Exercising due diligence

Section 10.22 of Circular 230, Regulations Governing Practice Before the Internal Revenue Service (31 C.F.R. Part 10), requires that all practitioners exercise due diligence when preparing, approving, and filing tax returns or any other paper related to an IRS matter.

This due-diligence requirement extends to any oral or written representation made to the IRS or to a client about any matter administered by the IRS. Thus, practitioners must use due diligence in three general areas: submitting documents to the IRS, communicating to the IRS on behalf of a client, and communicating to a client about a tax matter.

Due diligence basically means taking reasonable steps to ensure actions and information provided are correct. It does not require a practitioner to be correct. A practitioner can be wrong but still have conducted the due diligence required under Circular 230.

In submitting documents to, and communicating with, the IRS on behalf of clients, it is best to consider how the IRS examines tax returns, documents, and other statements. When IRS agents scrutinize returns, they look for large, unusual, or questionable items. Practitioners should take a similar approach to looking over a return or document to be submitted to the IRS. If an item is large, unusual, or questionable, the practitioner should question the item to verify it and keep documentation that the issue was questioned and how the issue was resolved. For returns claiming an earned income tax credit, it is also important to keep in mind not only that an ethical responsibility exists under Circular 230, but also that the Internal Revenue Code imposes a legal responsibility under Sec. 6695(g) to exercise due diligence when preparing returns claiming the credit. Failure to do so could lead to the imposition of a civil penalty and a referral to the IRS Office of Professional Responsibility (OPR) for Circular 230 discipline.

Besides fulfilling ethical responsibilities, due diligence also helps practitioners avoid civil penalties. Sec. 6694 imposes a penalty for a practitioner taking an unreasonable position or engaging in willful and reckless conduct. During investigations relating to Sec. 6694, a practitioner’s best defense is providing the IRS with documented due diligence to substantiate the position taken on the return. Again, due diligence does not mean practitioners have to be right; they just have to take reasonable care to research and obtain knowledge about the position before taking it. By providing documented due diligence, practitioners can explain why they took the position and show they used reasonable care when determining the position was appropriate.

TAX ADVICE AND RESEARCH

When a practitioner provides information to a client, the due diligence required is usually research-oriented. Here, the practitioner needs to be reasonably sure that information given—typically, answering a tax question—is accurate. Practitioners should do their best to highlight and document where they got their information. If they do not, and the information is wrong, any email communicating it to a now unhappy client will likely end up with OPR.

With today’s technology, documenting due diligence has become increasingly easy. When communicating with a client through email, it is always best to provide citations for positions. If clients want just a straight answer without citations, then, while researching, practitioners should always save a copy of the research trail, allowing them to quickly refer to documents relied on in determining a tax position. Most research software tracks research trails. After determining the position, practitioners should memorialize it in a memo to the client’s file.

DOCUMENTING DUE DILIGENCE

When preparing tax returns, the practitioner should save any questions about the return, either from preparer to reviewer or from preparer or reviewer to client, along with the answers, in the client’s file. This will provide evidence of why the practitioner took a particular position on the return.

Depending on risk tolerance, firms may require more documentation of due diligence. However, the methods discussed above should be followed at a minimum for a firm to avoid penalties under Circular 230, Section 10.36, for having insufficient firm procedures to ensure compliance with Circular 230 relating to due diligence.

PENALTIES AND SANCTIONS

OPR can sanction practitioners who do not exercise due diligence with a reprimand, censure, suspension, or disbarment. It is rare for OPR to disbar a practitioner for failing to use due diligence, but a suspension is more likely.

In OPR v. Kaskey (Complaint No. 2009-26 (Treas. App. Auth., Decision on Appeal 5/28/10)), a tax practitioner prepared returns for an S corporation owned solely by his clients, a married couple, and prepared the clients’ Form 1040, U.S. Individual Income Tax Return. When preparing the S corporation return, the practitioner reported a deduction for compensation of officers. However, he did not include the amount of compensation on his clients’ Form 1040. Thus, he underreported the income received by the clients.

OPR discovered what the practitioner had done. The case eventually went before an administrative law judge, where the practitioner was disbarred from practice before the IRS for failing to exercise due diligence and willfully failing to file his own tax returns. His disbarment and the reason for it were then publicly reported in the Internal Revenue Bulletin, as is required for censures and suspensions (see 2010-36 I.R.B. 324 and IRS News Release IR-2010-82).

At worst, then, failing to use due diligence can mean disbarment or a suspension from practice before the IRS, loss of clients because of derogatory public information, and a possible loss of license if the state CPA board sees the practitioner’s name in the Internal Revenue Bulletin.

Further, OPR can impose a monetary sanction requiring the practitioner to pay the gross receipts earned from the client for whom he or she failed to use due diligence. Even worse, if OPR can prove the lack of due diligence was systemic, it may be able to impose a monetary sanction for all gross receipts for the previous five years.

STEPS TO TAKE

While the impact of failing to use due diligence can be significant, practitioners can take several steps to avoid penalties. First, if they rely on another person’s work product, then they should use reasonable care in engaging, supervising, training, and evaluating the person they are relying on. Second, they should document positions and communications as described above. When OPR sends an allegation letter for failing to use due diligence, the first thing it asks for is any documentation that the practitioner did use due diligence. It is best to keep this documentation for at least the statute of limitation for OPR cases, which is five years.

Editor’s note: See also, by the same author, “Circular 230 Case Processing and the Application of Monetary Penalties,” The Tax Adviser, June 2014, page 422.

Nicholas Preusch (npreusch@gmail.com) is with PBMares LLP in Fredericksburg, Va., and is a former attorney for the IRS Office of Professional Responsibility.

To comment on this article or to suggest an idea for another article, contact Paul Bonner, senior editor, at pbonner@aicpa.org or 919-402-4434.