The Three Cutoffs for Keeping Tax Records
Tax time. A time to keep and a time to toss. Even storage space has a statute of limitations. We keep everything for defense against attack by the IRS and smother in the paper.
Couldn’t they suddenly, years hence, question the doctor’s office parking fee, the donation to the boss’s gift, the value of old clothes for Goodwill? Didn’t they just swoop down and tag Willie Nelson for $16.7 million because of abusive tax shelter deductions over a decade ago?
Not quite. Willie’s case was in court a long time before it hit the headlines. There are rules circumscribing our risk. It’s safe to clear out some paper every year.
Call it The Rule of 3, 6 and Forever. Generally speaking, the IRS has three years to challenge our tax returns, six years in certain circumstances and unlimited time if there was fraud. When the given time is up--or, in IRS terms, “the statute has tolled”--no action can be taken.
The first category is truly the catch-all, the period in which one is most likely to need those shoe boxes of sales receipts, bills, canceled checks--anything that documents the income or deductions claimed. Within those three years, the IRS can examine and challenge anything--and sometimes everything--on a return. And that’s where they put their emphasis: Most IRS inquiries to taxpayers--both requests for documentation and tax adjustments--come out of these first exams.
Specifically, they have three years from the date of filing or the date due, whichever is later. If a tax return was filed early, the clock doesn’t start till the April due date. If it was filed in August, it starts then.
Though one should keep everything for that time, it’s not likely to be needed. In 1991, when 112 million income tax returns were filed, the IRS examined only 1,124,000, or 1%.
The period of limitation goes to six years if the IRS believes that the taxpayer had unreported income of more than 25% of the amount claimed any of those years. And once the the statute of limitations is extended, the IRS needn’t limit itself to the income: It can challenge anything.
Unreported income isn’t a moral dilemma for most taxpayers. The vast majority are wage earners whose income is fully reported, mostly on W-2s, whether they like it or not.
Not much non-wage income goes unreported either, given the 1099s filed on interest, dividend and miscellaneous income--often the way the government learns of income unreported by a taxpayer. But understating income doesn’t clog up a taxpayer’s files: If it does become an issue, it’ll be the IRS, and not the taxpayer, that produces the documentation.
It’s the fear of category 3--no time limitation on the IRS challenge--that fills shoe boxes. But there are other limitations: The IRS can only take such late action if there was no return filed or the return was fraudulent.
This is big-time stuff, with big-time penalties. For fraud, the IRS can add civil penalties of 75% to the tax due. It can also pursue a criminal investigation, which could land the taxpayer in jail.
Simple mistakes or negligence don’t do it. The IRS must prove to a court the intent to deceive. Fraud is purposeful--claiming a dependent who doesn’t exist, depositing checks never reported. It’s not just claiming a charitable deduction of $5,000 on a watch later appraised for $2,500, says Rob Giannangeli, IRS spokesman in Los Angeles, but getting an appraisal of $2,500 and still deducting $5,000.
Criminal prosecution isn’t just for money launderers, narcotics dealers and illegal tax protesters. It’s also for the Maryland dentist who filed no returns on $1 million earned over three years but spent $295,000 for boats and planes, two each. Or the members of a supposed religious order in New York who took vows of poverty but worked outside, turning their paychecks over to the order in return for cash “living expenses.”
Actually, people who commit tax fraud probably hide or destroy more records than they keep. Few taxpayers of the shoe box-hoarding school really have to fear an IRS fraud investigation.
Indeed, after those first three years, few have anything to fear at all. Each April, they might as well prune their files for years three through six (1985 through 1988 now), keeping only summary material--returns, W-2s, 1099s, some paychecks, check registers and work sheets, and even less for previous tax years.
It’s probably more important to keep documents related to future tax filings--records of home purchase and home improvements, stocks still held, IRA contributions. These can hold down the capital gains that are taxable when the property is sold or cashed out.
Still, knowing all this, I personally keep almost everything forever . . . just in case.
