IRS Webinar Reviews Paid Preparer’s Due Diligence Requirements for 2021 Returns

A recent IRS webinar reviewed due diligence requirements for paid preparers who prepare returns that claim:

• The child tax credit (CTC), including the credit for other dependents (ODC),
• The earned income tax credit (EITC),
• The American Opportunity educational tax credit (AOTC), and/or
• Head of household filing status (HOH).

These due diligence tests may be especially challenging for the 2022 filing season, given the substantial changes in the CTC and the EITC for 2021. And due diligence is always important because the IRS can impose substantial penalties on return preparers who fail to satisfy the requirements.

Four Requirements for Due Diligence

Due diligence requires paid preparers to satisfy these four tests when a return claims any of the four tax benefits listed above:

1. Complete Form 8867, Paid Preparer’s Due Diligence Checklist, and submit it with the return.
2. Make sure any claimed benefit is based on facts.
3. Ask the taxpayer the right questions.
4. Keep records for three years.

Knowledge Test is Principal Component of Due Diligence Requirements

These first three due diligence requirements can be summarized as a “knowledge requirement” that has the following components:

1. To determine if the taxpayer is eligible for the claimed benefit, the preparer must interview the taxpayer, ask questions, and document the questions and the taxpayer’s responses.
2. Then the preparer must review the information to determine that the taxpayer is actually eligible for the claimed benefit(s), and accurately determine the amount of any credits.
3. If the preparer receives information from the taxpayer or a third party that appears to be incorrect, incomplete or inconsistent, the preparer must make reasonable inquiries to determine correct, complete and consistent information, and document those inquiries.

The webinar presenters recognized that these conversations with taxpayers can sometimes be uncomfortable. When that is the case, they recommended the preparer go over IRS forms, instructions and other materials with the taxpayer, to help the taxpayer understand what the IRS requires – and, in the worst case scenario, what the IRS will expect the taxpayer to produce in an audit.

Knowledge Test Example

As an example of how these due diligence standards work, the webinar discussed how a preparer should handle a new client who wants to claim the CTC for a child from Mexico.

1. First, the preparer reviews the requirements for the CTC, including the rule that limits the credit to children who are citizens, residents or nationals of the United States.
2. Next, the preparer explains that rule to the client, and asks probing questions about the client’s relationship to the child.
3. In response, the client explains that the child was born in Mexico, but has lived with the client in the U.S. since the client adopted her two years ago.

As long as nothing in the client’s explanation is incorrect, incomplete or inconsistent, this exchange satisfies the due diligence requirement. The preparer does not have to ask for documentation, such as the child’s green card.

Knowledge Test for Repeat Clients

Once the taxpayer has answered certain questions for one year, the preparer generally does not have to ask them again for the following year. However, there are exceptions.

For example, if a new client claims a benefit based on a grandchild, the preparer must use the knowledge test to ascertain that the child is actually the client’s grandchild, and also that the child satisfies all applicable requirements for the benefit claimed.

However, in subsequent years, the preparer does not have to ask about the client’s relationship to the child, because the preparer has already confirmed that the child is the client’s grandchild. Of course, the preparer generally does have to confirm each year that the child satisfies any applicable residency requirements for the client.

Common and Not-So-Common Due Diligence Pitfalls

The webinar presenters noted that child tax credit (CTC) claims can be particularly challenging this year because the credit was substantially modified for 2021. Among other things, these changes increased the amount of the credit, made it complete refundable, and paid half of it in advance for most taxpayers.

In response to these changes, the IRS moved all CTC worksheets to Schedule 8812 (1040), Credits for Qualifying Children and Other Dependents. Line 12 of Schedule 8812 calculates the CTC after application of the original AGI phase-out for the credit (that is, $400,000 for joint filers, and $200,000 for other taxpayers).

The webinar warned return preparers that the due diligence requirements apply if line 12 shows any amount above zero – even if the taxpayer does not claim the CTC on Form 1040.

Outside of the CTC, the webinar also reminded preparers that many taxpayers try to under- or over-report self-employment income, usually in an attempt to manipulate the EITC.

Consequences of Failing Due Diligence Requirements

The webinar reviewed what preparers can expect from the IRS if they do not meet due diligence requirements. Beginning with the first IRS contact, the paid preparer should review the due diligence requirements, and also review office procedures to make sure those requirements are being met.

The IRS outreach process may conclude that the preparer is following proper procedures, but it also may end up with the IRS agent recommending penalties.

Penalties for Violating Due Diligence Requirements

A paid preparer’s penalties for violating the due diligence requirements can be significant. For 2021, the due diligence penalty is $545. And that’s for each failure – not for each return. Thus, if a preparer fails to perform due diligence for a return that claims all four tax benefits, the penalty for that return is $2,180.

Even worse, if the preparer willfully fails to satisfy the due diligence requirement, the IRS may refer the preparer to the Office of Professional Responsibility, or even the IRS Criminal Investigation unit. The IRS may also ask the Department of Justice to seek an injunction to stop the preparer from preparing returns.

IRS Resources for Due Diligence Requirements

Finally, the webinar reviewed the many resources the IRS offers to help paid preparers satisfy the due diligence requirements. These include:

• training modules,
• videos,
• FAQs, and
• educational resources.

These materials are collected on the IRS website at www.IRS.gov/toolkit. This portal should also be one of the first results if a preparer does an internet search for something like ‘irs toolkit’. A video of the due diligence webinar is also available at the www.irsvideos.gov portal.