|Due Diligence Reminders for the 2012 Filing Season
Various tax developments of 2011 carried with them due diligence reminders for the 2012 filing season.
January 12, 2012
In 2011, several developments from all three branches of the federal government provided reminders, both subtle and direct, of questions to ask clients and actions to take to be sure practitioners are meeting due diligence obligations in preparing tax returns for individuals. This article provides a brief review of due diligence obligations as well as select 2011 developments and the actions practitioners should take in response.
Tax return preparers are not obligated to audit information received from clients. Generally, preparers may rely in good faith on client-provided information. However, actions are often required as summarized well in Revenue Procedure 80–40 which addresses due diligence for avoiding a preparer penalty under Section 6694(a). Per this Internal Revenue Service (IRS) guidance:
"the preparer may not ignore the implications of information furnished to the preparer or which was actually known by the preparer. The preparer shall make reasonable inquiries if the information as furnished appears to be incorrect or incomplete. Additionally, some sections of the Code require the existence of specific facts and circumstances, such as maintenance of specific documents, before a deduction may properly be claimed. The preparer shall make appropriate inquiries to determine the existence of facts and circumstances required by a Code section or regulations as a condition to claiming a deduction."
Similar due diligence obligations are stated in Circular 230, §10.22 (PDF) and AICPA Statement on Standards for Tax Services (SSTS) No. 3, Certain Procedural Aspects of Preparing Returns (PDF).
In late 2011, the IRS sent letters to approximately 21,000 preparers as part of an "effort to improve the accuracy and quality of filed tax returns and to heighten awareness of preparer responsibilities" (IRS Letters and Visits to Return Preparers — FAQs Filing Season 2012). The IRS selected the preparers because their prior returns had "a high percentage of attributes associated with returns typically containing inaccuracies and misinterpretations of tax law" (letter). IRS FAQs explain this letter campaign, which also involves IRS visits, to about 10 percent of the letter recipients. The FAQs include four questions related to due diligence, including some examples.
Note: The IRS website with the preparer letter, enclosures and FAQ related to the 2012 filing season can be found here and was also captured on January 4, 2012 and posted to the author's website (PDF) so it continues to be accessible should the IRS remove these documents in the future.
2011 Developments and Their Relevance to Due Diligence
Summarized below are selected cases, regulations, IRS rulings and tax agency actions that serve as reminders of questions preparers should ask clients or documents they should review. In addition to helping practitioners meet due diligence obligations, these questions and actions should help clients avoid potential audit adjustments and penalties. The selected items are presented in an order sequence that ties to Form 1040.
Schedule C, Profit of Loss From Business
The areas of inaccuracies to which the IRS referred in the 2012 preparer letters described above involved Schedules A, C and E. For each schedule the IRS included an enclosure noting the most common issues with a reminder of the need to ask sufficient questions of clients. Based on the issues identified for Schedule C (PDF), due diligence warrants the following action:
Action: Be sure that gross receipts are properly reported and verifiable by the books and records. Expenses must be ordinary and necessary, properly computed and paid or incurred during the tax year.
Schedule E, Supplemental Income and Loss
Based on the issues identified in the IRS letter for Schedule E (PDF), due diligence warrants the following action:
Action: Be sure that income and expenses (including depreciation) for rental property are properly calculated and reported. In addition, be sure that loss limitation rules (passive activity, at-risk and basis) are considered and applied properly.
Cancellation of Debt Income
The California Franchise Tax Board (PDF) conducted a review to determine if taxpayers were correctly reporting Cancellation of Debt (COD) income. They found that over 50 percent of the taxpayers they contacted had received a Form 1099-C (PDF), Cancellation of Debt, that was not correct.
Action: Ask for details on the transaction that led to a client receiving a Form 1099-A (PDF), Acquisition or Abandonment of Secured Property or 1099-C to be sure the amount is correct and to determine how to properly report the transaction.
Property Tax Deduction
In 2009, the Government Accountability (GAO) issued a report, Real Estate Tax Deduction — Taxpayers Face Challenges in Determining What Qualifies; Better Information Could Improve Compliance, GAO-09-521 (PDF) (June 12, 2009). This report addressed reasons why some individuals overstated their property tax deduction on Schedule A and how to improve compliance.
In 2011, the California Franchise Tax Board considered asking for parcel numbers of properties for which individuals claimed an itemized deduction for real property taxes. The FTB deferred this requirement until 2012 returns when they will also require reporting of the deductible and non-deductible amounts. In the meantime, the FTB has provided information on their website to help individuals determine what portion of payments made to the county assessor are deductible real property taxes (amounts that are not real property taxes under IRC §164 are either capital expenditures or are neither deductible nor capitalizable).
Given the GAO report and an awareness campaign by a large state, it is likely that the IRS and states may devote more scrutiny to whether real property tax deductions on personal residences are properly claimed.
Action: When asking clients for their real property tax information, also explain to them how IRC §164 and the regulations define real property taxes, noting that some amounts paid, such as for special assessments, are not deductible taxes.
Next month I will review more selected 2011 developments, such as charitable contributions, unreimbursed employee business expenses, Foreign Bank Account Report (FBAR) and Form 8938 (PDF), EITC and actions practitioners should take.
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Annette Nellen, CPA, Esq., is a tax professor and director of the MST Program at San José State University. Nellen is an active member of the tax sections of the AICPA, ABA and California State Bar. She chairs the AICPA’s Individual Income Taxation Technical Resource Panel. She has several reports on tax reform and a blog.