How Far Back Can the IRS Go to Audit My Return?

Not all audits are disastrous. But what about previous years? How far back can the IRS go? Is there a statute of limitations on taxes when it comes to audits?

Technically, the IRS has three years after the filing deadline to start an inquiry for a specific year. However, some exceptions may extend their reach to six years or even longer.

While audits aren’t necessarily common—only about 1% of returns are audited each year—keeping your finances organized is a way to reduce the stress and ensure that if it does happen, you’re prepared.

How Far Back Can the IRS Go?

While the legal assessment statute on taxes is three years, the rule states that the audit must be completed within a three-year window. Audit agents must open and close the audit within 26 months so the case can be completed by the three-year mark.

All things considered, if you have not received notice about an audit within two years, you probably have nothing to worry about unless there is something particularly egregious on your return.

Field audits are conducted at your place of business. They are more comprehensive types of audits and may start later than most typical audits. Still, they can only go back three years unless specific concerns arise.

In cases where the IRS suspects large income underreporting, they can go much further back.

·       Gross misrepresentation of income: six years. If you failed to report 25% or more of your gross income, the IRS could audit you going back six years. You could argue that the omission was due to an honest mistake or that the amount was not income, but if the IRS deems the omission fraudulent, they have the authority to go back unlimited years. The six-year statute does not apply to overstatement of deductions.

·       Basis overstatements: six years. Misrepresenting basis is not the same as not reporting income. An example might be if you sold your business property for $5 million and claimed a basis (what you invested in the property) of $2 million when it was $1 million. That would indicate that you paid capital gains taxes on $3 million when it should have been $2 million.

·       Foreign income, assets, etc.: six years. If you fail to report more than $5000 of foreign income, the six-year statute kicks in. There are lots of complexities around foreign accounts, but suffice it to say the IRS is still actively going after offshore assets and income. You must use Form 8938 to report such income and accounts. Failure to file means the limitations clock never starts—which may result in a lengthy, costly, painful process.

·       Failure to file IRS Form 5471: no time limits. Form 5471 must be filed if you own or partially own a foreign corporation. Penalties for not filing are $10,000 per form, and additional penalties can be levied for filing late, even if you owe no taxes. To put it succinctly, if you need to file Form 5471 and do not, your tax return will stay open for audit, overriding the three or six-year statute. If you own as little as 10% interest in a foreign corporation, you must file this form or face the consequences. Speak to your CPA to find out if this applies to you.

·       No return or fraudulent return: no time limits. There is no time limit if you never file a return or if the IRS can prove a return is fraudulent. Even if you think you filed but did not sign your return, the IRS considers that invalid. Hence, the three-year clock never starts to run, and an audit can occur anytime.

Other Scenarios Where a Statute Applies

Anyone filing a tax return must also abide by the three-year limitation. For example, you have three years to amend a return. And while you might think that this would trigger the three-year clock starting anew, it doesn’t always. If your amended return does not show an increase in tax owed, it will not trigger an extension.

Failure to file taxes could mean you won’t be able to collect the returns you are owed. For example, if you paid quarterly estimated taxes for five years but never filed, it’s possible that you may have overpaid. However, you won’t be able to get those payments back unless you file. You have two years—not three—to collect these overpayments, so it’s in your best interests to file.

Sometimes, the IRS will request an extension to complete the audit. While you might be tempted to refuse, it’s not a good idea. If you do, the IRS may assess additional taxes without adequately reviewing your file. If you receive such a request, speak to a qualified tax advisor immediately.

How to Avoid IRS Audits

You may be unable to avoid an audit forever, but you can be ready for it. A little preparation now will almost certainly help you avoid a lot of trouble in the future.

Here are a few tips to get you on the right side of the IRS audit machine:

1.       Keep great records. Statute extensions can be mitigated with good record-keeping. Know precisely when you filed your return so you can keep an eye on the three-year audit window. In many cases, the quality of your records can mean all the difference. Be ready to prove your deductions if they come into question. Keep receipts, calendar entries, boarding passes, previous returns, and all relevant backup for at least three years.

2.       Record every transaction and maintain details of all expenses. Using accounting software automates many of these processes; all you’ll have to do is check them periodically to ensure they are correct.

3.       Don’t claim a loss in multiple years. You can expect to hear from the IRS if you have claimed a business loss in more than three out of five years.

4.       Excessive deductions will almost always trigger an audit. The IRS knows what is usual and customary in your industry, and exceeding that by a significant margin is a surefire red flag.

Our tax prep experts are here to advise and support you throughout the year. If you have received an audit notice or just want to clean up your books to avoid issues in the future, book a call today.