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TF10066 - Earned Income Tax Credit (EITC)
The IRS is putting a new focus on EITC to address paid preparer EITC due diligence through compliance, outreach, and education because over 70% of EITC returns are prepared by paid preparers. There is an estimated error rate on EITC returns of 23%-28%, which results in $10-$12 billion in erroneous claims annually. The most significant EITC error issues are misreported income, issues related to the qualifying child, and incorrect filing status.
The tax preparer has a professional responsibility to comply with the due diligence requirements concerning eligibility for and amount of EITC. Any tax professional who fails to carry out the EITC due diligence requirements can be penalized $100 for each return that fails. There are four basic components of the due diligence requirements:
Preparers need to know that #3 above, Knowledge requirement, is where the IRS is concerned that the due diligence standard is not being kept. The IRS recently published EITC due diligence proposed regulations (Prop. Reg. 1.6695-2), which clarify the knowledge requirement of IRS Sec 6695(g). The new regulations state the tax return preparer must make reasonable inquiries if a reasonable and well-informed tax return preparer knowledgeable in the law would conclude that the information furnished to the tax return preparer appears to be incorrect, inconsistent, or incomplete. The tax return preparer must also contemporaneously document in the files the reasonable inquiries made and the responses to these inquiries.
To improve the due diligence efforts of preparers, the IRS EITC office and various software industry representatives formed a working group. The working group identified potential software enhancements and recommendations for the most common areas of EITC error. The group also identified additional actions paid preparers would need to take to meet their EITC due diligence requirements and determined if the issues could be addressed by software enhancements.
Our software was part of the working group along with many other software companies. The group represented 80% of all preparer, software-generated EITC returns. As a result of the working group, a list of best practices that software companies should employ to improve due diligence efforts was compiled.
For 2008, the software has been modified to implement most of the best practices identified by the working group. While the modifications make the process of generating a return with EITC a little more time consuming, the preparer will be more protected and will be in greater compliance with EITC due diligence than in previous versions of the software. The following information addresses the modifications to the software.
The EIC screen now incorporates the 8867 input screen instead of having two separate input screens (figure 1).
The dependent grid contains all of the 8867 questions relating to dependents. All questions must be answered for each qualifying child in order to get the EITC to generate (figure 2).
The questions on Form 8867 cannot be defaulted, and audits populate when the required 8867 information has not been completed (figures 3 and 4).
A new record page was added for documenting additional questions and how the information was obtained (figure 5).
A taxpayer signature block now includes the date and has default disclosure text that can be customized with a preparer’s own disclosure statement (figure 6).
The program also provides diagnostic audits to give guidance to the preparer for common areas of EITC error (figure 7).
The following is a list of trigger audits with additional questions to help the tax preparer comply with due diligence.
| This return is claiming 70% or more of the maximum EITC amount, and the following situation(s) exists (see audits below): | The IRS has indicated a higher likelihood of audit for these types of returns. It is important for the preparer to document additional questions and the taxpayer responses to satisfy the EITC due diligence requirements. |
| This return is claiming qualifying child(ren) who are other than a son or daughter (e.g., nieces, nephews, brothers, sisters, etc.). | Additional questions are necessary to satisfy the knowledge requirement and document the taxpayer's eligibility for EITC. Some possible questions to ask are: where are the parents of the QC; how long has the QC lived with you; does the QC receive support from anyone else? |
| This return is claiming disabled adult(s) as qualifying child(ren) for the earned income credit. | Additional questions are necessary to satisfy the knowledge requirement and document the taxpayer's eligibility for EITC. You may want to request a copy of documentation from the QC's doctor to support disability. |
| The age of the taxpayer compared to the age of the qualifying children appears questionable or inconsistent. | Additional questions are necessary to satisfy the knowledge requirement and document the taxpayer's eligibility for EITC. Could the taxpayer be a dependent of someone else? What is your relationship with the child(ren)? |
| The qualifying child(ren) have different last names than the taxpayer. | Additional questions are necessary to satisfy the knowledge requirement and document the taxpayer's eligibility for EITC. Who are the actual members of the household? |
| The filing status of this return is Head of Household, and there are young qualifying children for EIC with no child care expenses. | Additional questions are necessary to satisfy the knowledge requirement and document the taxpayer's eligibility for EITC. Who cares for the QC while the taxpayer is at work or while at school? |
| There is a Schedule C in the return without any business expenses. When figuring net earnings from self-employment, the taxpayer must claim all allowable business expenses. | Additional questions are necessary to satisfy the knowledge requirement and document the taxpayer's eligibility for EITC. Request copies of all receipts associated with the business. Where do they conduct business? |
| The taxpayer is claiming Schedule C income from a business involving child care, lawn care, landscaping, or hair care. This requires supporting documentation such as a Form 1099 and related expenses. | Additional questions are necessary to satisfy the knowledge requirement and document the taxpayer's eligibility for EITC. These types of business have an increase for misreported income. Request copies of typical expenses for each type of self-employed expenses (i.e., daycare expenses - food, baby food, formula, utility costs, depreciation, supplies). |
| Total income in this return appears to be insufficient to support the taxpayer and dependents. | Additional questions are necessary to satisfy the knowledge requirement and document the taxpayer's eligibility for EITC. Does anyone help provide your financial support? Do you own a home or rent or live with someone? |
| There are Schedule C losses in this return that reduce W-2 income so the taxpayer qualifies for the earned income credit. | Additional questions are necessary to satisfy the knowledge requirement and document the taxpayer's eligibility for EITC. |
As a reminder for all preparers, you cannot rely on the software alone to meet due diligence requirements. The preparer must ask additional questions when information does not appear reasonable or appears inaccurate, inconsistent, or incomplete.
Refer to the scenarios below for examples on EITC.
| Scenario 1: Your new client, Eloise Brant, tells you that her filing status is head of household (HH). Her gross income is $22,000. The only child she is claiming for the dependency exemption (i.e., the qualifying person for HH status) is her seven-year old nephew, Cal Davis. What questions would you ask Ms. Brant? How would you introduce your set of questions to Ms. Brant so that you are sensitive to the client and maintain your professionalism? |
Scenario 1 Discussion
Children commonly live with their parents and, if a taxpayer claims head of household status for a child who is not a son or daughter, it could be a warning sign that the taxpayer is not eligible to claim the EITC. It does not mean that Ms. Brant is committing fraud or even that you actually suspect fraud. It does mean that you must ask additional questions in order to satisfy the due diligence knowledge requirement.
You could introduce your questions with language such as: “So that I can understand your relationship with Cal and what credits and deductions you may be able to claim, I'll need to ask you some additional questions. Is that all right?”
Possible questions to ask:
There are no “right” or “wrong” answers to these questions. You may have thought of different questions to ask, or, Ms. Brant’s answers may lead to other questions. For example, you would expect Ms. Brant to know where Cal goes to school and what his class schedule is and you would need more information if she does not know. Perhaps Cal’s parents were not able to care for him and they placed him in her care. But if that only happened in the last few weeks of the year, it would make her ineligible for EITC and other child-related benefits this year. Regardless of the outcome, document your questions and answers in the Due Diligence grid on the EIC screen.
| Scenario 2: Bill Brock is 42 years old. During 2008, he had several “odd jobs,” earning a total of $14,300 for the year. He states that his dependents are Patty, his 10-year old daughter, and Percy, his 16-year old son, and that he uses the head of household filing status. Last year, Bill used the single filing status and did not claim any dependents. Why would a scenario such as this present EITC due diligence issues? How would you introduce your questions to Bill? What questions would you ask? |
Scenario 2 Discussion
A taxpayer filing as head of household, but who does not appear to have enough income to support the household, presents an EITC due diligence issue. But why? Although Mr. Brock’s income does indeed seem insufficient to maintain a household for three people, he could still use the single filing status and claim the children as dependents, which would reduce his taxable income to $0. And the EITC doesn’t have a support requirement anyway!
The problem is that if Mr. Brock was not able to support the children, they may not have lived with him. The idea is not to accuse Mr. Brock of anything, but to ask appropriate questions in order to satisfy the EITC due diligence knowledge requirement. You might introduce your questions by saying: “I need to determine your correct filing status to allow me to determine the tax benefits you may be eligible for. I’ll need to ask you some additional questions if that’s all right.”
Possible questions to ask:
Once again, there are no “right” or “wrong” answers to these questions. You may learn that the family is receiving government assistance or support from other family members, making Mr. Brock ineligible for head of household status, but eligible for EITC nonetheless. Or, you may learn that the children stay with Mr. Brock only occasionally and are not QCs for any purpose. The goal is to make sure that Percy and Patty are Mr. Brock’s qualifying children for EITC purposes and to document the responses in order to satisfy the knowledge requirement.
| Scenario 3: Matt Drake is 26 years old. He works full time and has earned income of $28,700. He tells you that he lives with one dependent—his son, Gary, who is 14 years old. Why would a scenario such as this present EITC due diligence issues? How would you introduce your questions to Mr. Drake? What questions would you ask? |
Scenario 3 Discussion
This situation could be difficult to handle with sensitivity and in a professional manner. Although not impossible, Gary is probably not Mr. Drake’s biological son. You might start your questioning with “I notice that Gary is only 12 years younger than you are. Did you say that he is your son?” Hopefully, he will reply that Gary is not his biological son, but his brother, nephew, girlfriend’s son, adopted son, etc.
But Mr. Drake could respond that Gary is his son. At that point, it would be good practice to inform him that there is a good possibility that the IRS will question the relationship and he should be prepared to validate it. Ask Mr. Drake if he would be able to substantiate to the IRS his relationship with his son, by showing a birth certificate, adoption papers, or other documents the IRS would likely request to prove the relationship. If your client does not believe he can substantiate the relationship, you should advise the client that the child cannot be claimed as his son.
Remember, your goal is not to audit your client or to accuse him of anything, but to be aware of the EITC due diligence knowledge requirement regarding this type of situation, question the taxpayer if needed, and document the client’s responses.
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Scenario 4: Variation 1: Your returning client is Beth Friedrich. She is 32 years old, divorced, and has a three-year- old daughter, Bonnie. She and her daughter live with her parents. Beth works part-time while she attends college, and no one else will claim Bonnie for any child-related tax benefit. Assume that Ms. Friedrich does not qualify to use the head of household filing status. As she did last year, she presents you with her Form W-2 showing a small amount of wages, $3,500, from her part-time job. But this year Ms. Friedrich tells you that she earned $10,000 from a hair and nail care business that she runs from her parents’ home. She indicates that she didn’t keep good records of her business expenses and would therefore prefer to not claim them. Variation 2: Your new clients are Milton and Helen Snider. Their children are Danny, age 10, and Sally, age 6. Mr. Snider earns $42,000 from his job. Mrs. Snider tells you that she has a catering business that operated at a $6,000 loss in 2008. She has some receipts with her that show various expenditures made for the year. For both variations, assume that there are no qualification concerns about claiming the children as dependents for purposes of the credit or overstatement of earned income. Why, then, is there an EITC due diligence issue? What are your concerns about the net self-employment income or loss reported by these clients? How would you discuss your concerns with each of these clients? |
Scenario 4 Discussion
In the previous three scenarios, the due diligence issues centered on concerns about whether the relationship and/or residence requirements to be a qualifying child of the client were met. In the two variations of Scenario 4, we assume that the children involved are qualifying children and our interest is instead on Ms. Friedrich’s and Mrs. Snider’s respective businesses. If there are no concerns about the clients’ families and households, why, then, is there an EITC issue at all?
Note that Ms. Friedrich would be eligible to claim the EITC with or without her hair and nail care business but, by adding $10,000 to her earned income, her credit potentially increases from $1,182 to $2,917, the maximum credit for an unmarried taxpayer with one child. By contrast, Mr. and Mrs. Snider would not be eligible for EITC at all unless Mrs. Snider’s business loss is factored in. By doing so, they would potentially receive a credit of $1,194.
At this point, it’s a good idea to revisit the EITC due diligence knowledge requirement. As a tax return preparer, you:
In these two instances, the implication is that the taxpayers could be misreporting their earned income to affect the amount of EITC they receive. As we’ve stated before, your goal is not to audit these clients or to accuse them of anything, but to satisfy the knowledge requirement by making reasonable inquiries about the business and documenting the clients’ answers. Some possible questions and discussion points are:
Variation 1 (Ms. Friedrich)
Variation 2 (Mrs. Snider)
This is not an exhaustive list of questions to ask these clients. You may think of others, or the responses you get may lead to other questions. Certainly in Mrs. Snider’s case, you would consider the “hobby loss” rules and remind her that a loss will be disallowed if the IRS determines that there is no profit motive for the activity.
In both instances, you should document your questions and the client’s answers. You should also inform the taxpayers that if the IRS questions and subsequently reduces or denies EITC, at the very least Form 8862, Information to Claim Earned Income Credit After Disallowance, must be completed to claim EITC again. EITC may not be claimed for two years if the IRS determines there was a reckless or intentional disregard of the rules and for ten years if the IRS makes a determination of fraud.
| Scenario 5: Your 17-year old client, Tessa Trueheart, has one child, a baby born November 27, 2008. Ms. Trueheart tells you that she is in her last year of high school. She has brought in a birth certificate for her baby and a Form W-2 showing wages of $2,980. Why does this scenario present an EITC due diligence issue? What questions will you ask Ms. Trueheart? |
Scenario 5 Discussion
This scenario surely brings home the knowledge requirement that you “may not ignore the implications of information furnished to, or known by, you.” In Ms. Trueheart’s case, there are no issues about income or whether there is a qualifying child. But, given these facts, you must consider §32(c)(1)(B):
Ms. Trueheart is only 17 years old, still in school, and has minimal income. Therefore, it is most likely that she lives with a parent who supports her. Appropriate questions might be:
Ms. Trueheart is likely to indicate that she lives with a parent, parents, or other relative(s). If so, you would determine that she is a qualifying child herself and is thus ineligible to claim the EITC for her baby.
| Scenario 6: Your client is Sheila Green. Ms. Green is divorced and has one son, George, for whom she has claimed EITC for at least the last five years that you have been preparing her return. George’s 19th birthday was in 2008. You ask Ms. Green if George is attending school full time. Ms. Green responds that George is “totally disabled.” What questions will you ask Ms. Green? |
Scenario 6 Discussion
To meet the EITC age requirement, a child must be under 19, under 24 at year-end and a full-time student, or permanently and totally disabled. At issue then is whether George meets the definition of permanent and total disability, defined in §22(e)(3) as follows:
You might begin your questioning by asking Ms. Green whether George is employed, and then determine how much and what type of work George does, or why he does not work. You also might ask if George receives any benefits or assistance because of his disability, and if not, whether he applied for any benefits or assistance and the outcome of his application. You might ask when George became disabled, since she did not indicate he was disabled the previous year.
To put the disability definition in terms that the client will understand, you might explain to Ms. Green that to be considered disabled under the law, George must have a serious medical condition that results in his being unable to work, and the medical condition must be expected to last continuously for at least a year or result in death. Then ask her if she understands the definition and ask about the nature of George’s disability.
Ms. Green might reply that George is not disabled, in which case you would simply tell her that she is not eligible for EITC this year. If George becomes a full-time student at some point before the year he turns 24, she may qualify again in a future year.
Or, Ms. Green might respond that George is indeed disabled and provide details about his medical condition. Ask her if she would be able to provide proof of disability and document her response. Proof of disability generally requires a physician’s statement. The statement must show that the disability has lasted or can be expected to last for at least a year, or is expected to result in death. Where applicable, a statement from the Department of Veterans Affairs that determines the dependent is disabled can be substituted for a physician’s statement. The statement should be retained in the taxpayer’s records in case the return is examined and proof of disability must be provided. Also, an individual receiving Social Security disability benefits is likely to meet the requirement for earned income credit purposes. You do not have to research the medical condition, or attach medical records to the return, but you do have to make reasonable inquiries into Ms. Green’s statement.
Or, Ms. Green might give you a vague statement, such as “Yes, George is disabled and can’t work.” Your questioning would be similar to that explained in the paragraph above, but you might reiterate the definition of disability (and the substantiation requirement) and also inform Ms. Green that if she is unable to prove George’s disability to the satisfaction of the IRS, EITC would be denied.
Summary of EITC Scenarios
The EITC scenarios above have presented due diligence issues related to the earned income credit. In some cases, the presence of a qualifying child in the home is questionable. In others, the client may have a disqualifying factor, such as lack of earned income in the EITC range. As has been illustrated, you cannot satisfy the due diligence knowledge requirement merely by completing a checklist or by relying on tax software to “catch” EITC issues. When dealing with personal and sensitive matters, such as a discussion about a child’s disability, deciding what questions to ask, how to ask them, and what to do with the responses you get, the process can at times be difficult or uncomfortable. As a tax professional, however, you must ask sufficient questions to allow you to meet your due diligence requirement if EITC eligibility—or any other tax issue for that matter—appears questionable to you.
EITC due diligence visits/audits are conducted annually, and selection is based on standard criteria applied to all EITC returns. The visits are conducted between October and March. If you are selected for an EITC due diligence visit, you will expect an appointment to be made either by phone or letter. The examiner will interview the preparer and the employer. The examiner will review 25 returns, and the sample will be expanded if non-compliance with due diligence requirement is noted. The examiner will review the questionnaire, Form 8867, and EIC computation worksheet. Then the examiner will determine if the preparer has complied with IRC 6695(g). If penalties are warranted, the examiner determines whether to assess penalties against the employer or employee preparer.
EITC Information for Tax Professionals
EITC for Tax Preparers
Due Diligence Requirements
EITC Due Diligence Compliance Program
Avoid Common EITC Errors