the SSN of the 25% co-owner of the S-Corp because it is the S-Corp that employees the preparers and not the co-owner.