Due Diligence Standards

Introduction

The federal tax system is based largely on voluntary compliance. Taxpayers report income, claim deductions, and calculate tax liability with the expectation that the information provided is accurate.

Tax preparers play an important role in maintaining the integrity of this system. A preparer is not expected to function as an auditor or criminal investigator. However, the IRS requires preparers to exercise due diligence when preparing tax returns.

Due diligence means more than entering information into software. It requires professional judgment, reasonable inquiry, attention to facts that appear incomplete, inconsistent, or incorrect, and documentation of the preparer's process.

Failure to exercise due diligence can result in penalties, disciplinary actions, reputational damage, and increased audit risk for both the taxpayer and the preparer.

What due diligence means

Due diligence is the level of care that a reasonable and competent tax professional would exercise under the circumstances. The preparer must gather sufficient information, review information provided, ask follow-up questions when necessary, resolve apparent inconsistencies, document significant findings, and prepare the return based on facts and applicable law.

Due diligence is both a professional obligation and a legal compliance requirement. It applies broadly to return preparation, and special due-diligence rules apply to certain credits and filing-status determinations.

A preparer who ignores obvious problems is not protected merely because the taxpayer signed the return. The taxpayer remains responsible for the return, but the preparer also has responsibilities.

The reasonable inquiry standard

Preparers may generally rely on information provided by taxpayers. Reliance is not unlimited. If information appears incorrect, incomplete, or inconsistent, the preparer must make additional inquiries.

The key question is practical: would a reasonable preparer ask additional questions under these circumstances? If the answer is yes, further inquiry is required before the return is finalized.

For example, if a taxpayer reports substantial self-employment income and almost no business expenses, the facts may be possible. But the pattern is unusual enough that a reasonable preparer should ask follow-up questions. The same principle applies when income drops sharply, deductions rise substantially, dependents change, documentation is missing, or taxpayer statements conflict with records.

Reliance on taxpayer information

Preparers are not expected to independently verify every document provided by a taxpayer. If a taxpayer provides a Form W-2 that appears legitimate and consistent with the taxpayer's facts, the preparer may generally rely on it.

Reliance becomes unreasonable when facts suggest the information may be inaccurate. A preparer may not ignore a mismatch between a child's claimed residence and school records, a missing brokerage statement after prior-year dividend income, or a taxpayer's statement that contradicts documents already provided.

The preparer should distinguish ordinary reliance from blind acceptance. Ordinary reliance is appropriate when information appears complete and consistent. Blind acceptance occurs when a preparer ignores warning signs.

Information requiring additional inquiry

Certain situations frequently require follow-up. Significant changes from the prior year, incomplete documentation, inconsistent statements, unusual tax positions, and credit eligibility issues should all trigger additional questions.

Examples include dramatic income changes, substantially increased deductions, new dependents, missing Schedule K-1s, missing brokerage statements, missing business records, large charitable deductions, high Schedule C losses, excessive vehicle expenses, earned income credit claims, child tax credit claims, education credit claims, and head of household filing-status claims.

Additional inquiry does not mean the preparer assumes the taxpayer is wrong. It means the preparer recognizes that the current facts are not sufficient to support the return position without more information.

Due diligence and specific tax benefits

The IRS imposes special due-diligence requirements for paid preparers on returns or claims involving the earned income credit, child tax credit, additional child tax credit, credit for other dependents, American opportunity tax credit, and head of household filing status.

For these benefits, the preparer must determine eligibility and, when relevant, the amount of the credit or status benefit. The preparer must ask adequate questions, evaluate information, complete the required due-diligence checklist, and keep required records.

These areas receive increased IRS scrutiny because they involve eligibility tests, residency rules, identification requirements, refundable credits, education expenses, and household facts that are often misunderstood or misstated.

Form 8867

Form 8867, Paid Preparer's Due Diligence Checklist, is used to document compliance with specific due-diligence requirements. Paid preparers use it for applicable returns or claims involving EIC, CTC/ACTC/ODC, AOTC, and/or head of household filing status.

The form helps demonstrate that the preparer asked required questions, reviewed relevant information, determined eligibility, and maintained appropriate records.

Students should not memorize a stale penalty amount. Penalty amounts and instructions can change. The safer exam habit is to understand that failure to comply with due-diligence requirements can create preparer penalties and that current IRS guidance should be checked for the applicable amount.

Documentation of due diligence

Good documentation is one of the strongest defenses available to a tax preparer. Documentation should show the questions asked, answers received, records reviewed, inconsistencies resolved, and conclusions reached.

Useful documentation includes interview notes, copies or descriptions of supporting documents, follow-up questions, taxpayer explanations, school or medical records used for residency, childcare provider information, education expense support, and notes explaining unusual circumstances.

The phrase 'the taxpayer told me so' is rarely an adequate defense when facts indicate additional inquiry was necessary. The preparer should document how eligibility determinations were reached.

Common due diligence failures

Common failures include failing to ask follow-up questions, ignoring inconsistent information, assuming missing information is unimportant, failing to document discussions, claiming credits without sufficient support, relying solely on taxpayer estimates, and completing Form 8867 mechanically without actually performing the required inquiry.

Many due-diligence problems arise not because preparers lack technical knowledge, but because they fail to investigate unusual facts. If information appears unreasonable, ask questions.

Documenting questions is often as important as asking them. Months or years later, documentation may be the only evidence that proper procedures were followed.

EA exam view

The EA examination frequently tests whether a preparer may rely on taxpayer information. The general rule is yes, but not when the information appears incorrect, incomplete, or inconsistent.

The exam also tests that preparers are not auditors. A preparer is not required to independently verify every fact in every case, but may not ignore facts suggesting that additional inquiry is required.

Form 8867 is heavily associated with paid preparer due diligence for refundable-credit and head-of-household determinations. Candidates should understand its purpose, when it is used, and why it matters.

Example 1: Basic reliance

Facts: A taxpayer provides Form W-2 and Form 1099-INT. All information appears complete and consistent with the interview.

Analysis: The preparer may generally rely on information that appears complete, consistent, and reasonable.

Result: No additional inquiry is required from these facts alone.

Example 2: Intermediate dependent issue

Facts: A taxpayer claims a dependent child, but the child's address on school records differs from the taxpayer's address.

Analysis: The discrepancy affects residency and possibly credit eligibility. The preparer should ask follow-up questions and review supporting documentation.

Result: Additional inquiry is appropriate before claiming the child-related benefit.

Example 3: Advanced Schedule C expense issue

Facts: A taxpayer reports $30,000 of Schedule C gross receipts and $29,500 of vehicle expenses.

Analysis: The deduction may be valid, but the ratio is unusual and vehicle expenses require careful support. The preparer should ask questions and review mileage and business-use records.

Result: Due diligence requires additional questioning and documentation review.

Example 4: EA exam style credit discrepancy

Facts: A taxpayer claims the earned income credit and says a child lived with them all year. School records show the child attended school in another state.

Analysis: The information is inconsistent. The preparer cannot ignore the discrepancy or automatically claim the credit.

Result: The preparer should conduct additional inquiry before determining eligibility.

Case Study 1: Earned income credit residency conflict

Facts: Jennifer reports wages of $40,000 and claims earned income credit eligibility for two children. During the interview, she says one child lived with her all year. School records suggest the child spent most of the year with another parent.

Analysis: The information is inconsistent. The preparer must make reasonable inquiries to determine residency, custody arrangements, dependency eligibility, and credit eligibility. Additional documentation may be necessary.

Exam takeaway: Due diligence requires further investigation before claiming the credit. Failure to inquire could expose both taxpayer and preparer to consequences.

Case Study 2: Head of household with unclear household costs

Facts: A taxpayer claims head of household and states that a qualifying child lived with her. She also says her parent paid most rent and utilities for the home.

Analysis: Head of household requires the taxpayer to pay more than half the cost of keeping up the home. The preparer should ask about household costs, who paid them, and whether the claimed status is supportable.

Exam takeaway: Form 8867 due diligence can apply to head of household status, not only credits.

Question 1

Which statement best defines due diligence in tax return preparation?

1. Entering taxpayer information into software without review.
2. The level of care a reasonable and competent preparer uses when gathering facts, applying law, and preparing a return.
3. Auditing every taxpayer document.
4. Guaranteeing that the IRS will not question the return.

Correct answer: B

Explanation: Due diligence requires reasonable professional care, inquiry, judgment, and documentation.

Why the other answers are wrong:

• A: Data entry alone is not due diligence.
• B: This is the correct answer.
• C: Preparers are not required to audit every document.
• D: Due diligence does not guarantee no IRS review.

Rule tested: Due diligence definition

Exam trap: Confusing due diligence with either data entry or auditing.

Question 2

When must a preparer make additional inquiries?

1. Only when the taxpayer asks.
2. When information appears incorrect, incomplete, or inconsistent.
3. Never, if the taxpayer signs the return.
4. Only when the return shows a balance due.

Correct answer: B

Explanation: Reasonable inquiry is required when facts suggest the information may not be reliable or complete.

Why the other answers are wrong:

• A: The duty is not limited to taxpayer requests.
• B: This is the correct answer.
• C: A signature does not erase preparer duties.
• D: The duty applies regardless of refund or balance due.

Rule tested: Reasonable inquiry

Exam trap: Assuming taxpayer signature eliminates preparer responsibility.

Question 3

Which form documents paid preparer due diligence for certain credits and head of household filing status?

1. Form 8867
2. Form 4506-T
3. Form 1040-ES
4. Form 1098-T

Correct answer: A

Explanation: Form 8867 is the Paid Preparer's Due Diligence Checklist.

Why the other answers are wrong:

• A: This is the correct answer.
• B: Form 4506-T requests transcripts.
• C: Form 1040-ES is for estimated taxes.
• D: Form 1098-T reports tuition information.

Rule tested: Form 8867

Exam trap: Confusing due-diligence forms with transcript or education forms.

Question 4

A taxpayer claims EIC for a child, but school records show the child lived in another state most of the year. What should the preparer do?

1. Automatically claim the credit.
2. Ignore the school records.
3. Conduct additional inquiry before determining eligibility.
4. Remove all dependents without asking questions.

Correct answer: C

Explanation: The conflict affects residency and requires reasonable inquiry.

Why the other answers are wrong:

• A: The credit should not be claimed automatically.
• B: Conflicting records cannot be ignored.
• C: This is the correct answer.
• D: The preparer should investigate, not make an unsupported removal.

Rule tested: Credit due diligence

Exam trap: Ignoring conflicting residency evidence.

Question 5

Which is a common due-diligence failure?

1. Documenting taxpayer responses.
2. Asking follow-up questions when facts are inconsistent.
3. Relying solely on taxpayer estimates when records are needed.
4. Reviewing supporting information.

Correct answer: C

Explanation: Relying only on estimates when support is required can fail due-diligence standards.

Why the other answers are wrong:

• A: Documentation supports due diligence.
• B: Follow-up questions are appropriate.
• C: This is the correct answer.
• D: Reviewing support is part of due diligence.

Rule tested: Common due-diligence errors

Exam trap: Treating estimates as adequate support.

Question 6

Which statement about preparer reliance on taxpayer information is correct?

1. Reliance is always unlimited.
2. Preparers may generally rely on taxpayer information unless it appears incorrect, incomplete, or inconsistent.
3. Preparers may never rely on taxpayer information.
4. Reliance applies only to paper-filed returns.

Correct answer: B

Explanation: Preparers may generally rely on taxpayer information, but warning signs require inquiry.

Why the other answers are wrong:

• A: Reliance is not unlimited.
• B: This is the correct answer.
• C: Preparers can generally rely on taxpayer information when reasonable.
• D: Filing method does not control this rule.

Rule tested: Reliance standard

Exam trap: Thinking reliance is all-or-nothing.

Question 7

Which benefit is associated with Form 8867 due diligence?

1. Earned Income Credit
2. Mortgage interest deduction only
3. Standard deduction only
4. Direct deposit election only

Correct answer: A

Explanation: EIC is one of the benefits covered by Form 8867 due diligence.

Why the other answers are wrong:

• A: This is the correct answer.
• B: Mortgage interest deduction is not the listed Form 8867 benefit here.
• C: Standard deduction alone is not the Form 8867 trigger.
• D: Direct deposit election is not a Form 8867 benefit.

Rule tested: Covered benefits

Exam trap: Misidentifying Form 8867 triggers.

Question 8

Why should a preparer document follow-up questions?

1. To show the process used to resolve eligibility and reporting issues.
2. To replace the need for tax law.
3. To guarantee no penalty can ever apply.
4. To avoid taxpayer review.

Correct answer: A

Explanation: Documentation shows questions asked, answers received, and conclusions reached.

Why the other answers are wrong:

• A: This is the correct answer.
• B: Documentation does not replace tax law.
• C: Documentation helps but does not guarantee no penalty.
• D: Taxpayer review is still needed.

Rule tested: Due-diligence documentation

Exam trap: Underestimating the importance of contemporaneous notes.

Question 9

A taxpayer reports $30,000 of Schedule C income and $29,500 of vehicle expenses. What is the best preparer response?

1. Automatically allow the deduction without questions.
2. Ask additional questions and review support because the facts are unusual.
3. Automatically disallow all vehicle expenses.
4. Move the expenses to wages.

Correct answer: B

Explanation: The deduction may be valid, but the unusual ratio and vehicle substantiation rules require inquiry.

Why the other answers are wrong:

• A: Unusual facts should not be accepted blindly.
• B: This is the correct answer.
• C: The preparer should investigate before deciding.
• D: Vehicle expenses are not wages.

Rule tested: Reasonable inquiry for unusual facts

Exam trap: Automatically allowing or disallowing without analysis.

Question 10

Which statement best captures the EA exam rule for due diligence?

1. Preparers are auditors in all cases.
2. Preparers can ignore inconsistent facts if the taxpayer signs.
3. Preparers are not auditors, but they must not ignore facts requiring additional inquiry.
4. Due diligence applies only to corporate returns.

Correct answer: C

Explanation: The key distinction is that preparers are not auditors, but reasonable inquiry is required when warning signs exist.

Why the other answers are wrong:

• A: Preparers are not auditors in all cases.
• B: Inconsistent facts cannot be ignored.
• C: This is the correct answer.
• D: Due diligence applies to individual return preparation as well.

Rule tested: Preparer due diligence standard

Exam trap: Confusing non-auditor status with permission to ignore warning signs.