The due diligence tax preparer penalty is a fine for income tax preparers who fail to meet due diligence requirements when preparing tax returns that claim certain credits or head of household filing status.
The IRS takes due diligence very seriously because fraudulent claims are becoming increasingly common. The agency even conducts “Knock and Talk” visits as part of its Preparer Compliance Program to educate preparers, discuss errors, and explain the risks of not providing accurate tax returns.
Let’s take a closer look at what due diligence for tax preparers means, how preparers should perform it, and the penalties for not following the rules.
What Is Due Diligence for Tax Preparers?
People use tax experts to prepare their income taxes for them because the experts know how to take advantage of tax rules. By claiming all possible tax credits or tax deductions, clients keep more of the money they earn rather than handing it over to the IRS.
U.S. income tax preparers must adhere to tax laws and conduct due diligence when they prepare tax returns for taxpayers who claim certain tax credits or head of household (HOH) filing status. HOH status gives an unmarried filer with a qualifying dependent tax advantages that a single filer does not have.
The IRS requires due diligence from tax preparers to make sure their clients really do qualify for the credits or HOH status because they will pay less tax to the IRS.
The credits that fall under due diligence are the following:
• Child tax credit (CTC), additional child tax credit (ACTC), credit for other dependents (ODC)
• American opportunity tax credit (AOTC)
• Head of household (HOH) filing status
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What Is the Due Diligence Tax Preparer Penalty for 2023?
Each failure on a return filed in 2023 carries a penalty of $560. If a preparer claims all four benefits on a return and fails to perform due diligence for each benefit, the penalty for that return is $2,240. The preparer can also be referred to the Office of Professional Responsibility, or even the IRS Criminal Investigation Unit, if their failure to comply is deemed willful. It’s also possible that the IRS may request the Department of Justice to seek an injunction to stop the preparer from preparing any future returns.
What Are the Four Due Diligence Requirements?
To comply with due diligence and avoid a penalty, the IRS requires a tax preparer to do the following:
Complete and Submit Form 8867
The form must be based on information obtained from the client. It can be submitted to the IRS with the e-Filed return or claim, or included in the filed return or claim.
Compute the Credits
The preparer must complete the appropriate worksheets for each applicable credit (such as those found in the instructions for Form 1040 or Form 8863) and keep records of the information and calculations used.
Conduct the Knowledge Test
The preparer must interview the client to verify that the information on income tax withholdings, earnings, dependents, and all relevant data are correct, consistent, and complete. The preparer must also keep a record of the interview.
Keep the Records for Three Years
Documents can be held in electronic or paper format.
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What Are Examples of a Due Diligence Penalty?
Let’s say a taxpayer who is preparing for tax season wants to claim the earned income tax credit (EITC). This credit is calculated by multiplying the taxpayer’s income by a percentage determined by the IRS. The amount of the credit phases out above certain income levels that vary depending on the number of qualifying children the taxpayer has. A due diligence penalty might be levied if the tax preparer makes one of the following common errors:
• The tax preparer fails to verify if a child qualifies under the EITC in terms of their age, relationship, or residency requirements.
• The tax preparer files claiming the client is single or head of household even though the taxpayer is married.
• The tax preparer reports inaccurate income or expenses for the client.
The IRS gives more specific guidelines to tax preparers in Publication 4687. The publication gives specific examples of situations where the practitioner should ask further questions to fulfill the due diligence requirement. For example, “A 22-year-old client wants to claim two sons, ages 10 and 11, as qualifying children for the EITC.”
In this case, the IRS recommends the tax preparer does some further checking because the children’s ages are so close to the client’s age. The preparer is expected to make reasonable inquiries to verify the children’s relationship with the client.
Another example from the IRS: “A client has two qualifying children and wants to claim the EITC. She claims to have earned $20,000 in income from her Schedule C business and had no business expenses.”
The IRS considers it unusual for someone who is self-employed to have no business expenses. Due diligence expects the preparer to ask additional reasonable questions to determine whether their client is carrying on a business and whether the information about her income and expenses are correct.
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Pros and Cons of the Due Diligence Penalty
The due diligence requirements demand extra work for tax preparers, such as conducting in-depth interviews and storing documents. However, preparers can establish policies and procedures with checklists and consistent practices, which should keep them organized and prevent them from falling foul of the IRS.
• If the tax preparer can show they have “reasonable cause” for an understatement on the return, and the preparer acted in “good faith” while preparing the return, the preparer generally will not be penalized.
• Following a due diligence checklist for every tax return ensures office procedures to minimize mistakes.
• If a checklist is always followed, it is more likely that the preparer acts in good faith while preparing returns and will not be penalized.
• Tax preparers may need to develop a system and a checklist for due diligence cases and follow it consistently.
• Tax preparers need to keep meticulous records of interviews and documents.
• Tax preparers must stay up to date with current and new requirements related to due diligence, as the IRS rulings change frequently to help reduce tax fraud and abuse.
The IRS takes due diligence seriously when taxpayers are claiming certain tax benefits or head of household status. Therefore, it’s critical that tax preparers follow the due diligence rules and develop consistent processes and checklists to ensure they comply. Due diligence penalties are significant, and a preparer may even be referred to the Department of Justice and prevented from practicing. The due diligence requirements may mean extra work for tax preparers, such as conducting in-depth interviews, creating checklists, and storing documents. However, the extra work is well worth it to keep them organized and on the right side of the IRS.
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What is the due diligence penalty for 2023?
The penalty for returns filed in 2023 is $560 for each failure on a return. If a preparer claims all four benefits on a return and fails to perform due diligence for each benefit, the penalty for that return is $2,240.
What happens to a paid preparer who fails to meet the due diligence requirements IRC 6695 G?
Under IRC 6695 G, the penalty in calendar year 2022 is $545 for each failure of a tax preparer to meet due diligence requirements and determine a taxpayer’s eligibility for the head of household filing status or the following credits:
• Any dependent credit, including the Additional Child Tax Credit and Child Tax Credit
• American Opportunity Credit
• Earned Income Tax Credit
• Lifetime Learning Credit
What happens if a tax preparer doesn’t meet the due diligence requirements?
In addition to facing penalties, a tax preparer who does not do due diligence will be referred to the Office of Professional Responsibility. If the failure is deemed willful, the preparer can be referred to the IRS Criminal Investigation, and the Department of Justice may take away the right for the preparer to work on any future returns.
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