When it comes to your tax files, how long do you have to keep documents to protect yourself in the event of an audit?
Invoices. Receipts. Every business has them, and it's important to keep adequate records. But how long should you keep them?
The general rule of thumb is to keep records to support income tax return deductions for seven years. If your business has other regulatory requirements, the record retention rules may differ. But for tax purposes, if you keep documentation to support deductions on your income tax return, seven years will cover most circumstances.
The reason behind the seven-year number has to do with the statute of limitations. The statute of limitations for the IRS to make changes to an income tax return is three years from the date of filing. If you file your 2015 corporate tax return on March 15, 2016, the IRS has until March 15, 2019 to examine your return and propose changes. Conversely, if you find an error on your return, you can file an amended tax return up until March 15, 2019. If you file an extension, you also extend the statute of limitations. Therefore, if you file on Sept. 1, 2016, the statue will expire on Sept. 1, 2019.
As with most IRS rules and regulations, there are exceptions to the general rule. If you do not report all of your income, and the underreported amount is more than 25% of the gross income reported on your tax return, the statute of limitations is increased to six years. Congress has recently expanded the six-year statute to include tax basis understatements as well as underreported income. You would think that you would know if you underreported your income, but the error could be inadvertent.
For example, you take a tax position where cash is received but income recognition is deferred until the occurrence of a subsequent event. If you are audited, and the IRS disagrees with the income deferral, it could go back for six years if the income deferral for those years is greater than 25% of gross reported income.
Another exception to the three-year statue rule is fraud. If the IRS determines that a tax return meets the criteria for civil fraud, there is no statute of limitations.
To start the running of the statute of limitations, you must file a tax return. If you don't file, the statute will not start running, and records relating to the unfiled tax period should be maintained indefinitely.
The general record retention rule of seven years is based upon the possibility of a six-year statute of limitations. You need to keep documents to support deductions for six years from the time you file your tax return. If you adopt a retention policy of seven years, to be done on an annual basis, you would retain the necessary documents under a worse-case six-year statute.
For example, in January 2016, the company destroys all documents for 2008. The tax return for the 2008 year would have been filed in 2009 and the six-year statute expired in 2015.
There are circumstances where a business should keep records for more than seven years. When an asset is purchased, the cost of the asset is recovered through depreciation deductions over the life of the asset. Eventually, the asset is either sold or otherwise disposed, and a gain or loss is taken on the tax return. The IRS will want proof of the original purchase price of the asset to support the gain or loss taken upon asset disposal. The documentation to support the cost of the asset may be more than seven years old. Asset purchase documentation should be kept until seven years after the asset is either sold or disposed.
Finally, if your business has a net operating loss or capital loss carryover, you need to maintain the records to support the carryover loss until seven years after the carryover is used.
For example, your business had net operating loss carryforwards for 2008, 2009, 2010 and 2011. In 2012, the business became profitable and the net operating losses were fully used.
The records for 2008 should be kept until 2020. But wait...this is 12 years. Why would anyone keep all of this documentation for so long? The reason is that the IRS can challenge your loss carryforward amount because the statute of limitations runs from the year the taxpayer uses the net operating loss, not the year when the net operating loss is incurred.
In summary, a seven-year record retention policy should be adequate for most documents other than asset purchases. If a business has carryover loss deductions, all documents should be retained until seven years after the losses are fully used.
By Pam Schuneman| Contributing Columnist
Pamela Schuneman, C.P.A., is a practicing tax accountant in Sarasota. She has 33 years of experience helping her clients navigate the vast federal tax system and has worked with businesses as varied as Fortune 500 companies to small sole-proprietors. Contact her at [email protected]