IRS Penalty 6695(g): What Every Tax Preparer Needs to Know About Due Diligence

IRS Penalty 6695(g): What Every Tax Preparer Needs to Know About Due Diligence

If you've been preparing taxes for more than a few years, you've probably heard about IRC Section 6695(g). But do you know exactly what triggers this penalty, how much it costs, and how to avoid it?

The stakes are high. The penalty for failing to meet due diligence requirements can run $500-$5,000+ per year depending on your practice size and history. For a busy tax prep office, one audit cycle could wipe out months of profit.

Yet many preparers still don't have a clear system to ensure they're meeting all the requirements.

This guide covers what you need to know to protect your practice.

What Is IRC 6695(g)?

IRC Section 6695(g) is part of the "Due Diligence" penalty structure. It specifically applies to penalties for failing to comply with due diligence requirements when claiming earned income tax credit (EITC) or child tax credit (CTC) returns.

The IRS expects tax preparers to exercise "due diligence" before claiming these credits on behalf of clients. This means:

• Asking the right questions — You must inquire about facts that would qualify or disqualify a client for the credits
• Verifying the information — You need to verify at least some of the key facts (income, dependents, filing status)
• Documenting your work — You must create a paper trail showing you asked and verified

If you skip these steps, you're vulnerable to the penalty.

The Dollar Impact

Here's what the penalty structure looks like:

• First offense: Up to $500 per return
• Second offense (within 10 years): Up to $1,000 per return
• Subsequent offenses: Up to $5,000 per return

For a small office that prepares just 100 returns a year and makes one due diligence error on, say, 10 of them, that's $5,000 in penalties for a single error.

The IRS doesn't typically catch these through client audits. Instead, they audit you — the preparer. During a preparer compliance exam, agents look at a sample of returns and check whether you documented your due diligence work.

If your work papers don't show that you asked about income, dependents, and other EITC/CTC eligibility factors, the penalty applies automatically.

Form 8867: Your Due Diligence Checklist

The most important document in your due diligence armor is Form 8867: Paid Preparer's Declaration for a Return with a Claim for Earned Income Credit or Credit for Other Dependents.

This form is the preparer's affidavit that you:

1. Interviewed the client — face-to-face, video, or phone

2. Asked about specific facts — income, dependents, filing status, education status

3. Verified key information — through documents or other means

4. Assessed eligibility — based on what you learned

5. Retained supporting documentation — for at least 3 years

If you claim EITC or CTC on any return, Form 8867 must be completed and filed with the return. There's no exception.

The Questions You Must Ask

Here's what the IRS expects you to document in your work papers:

About Dependents:

• Full name, SSN, date of birth
• Relationship to taxpayer
• Months lived in the home
• Citizenship status
• Disability status (if applicable)
• Whether the dependent had gross income

About Income:

• Source and type of income
• Expected income amount
• Whether income is reported correctly on W-2s, 1099s, etc.

About Household Status:

• Who lived in the home and when
• Marital status changes during the year
• Any custody arrangements (for CTC)

About Education (if claiming AOTC):

• Name of school
• Year in school
• Qualified education expenses

How to Avoid the Penalty: A Three-Step System

Step 1: Create an Interview Checklist

Don't rely on memory. Build a checklist that covers every EITC/CTC/AOTC question. Have clients complete it in your intake or during an appointment. File this checklist in your work papers.

Intaxion's bilingual intake can capture many of these facts directly, reducing transcription errors and creating a permanent record.

Step 2: Verify at Least Some Facts

The IRS doesn't require 100% verification on every item. But you need to verify something. Examples:

• View the child's birth certificate or Social Security card
• Review the child's school report card to confirm education status
• Look at a recent utility bill to confirm the address
• Verify dependent's SSN through the SSA IEVS system (available to practitioners)

Document what you verified and how.

Step 3: File Your Work Papers Correctly

Your work papers should include:

• Completed Form 8867 (signed and dated)
• The interview checklist or client questionnaire
• Documentation of verification
• Notes from your conversation with the client
• Copies of supporting documents (if relevant)

Organize these by return and keep them for at least 3 years.

Common Mistakes That Trigger Penalties

Mistake #1: Not Filing Form 8867

This is the #1 violation the IRS finds. You claim EITC or CTC but forgot to file Form 8867. Penalty applies automatically. There's no "we were going to file it" defense.

Mistake #2: Form 8867 Signed but No Interview

The form says "I interviewed the taxpayer," but your work papers show no evidence of an actual conversation. The IRS will assume the interview didn't happen.

Mistake #3: Missing Key Facts

Your interview notes mention the dependent's name but not their SSN, relationship, or time in the home. Incomplete due diligence = penalty.

Mistake #4: No Verification

You ask about facts but never verify them. One dependent claim gets challenged during an IRS exam, and suddenly all your work papers are under scrutiny.

Mistake #5: Delegating Without Documenting

You had a junior preparer conduct the interview, but their notes don't clearly document what was asked. You can't prove due diligence happened.

Your Due Diligence System Should Be Automated

If you're managing due diligence through spreadsheets, email templates, and handwritten notes, you're making this harder than it needs to be.

A solid intake system (like Intaxion) can:

• Capture all required EITC/CTC facts in a structured form
• Create permanent records of client responses
• Generate Form 8867 automatically from the intake data
• Flag missing information before you file
• Organize work papers by tax year and client

This doesn't just reduce your penalty exposure. It also saves time. Instead of typing up interview notes, you're reviewing structured data that's already verified.

What Happens If the IRS Audits You?

If the IRS selects you for a preparer compliance exam, expect them to:

1. Request a sample of returns (typically 10-25)

2. Ask for your work papers for those returns

3. Check whether Form 8867 was filed

4. Review whether you asked about and verified EITC/CTC facts

5. Propose penalties for any deficiencies

The IRS also looks at the pattern of errors. If you show due diligence for most returns but miss it on 2-3, that's often where penalties focus.

The Free Penalty Risk Calculator

Wondering how much penalty exposure you currently have? We built a free calculator that estimates your risk based on:

• Number of returns prepared per year
• Percentage claiming EITC/CTC
• Your current verification practices

It takes about 5 minutes and doesn't require any signup.

The Takeaway

IRC 6695(g) penalties are preventable. The IRS isn't trying to trap you — they want preparers to do due diligence to protect EITC/CTC integrity (and to prevent fraud).

If you have a documented system for:

1. Interviewing clients about EITC/CTC facts

2. Verifying at least some of those facts

3. Filing Form 8867 with every relevant return

4. Keeping organized work papers

...you'll pass an IRS audit on this issue.

The key is consistency and documentation. The form matters less than what you're doing.