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Due diligence: CPAs take note: IRS is increasing expectations.

due diligence is a hallmark of a CPA's performance and there are indications that the IRS intends to focus more closely on tax return preparer and adviser due diligence responsibilities. In light of this, CPAs are advised to review their processes and procedures to ensure compliance.

There are also indications that the IRS may have some expectations for preparer due diligence that extends beyond what the tax profession has come to believe is required and appropriate. This may lead to problems for tax professionals with the IRS in the examination process.

Background Indications

A hint of increased IRS expectations surfaced two years ago when U.S. Department of the Treasury and IRS representatives asserted that Circular 230 practitioners had an affirmative duty not just to ask their clients if they had signature authority over a foreign bank account, but were required to have a specific conversation with every client of the tax preparer concerning the foreign account reporting requirements even if there was no evidence the client had an account and where the client has indicated "no" or "none."

It should be noted that the IRS is in the process of issuing guidance in this area that may focus only on a heightened tax preparer "awareness" without the necessity of a "conversation" in every case.

Then the National Taxpayer Advocate's 2009 Annual Report to Congress discussed the possibility of imposing additional due diligence requirements on preparers.

While the report has not always carried great weight with Congress, the Treasury or IRS, one can safely assume that it will garner the full attention of the IRS when it comes to using the tax preparer as an enforcement tool.

Next came an IRS "information" project in January that involved sending letters to 10,000 tax preparers explaining a variety of due diligence responsibilities with regard to return preparation. The letter (as it indicated) was followed by a meeting between an IRS agent and the preparer at the preparer's office in a majority of cases.

Also, the forthcoming process of registering all tax preparers and subjecting them to Circular 230 professional standards is indicative that the Treasury and the IRS hope to measurably close the "tax gap" through increased compliance that will include enforcement activities with respect to tax preparers not adhering to appropriate standards of practice.

Buried, and perhaps overlooked by many practitioners and commentators, in the recent Circular 230 regulatory proposals to register tax preparers (and the related competency proposals) was an amendment to Circular 230 Sec. 10.36 pertaining to supervisory procedures to ensure compliance.

That provision subjects supervisory personnel to discipline where they do not adequately supervise and monitor the proper provision of tax advice (the "covered opinion" standards of Section 10.35) by the firm's owners and employees.

The proposals will extend the scope of supervisory responsibilities within any firm to the preparation of tax returns and claims for refund.


In other words, partners-in-charge or directors of a firm's tax practice are held responsible for the quality of the work under their supervision and may be subject to discipline along with a preparer of the return.

What is Due Diligence?

Generally, due diligence may be framed as a question: Did the practitioner (and the firm) exercise professional care to ensure that--based on the knowledge of the practitioner (and the firm)--the taxpayer's return is true, correct and complete?

Dictionary definitions generally view due diligence as the diligence, or care, that a reasonable person (in our context, a tax professional/preparer) would undertake in similar circumstances.

When an examination of taxpayer's return results in an understatement of tax, the IRS often asks:

* Did the preparer apply the law appropriately to the facts?

* What effort was made to obtain the pertinent facts?

* Should the preparer have made inquiries about items on the return or verified the evidence in support of the item?

* What documentation existed to support the professional duties of the preparer?

* What processes existed in the tax preparer's office or the preparer's firm to ensure the appropriate evaluation of facts, application of law, discharge of any indicated responsibility to verify information and to document these processes?

There are basically two aspects of due diligence that may impact a CPA preparing a tax return:

* Diligence pertaining to representations with regard to interpretations and compliance with tax law (including interpretive regulations and other tax authority guidance). These are tax positions for which the preparer must have knowledge of (or a reason to know of) to be responsible.

* Diligence pertaining to facts or evidence to support items reflected on a return. Generally, this is the taxpayer's representations about "facts" and the taxpayer's representations about amounts reflected in the return. However, the CPA cannot ignore the implications of the taxpayer's information or other information of which the CPA has knowledge. For example, the client asserts that adequate records to support entertainment deductions exist, but the CPA knows that adjustments for inadequate records arose in an examination of a prior year return. In that situation the CPA should likely review the supporting documents to ensure that they do exist.

Steps CPAs Should Take

Educate and inform clients in writing: While taxpayer representation (including in an organizer) may suffice for most information placed on a tax return, the IRS could assert (and. in fact, a taxpayer client may claim) that the preparer did not adequately explain the essential requirements for claiming of certain types of tax benefit on a return (including omissions).

Tax practitioners are advised to consider sending informative explanations with respect to the requirements for record-keeping, as well as the basis in tax law for certain types of lax benefits for which they will make representations to the tax practitioner. This would include an explanation of the necessity for answering any required questions on tax returns. This may be done either by a separate mailing to the client during the tax year (which makes it a good promotional opportunity), or inclusion with the tax return engagement letter.

An example of sensitive Form 1040 areas where this may be useful might include: real estate loss and real estate professional requirements for claiming losses, the requirements for employees and partners necessary to claim unreimbursed business expenses, hobby loss rules and the at-risk limitations for claiming deductions or losses. The foregoing items are not all-inclusive.

Train ... and Train: Hold training sessions for staff and partners to discuss due diligence requirements, including client inquiries and the critical importance of documenting the due diligence activities. Emphasize that the review function in the firm should establish that appropriate inquiries of the taxpayer were made and the appropriate documentation exists. If something is not documented, it is not done.

Tools: Review all checklists (with particular emphasis on return preparation and review) and engagement letters to ensure that they are current and contain appropriate and complete inquiries pertaining to expected taxpayer representations and revise and expand them accordingly.

Monitor: Review the process of tax returns from receipt of the information to delivery of the returns. Ideally, a part of this process should take place during the filing season. In any event, a representative number of tax return files across the spectrum of the firm's practice should be subject to a post-filing season review to ensure that firm's processes and systems (key elements of quality control) are functioning properly.

Tax Practice Quality Control: All CPA firms should have an established system of quality control for tax practice. The policies and practices of a practitioner or firm may be used to demonstrate that an error in a return arising from the preparers' conduct is an aberration and therefore the penalty should not be assessed or a disciplinary action should not be initiated. A documented system of quality control avoids error in the first place and can be used to demonstrate a penalty or other action should not be enforced against a preparer and firm supervisory members.

What Does the Future Hold?

When issues arise in connection with the preparation of a return, the question often comes down to whether the preparer exercised due diligence when preparing it.

Generally, a preparer should be able to prepare a return with the appropriate degree of due diligence merely by ascertaining that the client has completed the organizer. Based on what is presented in the organizer and all other information that the preparer knows about the client, a reasonable preparer would have no reason to suspect the information provided is not complete or accurate.

However, in other cases, it could be reasonable for the IRS to challenge whether the facts that the preparer knows, or could reasonably infer, from the organizer, or otherwise might know about the taxpayer, might trigger a need for the preparer to do more in terms of due diligence than merely rely on the taxpayer's assertion in the organizer. For example, that he or she had no signature authority over foreign bank or other financial accounts subject to FBAR.

In still other instances, the preparer may have other knowledge, regardless of a taxpayer representation, that demands heightened scrutiny. For example, the preparer knows the taxpayer has a close connection to close relatives in a foreign country.

CPAs are advised to consider defensive actions to minimize that possibility of IRS (or FTB) challenges with respect to due diligence. Even if a CPA subsequently prevails in such a dispute, defending a challenge may be time consuming at best.


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Kip Dellinger, CPA is senior tax partner at Kallman and Co. LLP in Los Angeles. You can reach him at
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Title Annotation:professionalissues
Author:Dellinger, Kip
Publication:California CPA
Geographic Code:1USA
Date:Oct 1, 2010
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