Maybe you've heard that you should hang on to your tax records for 3 years, maybe you heard 6 years, maybe 7, or even 10. But, as we will explain, the best answer may be: "for as long as you can."
The IRS has a webpage that alleges to answer this question. A critic would claim it is exceedingly dense and sort of misleading, but we'll let you judge for yourself:
Period of Limitations that apply to income tax returns
- Keep records for 3 years if situations (4), (5), and (6) below do not apply to you.
- Keep records for 3 years from the date you filed your original return or 2 years from the date you paid the tax, whichever is later, if you file a claim for credit or refund after you file your return.
- Keep records for 7 years if you file a claim for a loss from worthless securities or bad debt deduction.
- Keep records for 6 years if you do not report income that you should report, and it is more than 25% of the gross income shown on your return.
- Keep records indefinitely if you do not file a return.
- Keep records indefinitely if you file a fraudulent return.
- Keep employment tax records for at least 4 years after the date that the tax becomes due or is paid, whichever is later.
We'll do our best to translate. What the IRS is trying to say is that normally there is a three-year statute of limitations on assessments (ASED) from the date you file an original return. BUT – there are reasons why that may not actually be true.
For instance, if you leave off more than 25% of your income from your tax return, the IRS has a 6-year ASED. How would the IRS know if you left off 25% of income off your return? Yeah. Kind of interesting. The IRS would be claiming one thing based on records they have, and let's suppose you would claim that is incorrect. But…you got rid of your records because you actually did not under report by 25%. Now you don't have anything to support your claim because you got rid of your records per the IRS's own instructions!
While normally the IRS will only open an audit examination within three years of a tax return being filed, they can open an audit for 6 years if they believe they have "reasons". This is why the general rule every tax professional is taught — and the one I was taught when I got into tax practice — was to wait 7 years to get rid of tax records. But the 7-year rule on tax records can actually get you into trouble.
The Fraudulent Return Paradox
The first situation we must address is the ASED on fraudulent returns. There, the IRS has forever to assess, but how would they know if a return is fraudulent? Wouldn't the IRS have to compare their records with your records? The different between fraud and an innocent mistake depends on intent, but what if you didn't make a mistake? What if your return was actually correct but you no longer have the records to support your conclusion? What if you did make a mistake, but it could be proven the mistake had no bearing on taxes due? For example, you put down net income already deducting expenses instead of gross income and then deducting expenses.
Just because you didn't commit fraud doesn't mean the IRS won't think you were fraudulent.
International Reporting Forms
The second situation in which the 7-year rule could be unhelpful is when it comes to international income and assets.
Foreign and international tax reporting is the third rail of the tax world. Consequences of not reporting (or improperly reporting) are huge, and the IRS has marching order to hammer expats and international investors. They have created specific audit techniques known as International Practice Units (IPUs). These IPUs tell the IRS who they should target, and exactly what to look for to "catch" them doing things that result in massive penalties.
So what are some hot IPUs? Anyone missing or filing substantially incomplete Forms 5471 for foreign corporations, Form 926 for transfers to foreign corporations, Form 8865 for foreign partnerships, Form 3520-A/Form 3520s for trusts/gifts/foreign pensions. Also the Foreign Account Tax Compliance Act (FATCA) form for individuals, Form 8938 — if you don't file one when required, your entire tax returns' ASED remains open forever.
Here's the thing. If you do not file any of these forms, the ASED on that entire 1040 never closes. It remains open indefinitely. If you had a Form 5471 filing obligation in, say 1988, and you did not file it, the IRS could go back and hit you with penalties for not filing a Form 5471…and they also could open your entire return for examination. Did you deduct $2 for a ton of used underwear on your Schedule A? Well, you better have saved your records.
Additionally, there is an 8-year look back period if you are doing an offshore voluntary disclosure. This is regardless of the amount of unpaid tax. So you must keep information related to any foreign bank accounts for 5 years, or you could be penalized 50% of account value. This is true even if you filed an FBAR!
The advantage of using one of the offshore disclosure programs (including streamlined procedures) is that the IRS states it will effectively cap the ASEDs on previously open tax years. That is, if you file a Streamlined package and filed a Form 8865 for a foreign partnership for tax years 2013-2015, the IRS won't look to assess penalties or keep your return open for assessment for year 2012 and prior. Remember, if they think you've done anything fraudulent, they can always open the year up.
Gains and losses, and exchanges: Always keep those records
If you need to prove a long term gain, a loss, or anything that involves the value of a property or a security from waaay back, you'll probably need those records. For example, if in 1982 you bought a stock in a privately held corporation for $100,000, and sold it in 2015, you'll need to hang on to those records related to the sale until the ASED on your 2015 return expires. Assuming it was filed timely, and no extension was filed, that would be April 2019.
If the IRS thinks you filed a fraudulent tax return, or you missed filing any foreign reporting forms, they can assess against you. Therefore, the time period you would want to hang on to those records is…as long as you can. If you have a tax issue you need assistance with, contact us to schedule a free, confidential consultation. Call us at 888-727-8796 or email info@irsmedic.com.
