Tax documents: organize & keep your documents to protect from a tax audit

Saving your tax records is critical as they contain the answers to questions the
Internal Revenue Service (IRS) could ask you years after you file your return.  The length of time you should keep a document depends on the events the document records.  Keep proper tax records and you will not need to worry about an audit!

The IRS “clock”

The Internal Revenue Code requires that the IRS audits, assesses, and collects taxes within a specific time limit. This limit is known as the
statute of limitations (SOL). When it expires, the IRS can no longer take action. A statute is basically a timer: when the time expires the ability to file the law suit, or make the arrest, or assess the tax is gone. The intention of the SOL is to facilitate resolution within a "reasonable" length of time. Records must be kept until the SOL for an event has expired.

Note: An SOL does not start until you file a return. Therefore if you omit to file a return or if you file a fraudulent return, the IRS can indefinitely audit you with no time limitation. The SOL does not start to run for returns not filed, and does not apply in cases where the taxpayer has committed fraud on the return. Therefore filing a correct return every year will stop the IRS audit clock from running indefinitely.

To read more  -  when to file your tax return (tax calendar):

How long to keep tax documents?

General rule: 3 Years.

In general, the IRS has the right to review tax returns for the past 3 years from the date you filed the return. This includes requesting supporting documentation for the income and deductions you reported.
Note: The 3 year SOL also means you have 3 years to make a claim for a refund that you are entitled to, but did not receive.   

Under-reported income: 6 Years
If you failed to report a substantial amount of income (25% or more), the IRS has 6 years to create an audit assessment and you will need to keep your tax returns and all the related information for 6 years.
Note The IRS will also extend the SOL to 6 years if you hold offshore accounts and you had a foreign asset, like a bank account, and the amount of income derived from those assets exceeded $5,000 (IRC Section 6501e).

Keeping records longer
There is also an argument to be made for keeping tax records for the rest of your life. For example, tax returns can be helpful for settling estates, resolving disputes, applying for a bank loan, student financial aid, disability insurance or if you need to fix an error on your social security benefit statement.

How long can the IRS collect taxes?

Generally, the IRS has 10 years from the day a tax liability has been finalized to collect the unpaid tax. A tax liability is established by either the amount reported on a tax return or an assessment from an audit. The IRS does not necessarily have to collect the tax during this period, but does have to take collection action (e.g., levy or begin court proceedings) before this time has expired.
Note:  Several actions taken by taxpayers can halt the running of this 10 year clock such as filing for bankruptcy, submitting an offer-in-compromise, filing collection appeals, or filing an innocent spouse relief request. In addition, the SOL is also suspended if the taxpayer is out of the United States for a continuous period of six months or more or is a member of the Armed Forces serving in a combat zone.

To read more – what to do if you can’t pay the tax you owe:

What records to keep?

1. Employment records:  Paystubs can usually be discarded once you checked that they match the year-end forms (Forms W2).  However, you should keep these records at least 6 years if they support charitable contributions that were made via payroll deductions.

2. Stock & mutual funds: Keep brokerage statements (Forms 1099) until the stock is sold as they substantiate the capital gain computation. Also keep investment records if:
• you inherit stocks or funds -  keep records of the value on the day the original owner died to help calculate your basis when you finally sell them. Keep records of reinvested dividends that you’ve already paid taxes on so you won’t be taxed on them again when you sell the security.
• you took a capital loss on a stock sale : Because you can use only $3,000 in losses each year and carry forward the remainder, you could easily end up carrying this loss on your tax return for many years. Therefore, you must keep the documents to support the loss calculation in the event of an audit in future years. Otherwise, the loss carry forward could be disallowed.

3. Home purchase & improvements - Keep home records and home improvements records (such as new flooring, new roof, etc) as long as you own the house. You will need these records to minimize the tax that might be due if you don’t meet the home sale exclusion conditions when you sell.

4. Inherited & Gifted property - Keep records showing the value the property on the day the original owner died until you sell the property as these records will substantiate the capital gain computation. For gifts received, it is important to know the cost to the donor and to obtain receipts for gifts of property other than cash. This becomes your basis in the property when you sell.

5. Retirement accounts - Keep records of your contributions to IRAs until you withdraw all of the money from the account. These records substantiate the taxes paid on contributions.  The basis of your IRA must be tracked in order to exclude any nondeductible items within the IRA later when you are of an age to take distributions. Contribution statements (Form 5498, Form 1099-R, and IRS Form 8606) should be kept until you take the last distribution from your IRA.

6. Utility bills (electric, water, phone, cable): if you are self-employed keep bills as long as tax returns as they support business expenses tax deductions (such as home office deduction).

7. Essential personal records – Certain essential records should be kept indefinitely such as birth certificates, marriage licenses and social security cards. These should be kept in a safe location such as a locked file cabinet or a safety deposit box.

How to store your records: Paper or Electronic?

The IRS allows digital archives (such as external drive, CD, DVD) as proof of records and therefore you do not need to keep paper documents. I recommend scanning and storing documents in an encrypted form on external drives or on a cloud service to make your records secure and accessible.  Some businesses choose to use electronic accounting software such as
QuickBooks to organize their records.

To read more  -  QuickBooks software for your tax records:

After you have transferred your documents to an electronic format, shred them to reduce the risk of identity theft. Crucial paper documents such as birth certificates, social security cards, wills and life insurance policies, should be kept in a safe place indefinitely (fire and waterproof container, safe deposit box).

To read more  -  Protecting your tax identity:

How do returns get selected for an IRS audit?

A high Discriminant Index Function (DIF) score. The IRS uses a mathematical technique to score a tax return for examination purposes. The higher the score the greater the audit potential. The numeric score is based on a comparison of deductions on the return with the norms for the taxpayer’s income tax bracket.

A mismatch with information received from third party. A return may be selected if documentation such as W2 & 1099 does not match the information reported on the return.

A red flag on your tax return. The best way to limit your chances of being among the taxpayers audited is to avoid common mistakes on your return that raise red flags – such as an excessive deduction for:

Meals & Entertainment. Only ordinary business expenses (ie commonly accepted in the taxpayer’s trade) & necessary business expenses (appropriate and helpful to taxpayer’s trade) can be deducted. Taxpayer should keep records of vendors, customers and business topics discussed.

Automobile expense (such as gas, repairs etc). Only ordinary & necessary business expenses can be deducted. Taxpayer should keep a mileage log with detailed time, date and destination to support expenses.

Charitable contribution. If the deduction is higher than the average or is in round numbers, the IRS might think the taxpayer doesn’t have the required paper backup. Taxpayer should keep written proof of these deductions.

Home office. Dual use of the office such as a guest room or storage room is not allowed. Taxpayer should keep records showing exclusive use of the space used as office.

Business loss. Only activities carried for profit can offset their losses against the taxpayer’s other income. If a business has recorded a loss in 3 of the last 5 years, the IRS might question whether the activity is engaged in for profit and might restrict its deductions.

Earned income credit. The EIC is a refundable tax credit for low income working individuals. Taxpayer should keep the due diligence checklist that shows that they met all the requirements to qualify for the credit.

To read more  - what documents to keep (tax organizers):

It is in your best interest to file your prior tax returns at your earliest possible convenience to start the “IRS clock” and benefit from the 3 years statutes. For assistance with filing your prior year tax returns contact
Karine Bauer at Kbauer Financials LLC. Karine Bauer, EA is an Enrolled Agent licensed by the Treasury Department with unlimited rights to represent taxpayers before the Internal Revenue Service. She is an experienced tax professional with more than 20 years of international experience. As always, the views contained in this article are not tax or legal advice and are not a substitute for consulting with a professional. Contact Karine Bauer EA at Kbauer Financials LLC for advice on your specific tax situation.

Updated July 13th, 2019