One question our clients frequently us is just how long should I keep my receipts in case of an IRS audit? They’ve got file cabinets, drawers, and folders completely full of old receipts, bank statements, and invoices, and they’re running out of space. The short answer is to hold on to documents that are either paper or electronic for at least four years. However, there are a few important exceptions to this rule, and missing the proper documentation can leave you at the mercy of an IRS agent so read on.
The Statute of Limitations
A general rule of thumb with tax documents is to hold on to them for four years. The statute of limitations for tax purposes is a limit on the number of years the IRS has to audit your tax return. After that period you can relax and rest assured that you won’t get a notice in the mail or have an unfriendly auditor knocking on your office door.
The general time length of the statute of limitations is three years from the later of the due date of your tax return or the date you filed your tax return. For example, if you filed a 2010 individual tax return on March 30th, 2011 then the IRS has until April 15th 2014 to audit your tax return. Likewise, if you were to extend that same 2010 individual tax return and file it on October 15th, 2011, then the IRS has until October 15th, 2014 to audit your tax return.
There are two exceptions to the three-year rule that increase the length of the statute of limitations. First, if a tax return has a “substantial omission of income” (meaning it omits more than 25% of gross income) then the statute of limitations doubles to six years. For most honest taxpayers this longer period shouldn’t be a problem. One of the most common causes of an inadvertent omission of income is an incorrect calculation overstating basis in a partnership. The courts ruled in various tax cases1 that these omissions did not constitute an omission for purposes of the six-year rule; however, the IRS put the plug on those rulings by issuing a regulation2 stating that starting in 2010 basis overstatements do constitute an omission of income and can trigger the six-year rule. So make sure when you are selling or transferring a partnership interest that you consult your tax advisor to make sure your partnership basis is calculated correctly.
Second, if there is tax fraud on the tax return then the statute of limitations never expires. This clause is rarely invoked because the burden of proof on the IRS is too great to establish a liability so far back. However, it should serve as a warning for anyone who is knowingly hiding income that they can never truly have confidence that an old return won’t come back to bite them. Better to be honest, pay the tax, and be done with it.
In some cases you may elect to carryback a net operating loss (NOL) to a prior year. This does re-open the tax return, but only with respect to the NOL itself and not the rest of the return.3
Documents Affecting Multiple Years
There are some documents that should be kept for more than four years. For example, let’s say that you purchased a piece of equipment with a seven-year useful life. That asset gets depreciated on tax returns for the next eight years which means you should hold on to the original purchase invoice for twelve years to satisfy the statute of limitations. Other documents such as a settlement statement from purchasing real estate, debt covenants from a loan, or invoices for tenant improvements should all be held as long as possible because they can affect multiple years. For example, if you sell your home 30 years down the road and the IRS challenges your gain on the sale, you’ll need to have a copy of that original settlement statement to substantiate your basis.
The IRS Accepts Digital Copies
Luckily the IRS has gone digital and issued Rev Proc 97-22 which states that electronic bookkeeping systems and scanned copies of receipts are acceptable to the IRS. If you get audited you don’t need to worry about having the original copy of that invoice lying around. Instead, a printed copy from your computer will be just fine. This makes sense considering that most IRS audits are done via mail, and most taxpayers would only fax or send print copies of their original receipts anyway.
Four Pitfalls to Avoid
There are four pitfalls you can avoid that will make you all but bullet proof in an audit. The first pitfall is relying on your bank, credit-card company, title company, or CPA to have a copy of your documents rather than keeping your own copy. We recently had a client get audited, and the IRS agent requested copies of all bank statements from three years back. That bank was bought out by another bank, the local branch closed down, and our client was left in the lurch with no statements to produce. Having statements ready to produce for an agent helps them have confidence in your books and records, and generally makes the audit process faster and much less painful. Furthermore, many large companies only allow users to view statements up to 18 months back, and often charge fees to request older documents if they’re even available at all. Always save copies of all your statements even if you think someone else has a duplicate copy.
Second, if your business gets audited the IRS has heavy substantiation requirements for travel, meals, and entertainment. In this case it’s not good enough to simply have a receipt from a restaurant or a copy of the airline ticket. An IRS agent will typically ask for additional documentation to substantiate a deduction for travel, meals, or entertainment such as the:
- Date of the trip
- Business purpose of the trip
- Names of everyone in attendance
- Itinerary, brochures, or other documentation such as continuing professional education certificates received during the trip
These all may seem obvious at the time of the business trip, but when you’re three years out you’ll have a hard time remember exactly which trip that airline ticket you purchased applied to. By far the best practice is to always include a memo in your accounting software with details regarding what trip or event the expense ties to.
The third pitfall is not keeping proper travel records for business mileage. To those who frequently drive for business outside of commuting there are a wide variety of apps that help you easily gather IRS-ready documentation to substantiate your mileage deductions. One app we like is Triplog which automatically begins logging miles each time your phone connects to your car’s Bluetooth system, produces IRS-friendly reports, and syncs with QuickBooks.
The fourth pitfall has to do with incorrectly filing a tax return. The statute of limitations does not commence if a return is delivered to the wrong Internal Revenue Office. This can create a big problem with amended returns which generally must be paper filed. Whenever your return is paper filed, send it via USPS certified mail with return receipt required. E-filed returns have a unique acceptance number once they’re approved, and you should request that your accountant provide form 9325 which will have that code. The return receipt and the 9325 are accepted by the IRS and the courts as evidence that you got the statute of limitations ticking.
The Bottom Line
While keeping tax documentation around for four years will get you through most IRS audits, it’s always better to hold on to everything and to err on the side of more detail. If you haven’t kept good records in the past, begin today. Technology such as flatbed scanners and smartphone document scanning apps make creating and archiving PDF copies of receipts a snap, and files are small enough that there’s really no reason not to hold on to all your receipts and bank statements for the long haul. Make sure that you keep backups of your digital receipts using external hard drives or cloud-based backup services. Remember when it comes to IRS audits, it pays to be a packrat.
IRS Circular 230 Disclosure
To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax related penalties under the Internal Revenue Code, or (ii) promoting, marketing or recommending to another party any tax-related matters addressed herein.
1 - Intermountain Insurance Service of Vail, LLC, 134 TC No. 11; Bakersfield Energy Partners, LP, CA-9 2009-1 USCT 50,448; and Salman Ranch Ltd., CA-FC, 2009-2 USTC 50,528
2 - Reg. §301.6229(c)(2)-1
3 - IRC §6501(k)