Final Regulations Issued for Head of Household Due Diligence Requirements

November 7, 2018 | Kristine A. Tidgren

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.

New Law

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.

Final Regulations

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 Synopsis

Preparer 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 5

In 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!