Preserving Tax and Financial Records: How Long Is Long Enough?

Now that tax season is behind us for another year—unless, of course, you filed an extension—let’s take a moment to consider what might happen should this or some other dead-and-buried tax return one day arise from the grave to haunt you once more—most likely in the form of an audit. The foundation of audit defense is good recordkeeping. That begs the question of how long those records must be retained.

Just how deeply can the IRS dig?

The first and obvious question regarding record retention is how far back the IRS could potentially investigate. The minimum amount of time—the statute of limitations under the Internal Revenue Code—is three years for a normal return. The clock starts when the return is due or when the return is filed, whichever is later, meaning that if you file February 20, the three-year limit still runs from April 15.

However, should the IRS have reason to suspect that you have underreported your income by 25 percent or more, that three-year limit doubles to six years. If you fail to file a return altogether, or if the IRS suspects that you filed a fraudulent return, then there is no statute of limitations—no time limit at all.

If you’re the suspicious or cynical type, you might immediately wonder whether the IRS might not just claim fraud with reckless abandon in order to eliminate time limits. Fortunately, the law imposes a rather high burden of proof on the IRS to demonstrate fraud, even for civil (as opposed to criminal) tax fraud. For that reason, it is quite rare for the IRS to dig more than a decade or so into the past.

Factors that can change the statute of limitations

Certain circumstances can complicate the question of just when the statute of limitations on a particular return expires, however. The first is a simple request from the IRS for the taxpayer to voluntarily extend the statute, commonly for a year, while it completes an audit. In general tax advisors will advise playing nice with the IRS and complying, but always get professional advice specific to your situation in such a case.

For those who have committed criminal tax fraud or tax evasion, there are other considerations. If the taxpayer in question is living outside the U.S. or is a fugitive, the statute of limitations is “tolled,” meaning essentially that the clock stops running until the tolling condition ends. In addition, some courts have held that the six-year limit commences with the last act of tax evasion. A judge may well rule that such a “last act” occurred well after the return’s filing or due date.

Taxpayers with foreign accounts may face additional complications as well. For example, if you file a Report of Foreign Bank and Financial Accounts (FBAR) in a given year but fail to also file Form 8938, the Statement of Specified Foreign Financial Assets, the statute of limitations does not begin running until you do so. (In the eyes of the law, the tax return has not been properly filed until Form 8938, if required, has been submitted.) While much information is duplicated between the FBAR and Form 8938, they are designed to serve different purposes (law enforcement in the case of the former and tax administration in the case of the latter), and must both be filed.

Basic tax record retention requirements

The first principle of tax record retention is simple: Keep every document used in the creation of your tax return. Despite the statute of limitations, keeping all of your tax returns is a good idea—even if you could no longer be required to provide most of those records to the IRS. The scanner is a wonderful invention, and there is no longer any need for moldering file boxes stashed in the attic. Electronic records are just fine, and you can always produce a hardcopy from them if necessary.

If you claimed any business-related expenses, the receipts fall into this document category. If you assume that your bank or credit card statement containing the purchase in question is sufficient, you have assumed wrongly. The IRS considers such statements “insufficient documentation.”

Unless your memory is inhumanly good, it is also advisable to include a note with each expense regarding why it was deductible. In many cases this may be all but self-evident, but such thorough documentation is likely to favorably impress an auditor should things come to that.

Keep thorough documentation of investments

Investments—especially equity investments—can pose special challenges. One of the most common is the requirement to document the cost basis (the purchase price, in essence) of any investment sold in order to determine the capital gain (or loss, which can be an important deduction). Retaining all brokerage statements indefinitely is a very good idea. Perhaps you don’t typically hold equity investments all that long, but in some cases they can quickly become a nightmare.

Consider a mutual fund held in a taxable account. If that fund is held for many years, accurately determining the cost basis means having a record of every dividend payment. And while criminal defendants are innocent until proven guilty, when it comes to the Internal Revenue Code the burden is on the taxpayer to provide proof, not the IRS. If you are unable to prove the cost basis of a disposed investment, the IRS is entitled to assume that all proceeds of the sale were a gain.

You should also indefinitely retain records of nondeductible contributions to tax-deferred retirement accounts. Since it could literally be decades before you begin drawing income from these accounts, good records are indispensable.

Special record retention considerations for business entities

There are some special considerations that can affect legal entities. First, you should retain certain types of documents indefinitely. These include partnership agreements; contracts; commission or royalty agreements; deeds, titles, and other property records; intellectual property records; and records related to estate planning transfers.

Second, be aware that the actions of a partnership, LLC, S corporation, or other business entity can affect the statute of limitations. These are “pass-through” entities for tax purposes, meaning that the partners, members, or shareholders report and pay tax on their proportionate share of the entity’s income. However, these entities file an informational return as well. In some cases the IRS might send a tax notice to the entity but not to its constituents, meaning the entity could agree to an extension of the statute without their knowledge. Be particularly aware of this if you are a passive partner, member, or shareholder as opposed to one actively involved in the operation of the business.

Record retention can be a headache, but it is nothing compared to the headache of facing an IRS audit without documentation to back up a tax return. These days technology has made the storing of electronic records a relatively simple proposition—one that definitely beats digging through that shoebox full of receipts.