Usually, the IRS has three years to examine the personal returns of taxpayers and impose deficiencies and penalties and interest. However, in certain situations, it can go back even further as witnessed in a new Tax Court case.
In a new case, Pragrias TC Memo 2021-82, 6/30/21, the Tax Court allowed the IRS to go past the usual three years for an audit due to a substantial understatement of taxable income.
Details: The basic statute of limitations for IRS examinations is three years from the due date of your federal tax return. For example, if your return was due on April 15, 2021, but you filed it on March 1, 2021, the IRS has until April 15, 2024 to examine your return.
However, the statute of limitations is doubled to six years if your return includes a “substantial understatement of income.” Generally, this means you have omitted more than 25 percent of your taxable income. Suppose you earned $200,000 but reported only $125,000 in earnings. Because you omitted more than 25 percent of the income, you can be audited for up to six years.
Finally, if you never filed a return for a particular tax year or the return was fraudulent (or fraud is suspected), there is no time limit. The IRS can back as long as it likes.
The taxpayer in the new case tried to avoid tax liability on a technicality. He claimed that his understatement of tax was not an omission, so the statute of limitations should only be three years.
Key facts: The taxpayer was involved in a complex series of investments. In 2006, he received a capital gain from those investments of more than $4.9 million, but only reported about $1.5 million of the gain his tax return for that year.
Eventually, the IRS assessed a tax deficiency after three years had elapsed, but before the six-year statute of limitations expired. It reasoned that it could go back more than three years because the understatement resulted in an omission of more than 25 percent of the taxable amount that should have been reported.
However, the taxpayer objected. He claimed that the 25 percent-of-income rule wasn’t violated because he technically didn’t omit his share of the capital gain. Instead, he argued that he merely understated it. According to this interpretation of the rules, the IRS is barred from examining his return after three years from the filing due date for 2006 returns.
Tax outcome: The Tax Court disagreed with the taxpayer. It determined that the six-year statute of limitations period applies. According to the facts at the IRS’ disposal, the taxpayer understated his share of the capital gain by more than 25 percent of the gross income stated on the return. In other words, he “omitted” the amount in question.
Clients will often ask how long they should hold on to records. As this case shows, the bare minimum is three years, but six years may be recommended to be on the safe side and even longer for the faint-of-heart.