Understanding Due Diligence in Tax Preparation and Consulting

Due diligence in the context of tax preparation and consulting refers to the care and thoroughness a tax professional must apply in their practice, particularly in verifying client information, choosing appropriate tax strategies, and accurately filing tax returns. It encompasses a comprehensive and careful approach to ensure accuracy, compliance, and ethical practice in all tax related matters.

Definition and Importance

Definition: Due diligence involves a diligent, careful, and thorough effort by tax professionals to research, verify and consider all relevant facts and laws before making decisions, giving advice, or taking actions that affect a client's tax filings and financial planning.

Importance: The importance of due diligence lies in its role in maintaining the integrity of the tax system, protecting client interests, and upholding the tax professional's reputation. It ensures compliance with tax laws, minimized errors in tax filings, and reduces the risk of penalties for both the client and the professional. Due diligence is crucial for providing accurate, reliable tax advice and for making informed decisions that can withstand scrutiny from tax authorities.

Practical Application

Verifying Client Information- Tax professionals must rigorously verify all client provided information before it is used in tax calculations or filings. This includes:

• Reviewing original documents such as W-2s, 1099s, receipts and logs for deductions or credits.
• Asking clients detailed questions to ensure that information is complete and accurate.
• Double-checking data from common mistakes or inconsistencies that could signal errors.

Choosing Tax Strategies- Due diligence in choosing tax strategies involves:

• Analyzing the client's complete financial situation, considering both short-term and long-term implications of various strategies.
• Staying informed about the latest tax laws and how they apply to the client's circumstances.
• Weighing the risks and benefits of different tax planning options, avoiding aggressive strategies that could lead to legal issues.

Filing Returns-When filing tax returns, due diligence requires:

• Ensuring that all data entered on the tax return accurately reflects the client's financial documents and situation.
• Applying the latest tax laws and regulations correctly.
• Reviewing the completed return thoroughly before submission, looking for error or omissions.

Technology's Role- Leveraging technology is increasingly essential for enhancing due diligence in tax practice. Technology can:

• Improve Accuracy: Tax preparation software can reduce errors in calculations and ensure that returns are filled out correctly and completely.
• Facilitate Document Management: Digital document management systems help organize and securely store client documents, making it easier to review and verify information.
• Enhance Research: Online resources and tools enable tax professionals to quickly access the latest tax laws, IRS ruling, and court cases, supporting more informed decision-making.
• Streamline Communication: Secure client portals and communication tools allow for efficient and safe exchanges of information between tax professionals and clients, facilitating the collection of complete and accurate data.

In summary, due diligence is a fundamental aspect of tax preparation and consulting, ensuring accuracy, compliance, and ethical practice. Through the careful verification of information, thoughtful selection of tax strategies, and meticulous filing of returns, tax professionals can fulfill their obligations to clients and the tax system. Leveraging technology further enhances these practices, enabling more efficient and effective fulfillment of due diligence responsibilities.

Paid tax preparers are subject to a penalty if they do not exercise due diligence in all areas of the tax return but especially in determining eligibility for:

• Earned Income Tax Credit -EITC
• Child Tax Credit- CTC or Additional Child Tax Credit- ACTC
• Other Dependent Credit -ODC
• American Opportunity Tax Credit - AOTC
• Head of Household filing status- HOH

Form 8867: Preparer Due Diligence Checklist certifies a tax preparer has meet all specific due diligence requirements set forth in Treasury Regulations when preparing returns and claims for refund involving EIC, AOTC, CTC,/ACTC/ODC and/or HOH filing status.

To comply with the knowledge requirements, paid preparers should:

• Conduct and interview with the taxpayer every year and apply a commonsense standard to the provided information
• Evaluate whether that information appears to be complete and identify missing facts and ask enough questions to ensure the return is correct and complete
• Determine whether the information is consistent; recognize contradictory statements or statements that are inconsistent with what the preparer knows to be true.
• Help the taxpayer understand the documentation he or she should have to support the claims
• Ensure that the taxpayer is no under reporting or over reporting income by asking the necessary questions to determined that the correct income is reported
• Guide self-employed taxpayers through the reconstruction of income and expenses ensuring that all required items are included on the return
• Be sure all Schedule C for self-employed taxpayers include all income and associated expenses

Preparing Incorrect Returns Affects You, Your Clients and Your Employer

COSTLY FOR YOUR CLIENTS: Taxpayers who seek assistance from a professional tax return preparer expect the preparer to know the tax law and prepare an accurate return. If we examine your client's return and disallow the HOH filing status or disallow all or a part of the EITC, CTC/ACTC/ODC or AOTC, your client must pay back any amount refunded in error plus any additional amount assessed, with interest, and may be:

• Required to file Form 8862, Information To Claim Certain Credits After Disallowance (also available in SpanishPDF)
• Banned from claiming the credit(s) for two years if we find the error is due to reckless or intentional disregard of the rules
• Banned from claiming the credit(s) for ten years if we find the error is due to fraud

CONSEQUENCES FOR YOU: If we examine the returns or claims for refund you prepared and find you did not meet the due diligence requirements, we may assess a $500 penalty against you for each failure to meet due diligence requirements. (See Internal Revenue Code section 6695(g))

The penalty amount is indexed for inflation. For a return or claim for refund filed in 2023, the penalty that can be assessed against you is $600 per failure. Therefore, if due diligence requirements are not met on a return or claim for refund claiming the EITC, CTC/ACTC/ODC, AOTC and HOH filing status, the penalty can be up to $2,400 per return or claim.

If you fail to meet due diligence requirements, you can also face:

• Other civil return preparer penalties
• Suspension or expulsion from IRS e-file
• Disciplinary action by the IRS Office of Professional Responsibility
• An injunction barring you from preparing tax returns for others
• Criminal penalties for filing fraudulent returns