Due Diligence for Refundable Credits & HOH Filing Status

Rule

Paid preparers must meet four due-diligence requirements for every return claiming EITC, CTC/ACTC/ODC, AOTC, and/or HOH filing status. IRS estimates 1 in 4 of these claims contains an error. Failure to comply carries a penalty under IRC §6695(g) of $650 per failure (for 2025 returns filed in 2026; was $635 for 2024 returns filed in 2025), with no annual cap. The four requirements apply per credit category and per filing status.

The Four Due-Diligence Requirements

1. Complete and file Form 8867 (Paid Preparer's Due Diligence Checklist) — required every year, with no exceptions, for EACH EITC, CTC/ACTC/ODC, AOTC, and/or HOH claim. Form 8867 also documents the records the preparer relied on (school/medical/social-service records for qualifying-child residency/disability; business records when Schedule C is involved).

2. Compute the credit on required worksheets — complete and retain the worksheets from the Form 1040 instructions (or equivalent), showing how the credit was calculated and what information was used. Tax software auto-calculation does NOT substitute for knowing the law.

3. Meet the "knowledge requirement" — the preparer must know (and have no reason to know) that the information used to determine eligibility/amount is correct. The performance standard is how a reasonable, knowledgeable preparer who knows the law would handle it. Preparer must:

   • Apply common-sense standards to client information
   • Check that information is complete; fill in missing facts
   • Test for consistency; identify contradictory or known-false statements
   • Conduct a thorough interview with each client every year
   • Ask enough questions to judge the return's correctness
   • Document all questions asked and the client's answers

4. Retain records for 3 years — keep all five record categories (Form 8867; applicable worksheets; documents relied on; how/when/from whom info was obtained; questions asked and answers given). Retain for 3 years from the latest of: the return's due date (without extension), the e-file transmission date (signing preparer), the date furnished to the taxpayer to sign (non-e-file signing preparer), or the date submitted to the signing preparer (non-signing preparer).

Credits Covered

Most Common EITC Errors (>60% of errors)

1. Claiming a child who is NOT a qualifying child (fail relationship/age/residency/joint-return tests)
2. Married taxpayer claiming EITC without filing jointly (legally separated or lived apart last 6 months may qualify)
3. Income reporting errors (omitting income OR fabricating Schedule C income/omitting expenses)

AOTC Common Errors

• Student not at an eligible institution (e.g., unaccredited school not in DOE aid program)
• Claiming non-qualified expenses (room/board, insurance, medical, transport, sports/hobbies, non-credit courses)
• Claiming AOTC for more than 4 tax years
• For 2026+: failing the new SSN requirement for taxpayer, spouse, AND student

CTC Common Errors

• Child 17 or older at year-end (no exceptions — differs from dependent age rules)
• Child not claimed as a dependent on the return
• Child lacks valid SSN (ITIN child → no CTC, but $500 ODC may apply)
• Child did not live with taxpayer >half the year

Authority

• IRC §6695(g) — due-diligence penalty ($650 per failure for 2025 returns, no annual cap)
• Form 8867 — Paid Preparer's Due Diligence Checklist
• Publication 4687 — Paid Preparer Due Diligence
• Publication 596 — Earned Income Credit
• Publication 5713 — Due Diligence Interview
• Circular 230 §10.22 — due diligence (general)
• IRC §6694 — preparer understatement penalty (also applies to EITC errors)

Edge Cases

• SSN vs. ITIN for EITC: If the taxpayer OR spouse (if married) holds an ITIN, they CANNOT claim EITC — even if all qualifying children have valid SSNs. Both the taxpayer and spouse (if filing jointly) need valid SSNs.
• CTC vs. ODC SSN rule: A child with an ITIN fails CTC/ACTC but can still be the basis for the $500 ODC. Do not assume an ITIN child gives no credit at all.
• AOTC 4-year limit: Counts across all years the credit was claimed (by the student or, if a dependent, by the parent). A student who changed majors and has been an undergraduate for 5 years likely no longer qualifies for AOTC — consider Lifetime Learning Credit instead.
• No extra documentation required if info is consistent: The preparer is not always required to obtain relationship/residency proof before filing — BUT must request additional documents when information appears incorrect, inconsistent, or incomplete.
• "Borrowed/sold" dependents: A preparer who lets one taxpayer's qualifying child be "shared" with another taxpayer to generate EITC for both is participating in fraud. Any EITC claimant must have a valid SSN for employment purposes.

Common Traps

• Form 8867 is required EVERY year, for EVERY claim, with NO exceptions — even for a long-time client. Candidates wrongly think it's only needed for new clients.
• Software does not satisfy the knowledge requirement: Using tax software does not relieve the preparer of the duty to know the law and interview the client.
• The penalty is per failure, no cap: A single return can generate up to $2,600 (4 categories × $650). Across all clients there is NO aggregate cap.
• Missing Schedule K-1: If a client previously received partnership K-1 income but did not provide it this year, the preparer MUST ask about it (§10.21/§10.34 knowledge duty) — not just rely on what was handed over.
• No third-party verification required: Due diligence does NOT require the preparer to verify client answers with third parties — only to ask probing questions and document them. Candidates often wrongly pick "verify with third parties."
• Taxpayer consequences differ from preparer consequences: If IRS disallows the credit, the taxpayer must repay with interest, may have to file Form 8862, and is barred from claiming the credit for 2 years (disregard/willful disregard) or 10 years (fraud). The preparer faces the $650 §6695(g) penalty separately.
• EITC married-separate bar: A married person cannot claim EITC using HOH or MFS — must file jointly unless the separated-spouse rule applies (lived apart the last 6 months).

Connected Rules

• practitioner-standards-tax-advice — §10.34 return standards, reliance on client info, knowledge duty
• circular-230-rules — §10.22 due diligence, §10.35 competence
• penalties-refund-professional-responsibility — §6695(g) penalty detail, §6694 understatement
• irs-authority-practice-requirements — preparer classifications, PTIN

Scenarios Worked

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