|Due-Diligence Reminders for the 2012 Filing Season (Part 2)
More due-diligence issues practitioners should be aware of for this filing season.
February 9, 2012
Part 1 of this article, in the January issue, discussed how the IRS is sending letters and visiting practitioners to “improve the accuracy and quality of filed tax returns and to heighten awareness of preparer responsibilities.” This month, we look at recent developments that practitioners should pay attention to while preparing 2011 returns.
Charitable Contribution Deduction
There were a few court decisions issued in 2011 dealing with the charitable contribution deduction and whether amounts claimed by individuals were allowable charitable contributions and whether proper documentation existed. In Van Dusen, 136 T.C. No. 25 (2011), the IRS questioned whether the taxpayer’s volunteer work of caring for feral cats was performed for the charitable organization and within the organization’s mission. The IRS also questioned whether sufficient documentation existed.
The court found that the taxpayer’s work was indeed for the organization and within its mission. To deduct unreimbursed expenses of the volunteer work, the court observed that receipts were needed and the expenses had to be related to the charitable work without a personal element. This required separating the taxpayer’s personal expenses for caring for her pet cats from her expenses caring for the foster cats she took in. The court then also distinguished between expenses of $250 or more and those below $250 by applying a percentage to the expenses that were personal and a percentage to the expenses that were charitable. Those expenses that were $250 or more required contemporaneous acknowledgment from the charitable organization and were disallowed for lack of that documentation. The court noted that the Cohan rule (39 F.2d 540 (2d Cir. 1930)) cannot be used to excuse incomplete documentation for expenses of $250 or more because the law is specific on what records are needed.
In Linzy, T.C. Memo. 2011-264, charitable contributions of $250 or more were disallowed because the taxpayer did not have the contemporaneous written acknowledgment required by Sec. 170(f)(8). In Bradley, T.C. Summ. 2011-120, the court allowed the taxpayer’s charitable mileage deduction. The court found that the printout of Mapquest directions showing the distance of trips, along with a record of the number of trips, was a reliable written record as required under Regs. Sec. 1.170A-13(a). It met the requirements for substantiation for amounts under $250, but a deduction for renting a bus to transport a cheerleading team did not meet the $250-and-over substantiation requirement because the taxpayer did not get a contemporaneous written acknowledgment from the donee organization.
Action: Implement a procedure to be sure that donations are only reported on Schedule A if there is proper documentation. The cases and the IRS’s 2012 preparer letter remind practitioners that there must be receipts for all cash contributions (also see Sec. 170(f)(17)), “adequate documentation” for all noncash contributions, and there are heightened requirements for donations of $250 or more under Sec. 170(f)(8) (see Regs. Sec. 1.170A-13). Remind clients of these requirements throughout the year and either ask for the documentation or use the engagement letter for clients to confirm that they have the required records with the specific requirements spelled out in the engagement letter.
Unreimbursed Employee Business Expenses
In Farias, T.C. Memo. 2011-248, the IRS disallowed over $23,000 of unreimbursed employee business expenses claimed by a teacher, which included a deduction of more than $8,000 for a Mediterranean cruise. The court agreed with the IRS and also upheld imposition of the accuracy-related penalty because the taxpayer did not reasonably rely on the preparer when she gave the preparer only the total expense amount and not any receipts or supporting documents. While the question of whether the preparer should have asked for documentation was not before the court, the dollar amount of the expense arguably falls within the Rev. Proc. 80-40 statement that preparers “may not ignore the implications of information furnished to the preparer or which was actually known by the preparer.”
Action: Be sure any unreimbursed employee business expenses are allowable and that documentation exists to support any deduction for business miles. Any travel, meals, or entertainment claimed must be supported by receipts and documentation of the business purpose. Questions should be asked of employees claiming unreimbursed expenses such as whether the employer would have reimbursed them if requested, the employer’s expectations, and for large amounts relative to salary and the nature of the person’s job, details should be examined and discussed with the client.
FBAR and Form 8938
TD F 90-22.1, Report of Foreign Bank and Financial Accounts (FBAR), is not filed with Form 1040, but is mentioned on Schedule B, Interest and Ordinary Dividends. The IRS Office of Professional Responsibility (OPR) states that preparers of Form 1040 “have a duty under Circular 230 to inquire of their clients with sufficient detail to prepare proper and correct responses to the foreign bank account questions on Schedule B” (OPR, “Professional Responsibility and the Report of Foreign Bank and Financial Accounts” (undated)).
OPR further states that preparers are not obligated to prepare the FBAR even if income from the account is reported on Schedule B. Yet, the preparer has an obligation under Circular 230 to advise clients of possible penalties, which would be the consequence of failure to file the FBAR.
Starting with 2011 returns, some individuals will be required to attach Form 8938, Statement of Specified Foreign Financial Assets, to their return (related to provisions added by the Hiring Incentives to Restore Employment (HIRE) Act, P.L. 111-147). There are significant penalties for failure to file the form or to file one that is incomplete. Many clients might be required to file both an FBAR and a Form 8938.
Action: Ask questions to determine if clients are required to file an FBAR and Form 8938. If an FBAR is required, determine who will prepare it. If Form 8938 is required, the preparer will need to complete it along with the Form 1040. The engagement letter should explain these reporting requirements, applicable penalties for failure to file either, and clarify who will file any required FBAR.
Earned Income Tax Credit
Since 1997, preparers have been required to complete specific due-diligence requirements for returns claiming the earned income tax credit (EITC) (Sec. 6695(g)). Form 8867, Paid Preparer’s Earned Income Credit Checklist, is used to fulfill these requirements. New for 2011 tax returns is that Form 8867 must be attached to the return (rather than only maintained in the files) (IR-2011-122 and T.D. 9570). Also, a provision in the United States–Korea Free Trade Agreement Implementation Act, P.L. 112-41, increased the preparer penalty for failure to comply with Sec. 6695(g) from $100 to $500, effective for tax returns filed after December 31, 2011.
Action: Be sure to complete and attach Form 8867 for all clients claiming the EITC.
Clients may owe taxes besides federal and state income taxes that they are unaware of, or they may presume that their tax preparer will inform them of those obligations. These taxes include use taxes, such as those on purchases from out-of-state vendors and mail-order or internet purchases, business license taxes owed to a city in which they do business, and gift taxes.
State and local governments in need of revenue have stepped up efforts to find noncompliant taxpayers. For example, state and local governments may be sharing information to try to find nonfilers.
One area where gift taxes may be overlooked is on transfers of residences between family members. A 2011 case illustrates how the IRS might pursue obtaining information about gifts (In the Matter of the Tax Liabilities of John Does, No. 2:10-mc-00130-MCE-EFB (E.D. Cal. 12/15/11)). The IRS sought information from a California tax agency on certain home transfers such as from a parent to a child, due to the concern that gift tax returns were not filed on all such transfers.
Action: Use engagement letters and periodic newsletters to remind clients of other taxes to which they may be subject. Ask clients what other taxes they pay, if they have made purchases for which sales tax was not charged, and if they have made any gifts.
In Woodsum, 136 T.C. No. 29 (2011), the taxpayer provided more than 160 information returns for 2006 to his preparer. One form, a Form 1099-MISC for $3.4 million, was omitted from the 115-page return that reported AGI of $29.2 million. Before the return was filed on extension, the taxpayer met with the preparer, briefly discussed the return, and signed it. He did not review the return to ensure that all income was reported.
The taxpayer challenged the assessed accuracy-related penalty of $104,295, but the court found that the taxpayer could not argue that that he had reasonably relied on the preparer’s professional advice when the error was a clerical type of error. The court also stated: “‘Even if all data is furnished to the preparer, the taxpayer still has a duty to read the return and make sure all income items are included’” (quoting Magill, 70 T.C. 465, 479–480 (1978)).
Action: Remind clients that they are responsible for the accuracy of their tax return and, therefore, they need time to review it carefully. Implement procedures to ensure that all clients get their completed return at least a few days prior to the due date.
Due diligence in return preparation involves knowing when to ask questions and obtain documentation that is necessary for a particular tax rule or because circumstances warrant digging deeper into a transaction. Court cases, IRS rulings, tax agency actions, and legislative activity serve as good reminders of areas that may need extra questioning as well as the types of questions to ask or actions to take.
Use of engagement letters is an efficient way to obtain the most complete information from clients. Engagement letters, along with periodic newsletters or client letters, are good ways to remind and inform clients about the rules for such common items as charitable contributions, employee business expenses, and rental activities.
Effective fulfillment of due-diligence obligations requires some advance planning such as designing engagement letters, educating firm personnel, and establishing office policies and procedures. Such actions could have tremendous benefits as due diligence is a key to avoiding both client and preparer penalties, and reduces the likelihood of practitioners’ being contacted by their licensing bodies or the IRS.
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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.