Although nearly 65 percent of Earned Income Tax Credit returns are prepared by paid preparers, the error rate is roughly the same as when the return is prepared by the individual, according to Internal Revenue Service spokesperson Nancy Mathis.

One problem for practitioners is a lack of familiarity with the EITC rules, noted Vicki Mulak, a Tustin, Calif.-based enrolled agent and certified financial planner. "A lot of practitioners just don't have a lot of EITC clients, but we all have some," she said. "So we don't feel like we're specialists in this area."

To aid tax professionals in navigating the complex EITC rules, the IRS has developed a special Web site, The site reminds preparers that it is their responsibility to follow due diligence requirements and avoid EITC errors.

This tax season, there is one major tax law change to the EITC. In computing the credit, a taxpayer with nontaxable combat pay has the option of counting that pay as earned income, or omitting it. The decision has no effect on the amount of combat pay that is not taxed.

"For the earned income credit, you get to choose whether or not you want to include nontaxable combat pay and income," said Bob Erickson, senior technical advisor for tax forms and publications with the IRS, at a recent Tax Talk Today conference. "That means you have to determine whether it is to your benefit, because it might help you in some cases, and it might hurt you."

"The choice is not automatic," he said. "By making the election to treat it as earned income for the earned income credit, you have to put it on a line on the 1040 next to the earned income credit called nontaxable combat pay election on the form."

And, he noted, "You have to choose to include all of your combat pay or none of your combat pay. That prevents some kind of manipulation of the earned income credit."

Success - and shadows

Since its enactment in 1975, the EITC has helped lift millions of individuals out of poverty and has a high participation rate relative to other low-income programs. However, it is also considered to be one of the most abused programs. The IRS estimates that EITC overclaim rates for 1999, the most recent data available, were between 27 percent and 32 percent of dollars claimed, or $8.5 billion and $9.9 billion, respectively.

"Because of the persistently high rates of noncompliance, we also have identified the EITC program as a high-risk area for the IRS since 1995," Government Accountability Office investigators said in a report to House Ways and Means Oversight Subcommittee chair Rep. Amo Houghton of N.Y.

The leading sources of Earned Income Tax Credit errors were children who did not meet the EITC residency or relationship requirements ($2 billion); taxpayers who used an incorrect filing status ($2 billion); and taxpayers who misreported their income ($3 billion).

"The IRS is concerned about fraud," said Mike Lister, chief executive of Parsippany, N.J.-based Jackson Hewitt. "We look at it from the point of view of education. We encourage people to use paid preparers to make sure they get it right."

"What complicates it is the definition of child and levels of support," he said. "We built into our own software the due diligence for the consumer so they're sure it's right and they get the right amount back."

The IRS takes steps

The IRS conducted three tests last filing season to address these three leading sources of EITC errors:

* A qualifying child test, where selected taxpayers were asked to document that their child lived with them for more than half the year;

* A filing status test, where selected taxpayers were asked to provide documentation to prove the accuracy of their filing status; and,

* An income misreporting test, where a new screening process was used to select EITC returns that identified taxpayers likely to have the most significant changes in their assessments due to underreporting of income.

Some of the information was not well documented, according to the GAO, which hindered monitoring and oversight. For the 2005 tests, the IRS has made some key changes to the qualifying child test to encourage taxpayers to certify in advance of filing their return.

The IRS has also changed the sample selection criteria for the filing status test to better target non-compliant taxpayers.

With nearly a third of the $30 billion paid out under the Earned Income Tax Credit program going to those who don't deserve it, the IRS is increasing its compliance efforts.

The IRS reminded preparers that paid tax professionals are required to follow four due-diligence procedures when filing EITC claims: completing Form 8867, Paid Preparer's Earned Income Credit Checklist; completing the appropriate EIC worksheet in Form 1040, 1040A or 1040EZ instructions or in Pub. 596; having no knowledge that any of the information used to determine the taxpayer's eligibility for the credit and/or the credit amount is incorrect; and keeping Form 8867 and the EIC worksheet, and a record of how, when and from whom the information used to prepare the form and worksheets was obtained.

The documents - paper or electronic - must be kept for three years after June 30 following the date that the return or claim for refund was presented to the taxpayer for signature.

Professionals who fail to follow due-diligence requirements may be assessed a $100 penalty for each failure. Taxpayers who engage in reckless or intentional disregard of EITC rules and regulations may be hit with an accuracy-related penalty of 20 percent of the underpayment of tax and a two-year ban from claiming the EITC.

If they are involved in fraudulent claims, they may incur a fraud penalty and a 10-year ban from claiming the EITC.

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