The After-Tax Irritant: How to Store Records

Although the pain of filing tax returns passes, the need to store the records is a continuing irritant. One must decide what to keep, and how long to keep it, or, leaping over indecision, just keep it all--usually in drawers or boxes already full of four, 10, even 20 years of tax records.

Annually, tax preparers, the IRS and the media reiterate that the statute of limitation for an IRS challenge is three years, six years under certain circumstances, unlimited only in the case of fraud. Nevertheless, confused or fearful, we keep it all forever.

The general rules seem straightforward: The IRS must examine income tax returns and assess additional taxes within three years from the due date or the date of filing, whichever comes later. If the taxpayer understated gross income by more than 25% of the amount reported, however, the IRS has another three years--six in all--to make its challenges. And if no return is filed, or the return is fraudulent, there’s no statute of limitations on IRS action.

All Not Frauds

Now, all those people who keep records forever aren’t necessarily frauds, although they may shade facts in their favor, or may be, as tax preparers say, “aggressive” in their claims. But they recognize that to some extent, fraud is in the eye of the judge, that some of the IRS’s 120,000 employees are bound to be overzealous, and they fear a fraud charge, and a future fight.

Indeed, it’s a serious charge, with harsh penalties. Civil penalties are 75% of the additional tax owed, plus an additional 50% of any interest due--these assessed by the IRS examiners, with Tax Court making final judgment if the taxpayer appeals. A case can also be referred for criminal investigation, and thence for prosecution by the Justice Department in federal court, with a possible fine or jail time added on.

But use of the term “fraud” is not casual: It’s not negligence or ignorance of the law. There must be intent to evade taxes, a “bad purpose,” in the words of Manuel Godinez, a group manager in the IRS’s criminal investigation division, Los Angeles District, and the burden of proving that intent is on the government.

‘Degree of Bad Purpose’

The difference between criminal and civil cases, says Godinez, is “the degree of bad purpose,” and relatively few become criminal cases. In 1988, when 194.3 million tax returns were filed (107 million individual), Criminal Investigation sent only 3,044 cases for prosecution. “We have to be selective because we’re the smallest (IRS) division,” says Godinez, “and our cases can take 18 months. For every 10 to 15 referrals, we’ll accept one.”

Almost half involved narcotics, money-laundering, fraudulent tax shelters or illegal tax protesters. The selection depends partly on the degree of bad purpose, partly on publicity value and current political concerns. Many cases are headliners, “which tell Joe Blow Taxpayer that we don’t just go after the little guys, but will take on the big ones, too,” says Rob Giannangeli, IRS spokesman in Los Angeles. A recent example: hotel magnates Leona and Harry Helmsley, accused of tax fraud after the IRS claimed they diverted millions of corporate dollars to the decorating of their private mansion (jade artwork, landscaping, marble dance floors), and deducted them as business expenditures from corporate taxes.

Civil fraud penalties are somewhat more common--9,304 assessed in 1988--but still selective.

Overstating the business value of some $10 lunches may simply lose a taxpayer the deductions; a fraud case requires, says Giannangeli, “some sort of definitive act, like keeping two sets of books, altering documents, claiming dependents that don’t exist, making unex plained bank deposits, or listing property in relatives’ names.” Intent must be provable--the difference, says Giannangeli, between giving a watch to charity estimated at $5,000 when it’s later appraised at $2,500, and getting a $2,500 appraisal and then claiming it’s a $5,000 gift.

Indeed, Tax Court rulings demonstrate stringent standards for judging intent. Large understatements of income have not alone been able to prove fraud, nor has “gross neglect” of bookkeeping procedures, nor did the behavior of a taxpayer who filed no returns for given years until called in, produced no books or records until the trial, and then gave inconsistent testimony.

But fraud was found in the case of a taxpayer who claimed theft losses on a Picasso painting that the government proved didn’t exist. Similarly, the court ruled fraudulent a neurosurgeon’s understatements of income, given the deposits into his personal checking account of practice fees that had not been recorded, and a regular $1,000 error--13 times in two years--in the addition of his monthly receipts.

Such judgments may reassure ordinary people who save all tax records in case they’re ever accused of fraud. Someone trying to perpetrate a fraud will probably keep no records at all, since no records can prove their assertions.

As for everyone else, says Shirley Nakagawa, IRS spokesman in the Los Angeles District, “If you think you might need to explain something, or you’re being audited and haven’t gotten an audit report when the three years is almost expired, then you’d better keep everything a while longer.”

Fraud considerations aside, one should routinely keep anything, says Giannangeli, that “has bearing on the future,” if not current taxes. Certain records, in IRS words, verify “the basis of property,” or what the taxpayer put into it. When a home, for example, is sold, and the proceeds reported, computation of taxable capital gains takes into account all monies put into it.

Similarly, one should keep records of any investment not yet matured or liquidated--stocks, bonds, IRAs, partnerships, art and jewelry collections--and not just for the IRS. Such information can establish a later sale price, or back up an insurance claim.

Then there are the tax returns themselves, generally kept for seven years by the IRS (given those six-year limitations), and for the rest of their lives by taxpayers, even those who discard the background documentation. After all, old returns might some day provide guidance, or curiosity value, and they take up little room.