Due Diligence Penalty: What Tax Preparers Should Know

The Internal Revenue Service (IRS) assesses a due diligence penalty on paid tax return preparers who fail to meet specific verification and documentation standards. This penalty is designed to improve the accuracy of returns claiming certain tax benefits by holding preparers accountable for confirming a client’s eligibility. These regulations are firm requirements, and the focus is on the preparer’s actions to ask the right questions and maintain proper records. For anyone who prepares tax returns for compensation, understanding these obligations is necessary to avoid professional and financial consequences.

Scope of Preparer Due Diligence

The due diligence rules apply to any individual compensated for preparing, or employing people to prepare, all or a substantial portion of a tax return or claim for refund. This broad definition includes professional tax preparers, accountants, and anyone else who receives payment for tax preparation services. The regulations are triggered when a return claims one or more of the following designated tax benefits:

• The Earned Income Tax Credit (EITC), a benefit for working people with low to moderate income.
• The Child Tax Credit (CTC), Additional Child Tax Credit (ACTC), and the Credit for Other Dependents (ODC), which assist with the costs of raising children.
• The American Opportunity Tax Credit (AOTC), which helps pay for the first four years of postsecondary education.
• The Head of Household (HOH) filing status, which provides a higher standard deduction for unmarried individuals supporting a home for a qualifying person.

A preparer’s obligation is activated whenever a client seeks to claim any of these benefits. The rules are benefit-specific, meaning the required verification steps must be performed for each credit or status claimed to confirm eligibility.

The Four Core Due Diligence Requirements

The foundation of preparer due diligence rests on four specific actions mandated by Treasury Regulation section 1.6695-2. The first requirement is the completion of Form 8867, Paid Preparer’s Due Diligence Checklist. This form must be filled out and submitted with any tax return claiming the designated tax benefits. The form acts as a roadmap for the preparer, guiding them through the eligibility questions for each benefit. It documents that they have performed the necessary checks based on information from the taxpayer and their own inquiries.

A second requirement involves the computation of the credits. The preparer must complete and attach to the return any applicable worksheets that demonstrate how the amount of each claimed credit was calculated. For instance, the worksheet for the EITC requires a detailed calculation based on earned income, investment income, and the number of qualifying children.

The third requirement is the knowledge component. Preparers cannot ignore information they know or have reason to know is incorrect. They must make reasonable inquiries to determine if the client is eligible for the tax benefits they are claiming. For example, when a client claims the AOTC, a preparer should ask if the student has a prior felony drug conviction. They should also inquire about who paid the tuition and whether any tax-free scholarships were received, as these factors affect qualified expenses.

Finally, preparers are subject to record-keeping rules. They must retain specific documents for three years from the later of the return’s due date or the date it was filed. This includes a copy of the completed Form 8867, the worksheets used to compute the credits, and copies of any client documents relied on to determine eligibility. A record of the questions asked and the client’s responses to satisfy the knowledge requirement must also be kept.

Penalty Assessment and Amount

Failure to comply with any of the four due diligence requirements can result in a financial penalty assessed against the preparer, not the taxpayer. For returns filed in 2025, the penalty is $635 for each failure, and this amount is indexed for inflation. A key aspect of this penalty is that it is assessed per failure, per return, meaning a single tax return can generate multiple penalties. For instance, if a preparer fails to meet the requirements for three claimed benefits on one return, they could face a total penalty of $1,905.

Beyond the monetary fine, non-compliance can lead to other consequences. The IRS can refer the preparer to its Office of Professional Responsibility (OPR) for disciplinary action, which may include censure, suspension, or disbarment. In cases of repeated disregard of the rules, the IRS may seek an injunction to bar the individual from preparing tax returns professionally.

Responding to a Proposed Penalty

When the IRS determines that a preparer may have failed to meet their due diligence obligations, it will send a formal notice proposing the penalty. This notice identifies the specific tax return and outlines the reasons for the proposed penalty. Upon receiving this notice, the preparer has a defined period, usually 30 days, to respond in writing.

The response package should be a direct rebuttal to the IRS’s claims and include evidence demonstrating that due diligence was performed, such as the required forms, worksheets, and interview notes. After the preparer submits their response, the IRS will review the documentation. Based on this review, the agency may abate the penalty if the evidence shows compliance, or it may proceed with a formal assessment. If the preparer disagrees with the final determination, they have the right to a formal appeals process.