Final Regulations Issued for Head of Household Due Diligence Requirements
On November 7, 2018, Treasury issued final regulations to implement new due diligence requirements applying to tax return preparers making head of household eligibility determinations for their clients. The final regulations largely track the proposed regulations, which were issued July 18. They do clarify, however, that a preparer cannot rely on pre-existing knowledge acquired outside of a tax preparation engagement to meet the due diligence requirement. The regulations also affirm the importance of contemporaneous documentation.
The Tax Cuts & Jobs Act added yet another heightened due diligence penalty, this time for failure to use due diligence in preparing an income tax return on which head of household status is claimed. Tax return preparers have grown accustomed to the due diligence penalties already in place for the earned income credit, the child tax credit and additional child tax credit, and the American opportunity tax credit. Thanks to the TCJA, Form 8867 has another column and tax return preparers are subject to a $520 penalty for each misstep on every return. With this penalty, Congress continues to enlist preparers as the first line of defense for eliminating fraudulent returns.
IRC § 6695(g)(1) now states that any tax return preparer with respect to any return or claim for refund who fails to comply with due diligence requirements …with respect to eligibility to file as a head of household under IRC § 2(b) on the return shall pay a penalty of $520 (when adjusted for inflation) for each such failure.
The final regulations clarify the requirements of the new due diligence requirements. Treas. Reg. §1.6695-2(a)(1) summarizes the requirements, effective January 1, 2018:A person who is a tax return preparer (as defined in IRC § 7701(a)(36)) of a tax return or claim for refund under the Internal Revenue Code who determines the taxpayer’s eligibility to file as head of household under IRC § 2(b), or who determines the taxpayer’s eligibility for, or the amount of, the child tax credit (CTC)/additional child tax credit (ACTC) under IRC § 24, the American opportunity tax credit (AOTC) under IRC § 25A(i), or the earned income credit (EIC) under IRC § 32, and who fails to satisfy the due diligence requirements …will be subject to a penalty as prescribed in IRC § 6695(g) (indexed for inflation under § 6695(h)). A separate penalty applies to a tax return preparer with respect to the head of household filing status determination and to each applicable credit claimed on a return or claim for refund for which the due diligence requirements of this section are not satisfied.
Filing a Completed Form 8867 is Not Enough
The final regulations clarify that filing a completed Form 8867 is not enough. In addition, the preparer must meet the following requirements:
- Tax return preparers who prepare returns or claims for refund claiming one or more of EIC, CTC/ACTC, and AOTC must either (1) complete applicable worksheet(s) or (2) record in one or more documents the tax return preparer’s method and information used to make the computations for the credits.
- Tax return preparers must retain related records for at least three years from the latest of the following:
- The due date of the tax return (determined without regard to any extension of time for filing);
- In the case of a signing tax return preparer electronically filing the tax return or claim for refund, the date the tax return or claim for refund was filed;
- In the case of a signing tax return preparer not electronically filing the tax return or claim for refund, the date the tax return or claim for refund was presented to the taxpayer for signature; or
- In the case of a non-signing tax return preparer, the date the non-signing tax return preparer submitted to the signing tax return preparer that portion of the tax return or claim for refund for which the non-signing tax return preparer was responsible.
- Tax return preparers must meet knowledge requirements concerning the basis for the benefits claimed on returns or claims for refund and also contemporaneously document inquiries and responses related to meeting these knowledge requirements.
A tax return preparer who completes Form 8867 but fails to comply with one or more of these additional requirements has not satisfied the due diligence requirements of § 6695(g).
Pre-Existing Knowledge Acquired Outside of a Tax Engagement Cannot Meet Knowledge Requirement
The final regulations add Example 6 to clarify that a tax return preparer who possesses pre-existing knowledge that was acquired outside the context of the preparer’s tax return preparation practice cannot meet the knowledge requirement. Rather, the preparer must make reasonable inquiries to determine the applicable facts, and the inquiries and responses to those inquiries must be contemporaneously documented in the tax return preparer’s files.
Example 6 SynopsisPreparer E knows from prior social interactions with S that the children resided with S for more than one-half of the 2018 tax year and that the children did not provide over one-half of their own support for the 2018 tax year. To meet the knowledge requirement , Preparer E must make reasonable inquiries (as if he did not have that prior knowledge) to determine whether S is eligible to file as head of household and whether each child is a qualifying child for purposes of the EIC and the CTC and must contemporaneously document these inquiries and the responses.
Preparers Must Engage in Reasonable Inquiries When Information Provided is Incomplete
The final regulations also clarify that preparers must ask additional questions when the information provided by the taxpayer is incomplete. The regulations revise Example 5 to demonstrate this requirement more clearly.
Example 5In 2019, S engages Preparer E to prepare S’s 2018 federal income tax return. During Preparer E’s standard intake interview, S states that S has never been married and that S’s niece and nephew lived with S for part of the 2018 tax year. Preparer E believes S may be eligible to file as head of household and claim each of these children as a qualifying child for purposes of the EIC and the CTC, but the information furnished to Preparer E is incomplete. To meet the knowledge requirement in paragraph (b)(3) of this section, Preparer E must make reasonable inquiries to determine whether S is eligible to file as head of household and whether each child is a qualifying child for purposes of the EIC and the CTC, including reasonable inquiries about the children’s residency, S’s relationship to the children, the children’s income, the sources of support for the children, and S’s contribution to the payment of costs related to operating the household, and Preparer E must contemporaneously document these inquiries and the responses.
What Does This Mean?
Documentation to comply with the new head of household due diligence requirements will take a little longer this year, but the final regulations state that "the total time required should be minimal." With all the changes required for 2018, especially if your state requires dozens of adjustments, it sounds like death by a thousand cuts. But keep in mind that the due diligence provisions have teeth. A single return without due diligence claiming AOTC, CTC, EITC, and head of household status subjects the preparer to a $2,080 penalty. These requirements cannot be ignored. Firm procedures must be updated to comply. And remember, Form 8867 is not enough!
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