A Pennsylvania citizen, who will be identified here as “P,” has a bone to pick with the collections agency that handles taxes for his municipality. P says he duly paid his 2015 local income tax, but just a few weeks ago got a nasty notice calling him a delinquent and demanding immediate payment of more than $2,000 in taxes and penalties.
P asks: Isn’t there a three-year limit on tax audits? What am I supposed to do if my bank can’t locate a five-year-old cancelled check? Do I have to pay the taxes twice? Short answer: Yes. If you don’t have good records you can get nailed for taxes you don’t really owe. Three years of documents won’t cut it. Seven years is more like it. Some tax records should be kept on hand until you’re dead.
Barry Dolowich, a CPA in Monterey, California, is representing a Nevada citizen who just got a dunning notice from California’s notoriously aggressive Franchise Tax Board. What did this taxpayer do wrong? He inherited a house in California and sold it, at a loss, in 2015. He didn’t file a California income tax return for that year. The state wants him to fork over $30,000-plus on the supposition that the entire proceeds were profit.
David Caplan, a CPA in Lafayette Hill, Pennsylvania, is fighting for a taxpayer from whom the Internal Revenue Service wants to extract approximately $35,000. This client, now in her 80s, had a small business whose withholding taxes were handled by a payroll processor. It took the sleepy IRS a decade to figure out that the processor was embezzling money and forging powers of attorney in order to keep clients in the dark about delinquency notices. The crook is now in jail and evidently has scant assets. The former business owner paid the tax money once and may have to pay again.
There is indeed a three-year rule on tax audits, but it doesn’t provide the protection you think it does. Normally the IRS has three years from a return’s due date (or when you filed, if you got an extension) in which to challenge your numbers. Many states copy that rule; a handful, including California, stretch out the audit period to four years.
But there are exceptions. Three years becomes six if the tax collector can show that there is a “substantial understatement” of your liability. For the federal government, “substantial” means by 25% or more; state rules vary on this point.
The other exception is if no return was filed. On the theory that a nonfiler is akin to a fugitive bank robber, undeserving of having the clock run on a statute of limitations while he is in hiding, the three-year period does not start until the return comes in.
This presents a potential hazard for people who don’t retain yellowed records. A Pennsylvania township could in principle send out a notice declaring, “We were just going through some old punch cards and can’t find a record of your 1997 return. Please send in $2,000 plus 22 years of penalties.”
Matthew Melinson, a state and local tax partner in Grant Thornton’s Philadelphia office, says he hasn’t witnessed anything that egregious, but has seen states trying to collect ten years of tax from nonfilers. Given that records are now electronic, he says, you should keep returns for a long time—seven years, at least.
Herewith a nine-point guide to record retention:
1. Keep copies of income tax returns and proof of tax payments as long as you can.
2. Discard supporting documents (like receipts for business expenses and charitable donations) after seven years. That covers you for six years beyond your filing date.
3. Keep records of asset costs for seven years after you dispose of the asset, recommends Stephanie Pervez, who leads the private-clients practice at CohnReznick in New York City. If you bought a house in 1990, remodeled it in 2000, and sold it in 2019, you’d keep both sets of closing documents and the remodeler’s bill until 2026.
4. Keep support for carryforward items (such as for capital losses) until seven years after using up the carryforward. Says David Klasing, an Irvine, California, attorney representing clients with big tax headaches: “A lot of times they won’t contest the original accrual of a net operating loss until you try to use it.”
5. Keep copies of gift tax returns forever. Your executor may have to attach them to an estate tax return, Pervez says.
6. Maximize the value of your health savings account by preserving both the assets and medical receipts for a long time. Instead of using the HSA to cover co-pays and other costs, you pay them out of your checking account and let the HSA grow. In retirement, you pull the money out, making the withdrawal tax-free by matching it to past medical costs, which can stretch back for decades. The strategy only works if you can retrieve the receipts.
7. Consider filing a nonresident return, perhaps one showing a small amount of income, in states where you have some business connection. That starts the clock running on an audit period, and might protect you from an open-ended tax grab going back a decade. California, in particular, is known for an expansive notion of what constitutes local income. It went after a scriptwriter living in Arizona because the scripts were used by California film companies.
8. Keep proof of filing. Melinson has his clients retain either a certified mail receipt for a paper return or an email confirming acceptance of an e-filed return.
Here’s another way to establish that a return was received. Instead of having all your refund applied to the next year’s estimated tax, direct $20 of it into your bank account. Keep the bank statement.
9. Keep an eye on your tax preparer, or payroll tax handler. Tax collectors are predictably reluctant to give a break to victims of dishonest intermediaries, lest taxpayers seek out sketchy ones in order to lower their tax bills. But if you can document your diligence you might get mercy.
What will become of the forlorn taxpayers cited above? Taxpayer P is the victim of Pennsylvania’s quirky local-tax system. Much in the manner of a feudal king farming out tax collection to independent agents, municipalities delegate enforcement to private-sector firms, sometimes dropping the ball in the hand-off. For P, the middeman is Kratzenberg & Associates, doing business as Keystone Collections Group. A Keystone executive says this taxpayer can get his problem quickly resolved if he has the right documents.
The Nevadan with the house in California? He will probably owe the state little. The house, with a cost basis stepped up to the value on the owner’s death, was clearly sold at a loss. The worst that the Franchise Tax Board can do is to impose a failure-to-file penalty, and accountant Dolowich hopes this penalty will be waived.
The retiree with the ancient payroll tax liability may be out of luck. Accountant Caplan says the IRS agreed to a reprieve for her and some of the other victims on the hook collectively for at least $3 million. Then the agency changed its mind. She and 100 or so other taxpayers are in limbo.
I aim to help you save on taxes and money management costs. I graduated from Harvard in 1973, have been a journalist for 45 years, and was editor of Forbes magazine from 1999 to 2010. Tax law is a frequent subject in my articles. I have been an Enrolled Agent since 1979.