So what are the general rules of tax record retention?
For most people they can get rid of their tax records after three years. Why? In most cases, the IRS is really only allowed to audit the last three years. For instance, right now it is 2018. In 2018, 99% of the examinations the IRS commences are for tax years 2015-2017.
But many of you might have heard about the rule that says you need to retain your records for 7 years. So where did that number come from? the answer is that the IRS has a few exceptions to its three-year look-back period. If you understate your income by more than 25%, the IRS can go back an additional 3 years for a total of 6 years. But that’s sort of an interesting paradox. How does the IRS know you understated your income by 25%? Wouldn’t an auditor have to conduct an examination to know that you did that? And this is why we see so few audits that get opened for six years. The IRS needs to have some credible information you understated your income by 25% through some verifiable source before that audit begins.
What’s the most common way this happens? Taxpayers and their representatives don’t organize their files correctly when under audit and just dump too much data on an auditors desk which includes information on years outside the 3-year period the auditor was examining.
The fraud exception to IRS tax record retention
Another exception is if you file a fraudulent return, the IRS can examine and assess indefinitely. So the IRS advises you to keep your tax records indefinitely if you file a fraudulent return. Which I suppose makes sense from the IRS’s perspective. But let me tell you a story that demonstrates how this advice helps the government, not taxpayers.
Before he hired us to negotiate a settlement, our client Steve got involved with one of these tax protestor groups. He stopped filing his taxes. But he had every one of his records for the last 20 years. So the grand jury subpoenaed his records by sending a notice to the custodian of record of Steve’s corporation, which happened to be Steve. So a 5th Amendment claim against self-incrimination would likely never work.
And because all his records were perfectly kept, the IRS was able to assess him for years they would have had a difficult time doing otherwise. If Steve got rid of this records, the IRS would be limited to assessments of the more recent years. If the IRS only assessed for the more recent years his balance would have been lower, meaning perhaps he wouldn’t be charged, or at a minimum his sentences would have been greatly reduced as the time to serve is calculated on the claimed loss to the government. I am not advising anyone to do anything fraudulent, in fact our long-standing philosophy is that if your current business plan requires you to cheat on your taxes in order to be profitable, then you should get a new business plan. But do you see how the government isn’t really here to help you?
Real Estate, property and IRS tax record retention
The IRS correctly advises that if you have property you should hang on to all your records for as long as you own the property plus the typical three years thereafter. Yet, we encountered a case where this rule would have resulted in a $40,000 tax bill to a client had he followed the IRS’s advice.
Our client Rod was foreclosed on in 2008. The foreclosure sale paid off the first mortgage but not the Home Equity Line. So the Home Equity bank attempted to collect from Rod. Now Rod has been struggling so finally in 2016, the Home Equity bank wrote of his balance sending Rod a cancellation of debt 1099 — as this is considered income to Rod. However, it is possible to exempt this forgiveness of debt if we can prove the home equity line went to improvements to the house and not say a vacation to Tahiti. So now, we need the records related to Rod’s old house to prove that this income should be excluded. Luckily for Rod he had this info and we were able to wipe out this phantom income and save him a good amount in a very efficient manner.
Sure we could have done other things if he didn’t have this information. But a successful resolution was far easier because he did. Yet right here on IRS.gov it says for Rod’s situation that he should have been able to get rid of those tax long ago. 2008 is the year he disposed of the property. His tax 2008 return was due Oct 15th 2009. Meaning according to IRS guidelines, three years later on Oct 16 2012, he should have been able to shred all records related to his house with no negative consequences. But clearly that was not true. Thank goodness he never saw this page.
Some big misses – FBAR record keeping requirements
The Report of Foreign Bank Accounts, or FBAR, is a US Treasury form that is administered by the IRS. For decades the form was ignored by the IRS. This however was changed in 2009, when the IRS realized it could use the threat of ruinous FBAR penalties — up to 50% of account value — to cajole people into the first Offshore Voluntary Disclosure Initiative. So there is a failure to file penalty for FBARs, yet there is also a penalty for failing to keep records. You must keep records on all foreign bank accounts for 5 years. The fact that this information is missing on irs.gov is understandable — the IRS has a lot on its plate. But it is also unforgivable.
Because the IRS is rather obstinate about finding that someone had reasonable cause and is entitled to an FBAR penalty waiver. It is unforgivable as the IRS is fine taking 50% of someones assets for this FBAR record-keeping oversight. But it is the same exact oversight that IRS.gov makes. It fails to mention the 5 year record retention requirement on tis record retention web page. So why are we holding taxpayers to a higher standard of care than the IRS?
What about if you were audited — retaining records of your examination
The IRS does not mention this, as this advice would probably help you, not them. If you are ever audited, you might want to hang on to those audit records forever. Why? Because you may be audited later and you may be raising a claim that the IRS was previously OK with or due to their bad advice helped contribute to. We had a case of a client who was audited twice in the 2000s. Bob had a business in Belgium and told the auditors about the business and the checking accounts in Europe. HE gave them all source documents. Yet during BOTH exams, the examiners failed to mention to Bob his FBAR obligations and his Form 5471 requirements. Even though it was immediately obvious to anyone with knowledge of international tax law that he’d had these requirements. The audits closed with no changes so Bob assumed he was doing everything right.
But no. The IRS, with its new-found FBAR and international l focus, audited him again — and attempting to assess him massive FBAR and Form 5471 penalties. We asked for the files of the audits from the IRS, but surprise, they didn’t have them. And so we asked Bob — hey you happen to hang on to anything from the audits. And sure enough he did. And thanks to the records he kept, the IRS agreed to VASTLY lower their proposed penalty. The fact is that Bob saved himself six-figures in penalties because hung on to records IRS.gov made no mention of.
The foreign informational return exception
Speaking of Form 5471, which is a type of foreign informational return for US shareholders of a foreign corporation to file. Well there are a litany of other foreign informational returns. And they all have the same problem. These other forms include:
The problem is this. If the IRS deems you to have filed a substantially incomplete foreign informational return, the IRS can open your entire tax return, no matter how old it is to a complete and full examination. So in fact, the IRS’s entire web page dedicated to record retention becomes wholly obsolete if foreign informational returns are involved. Again: If the IRS deems any foreign return substantially complete then there is NO time limitation on additional assessment at all.
If you file or are supposed to file any of these foreign informational returns, you might want to ignore the IRS’s explicit advice and rather, hang on to your tax records forever.