In doing an annual review with clients recently, they asked, “R. J., we’re doing some great stuff here. But can IRS come back and audit me? How long is that window open?”
That’s a great question to ask!
Fortunately, a statute of limitations imposes limits on IRS audits and tax assessments. For inquiring minds out there, it’s called the “Assessment Statute Expiration Date” or ASED. (I am just sure this is going to NOT come up at your next party! But OK … you can test the waters!)
But how long does the ASED last? When can you lay that worry to rest?
The IRS must close an audit and impose any tax assessments before the ASED expires. Any tax payment assessed after the ASED expires is an overpayment that the IRS must credit or refund.
The ASED varies depending on why the IRS initiates the audit. On the low end, there is a 3-year ASED for minor infringements. On the high end, however, they have forever. (And, just when you thought it was safe to get back into the water!)
Even though IRS is hiring thousands of new auditors, there is a way you can be tax smart and still sleep at night … Imagine That™!
Table of Contents
The General Audit & Tax Assessment
If nothing fishy is going on, the IRS has three years to audit your tax returns and impose a tax assessment.
The three-year period starts to tick down at the latter of the two dates below:
- The due date of the return
- The date you actually file your return (think extensions … like to October 15th for a personal return)
For pass-through entities (multi-member LLC, S-Corp, or partnership), the tax audit period starts when the individual tax return is filed.
What might this look like?
If you’re like my wife and want to file as early in the year as you can, the 3-year time period still starts April 15th (or tax day for that year). You cannot save a few weeks by being efficient!
Sometimes it’s not April 15th or 17th.
Sometimes, if it’s a catastrophic weather year (e.g., fire, flood, earthquake) it can actually defer the firing date without penalty.
For example, in the 2022 tax year in California, there was major flooding throughout much of the state. IRS allowed for taxpayers in affected counties to defer filing their personal tax returns until October 15th without penalty … even if they owed taxes. In that case, October 15th was still when the three years start ticking down.
That’s all well and good, but when might you know that you’re going to get audited?
The IRS usually audits tax returns between 12 and 18 months after the returns are filed. The IRS knows that these things take time, and there are often appeals. Plus, they need to issue the closing letter. That gives the auditor many months to review records and double-check that everything is in order.
IRS instructs its auditors to complete audits on individuals within 26 months of their tax filing, and complete business audits within 27 months. That way, the IRS has an additional 9-10 months to complete all of its processing and still allow you to appeal.
Okay, easy stuff done. Here’s where the rules can get murky.
The "You've Been Naughty" Statutes
As a general rule, the IRS doesn’t bother auditing returns over 2.5 years old, give or take. However, the IRS is allowed to go back six years (functionally five and a few months to allow time for conducting the audit and doing the paperwork) if the taxpayer has engaged in “bad conduct.”
Substantial Understatement of Income
If you omit more than 25% of your gross income from your tax return, then the IRS has six years to come knocking. That’s not just one line item. That’s all omitted income items get combined to see if you’ve breached the 25% threshold.
What might that look like?
Let’s say our friend Tina realizes it’s April 14th, 2024, and her taxes are due TOMORROW! (She’s cutting it real close, we know, but life happens.) On her 2023 Schedule C, she reports $200,000 of fee income and claims $150,000 in deductions. That’s it.
But our friend, in her rush, forgot to add the $60,000 in interest income for the year to her tax return. Oops!
The unreported $60,000 is 30% of her reported $200,000 gross income on her return. So, the IRS has until 2030 to audit the mistake.
Substantial Overstatement of Tax Basis
Overstating the tax basis of an item of property results in an understatement of taxable gain when the property is sold. That’s also treated as an omission from gross income. Ouch! Once again, our 25% rule applies, changing the statute of limitation from three years to six years.
Let’s look at another example. Our friend John did not carefully check his work on his tax returns. (Even if your accountant does your taxes, always check!)
John sold a rental property for $2 million and claimed a tax basis of $1.5 million. When he filed his taxes, he reported a $500,000 gain from the sale and no other income.
BUT … John’s rental property basis was only $500,000. He just wasn’t paying attention, and somehow, a pesky “1” worked its way in there. Oops!
John’s overstatement of basis resulted in the omission of $1M in gross income from his return – well over 25% of the $2 million in gross income he reported. Once again, that’s a 6-year statute of limitations issue for John … not three years.
Omission of More than $5,000 in Foreign Income
If you forgot that offshore account and had more than $5,000 in income from it, that’s another 6-year statute of limitations trigger. It doesn’t matter if you remembered to disclose the foreign account to the Treasury Department’s Financial Crimes Enforcement Network by filing Form 114, Report of Foreign Bank and Financial Account (FBAR).
What If I Didn't File A Return At All?
Whoops! Something happened that only seems to happen in science fiction, and there was no return filed?
Unfortunately, the IRS can audit non-filers whenever they please. There is no statute of limitations. Since it can take the IRS several years to discover non-filers, this makes sense.
So, even if you don’t owe any taxes or aren’t required to file, it’s a good idea to file your taxes (or lack thereof) anyway to avoid an audit headache. (You could also die … a little severe but some have tried it.)
So, I Saw My Accountant's Mugshot...
You would never file fraudulent returns. But let’s say your accountant had other ideas in mind and filed some grossly inaccurate returns that definitely qualify for an “Intent to evade tax.” Even if you discover your accountant was somewhat dishonest and filed an amended non-fraudulent return, the IRS still has no statute of limitations on auditing that year’s tax return.
Bummer.
But what is fraud, you ask? If you don’t know what counts, then you don’t know what to look for, right? Here is what to look for if your accountant seems a little suspect.
“Fraud” is not defined in the tax code or in IRS regulations. Instead, the IRS looks for these indicators:
- Understating income
- Maintaining inadequate records
- Concealing income or assets
- Failing to cooperate with IRS auditors
- Engaging in illegal activities
- Providing incomplete or misleading information to a tax return preparer
- Filing false documents, including false tax returns
The IRS and U.S. Tax Court hold that if your tax return preparer committed fraud on your return, the fraudulent return exception could also apply to you. This is the case even if you did not know of the preparer’s fraudulent intent when you filed your tax return.
OK ... Anything Else?
Only three more points. Here we go.
First, there are some special rules around the Employee Retention Credit and it’s ASED. Since we wanted to keep this article short, you can read more about ERC rules here. The brief version is most quarters of the ERC have five year ASEDs, but it varies depending on the quarter.
Second, filing an amended return can extend the statute of limitation by 60 days, but only if it’s within 60 days of expiring. For example, if you file your amended return one day before the normal 3-year statute ends, then the IRS has 59 more days to audit you. If you filed the amended return 62 days before the end of the normal statute, then it still runs out at the 3-year mark.
Third, the IRS often asks you to agree to extend the statute of limitations during audits. We’re not lawyers, so you should talk with your attorney before you sign that extension agreement.
Extension is voluntary. You don’t have to sign the form (Form 872). But if you don’t, then the IRS has to issue the examination and notice of deficiency based on the information it has. This may or may not be in your favor.
You can also negotiate the terms of the extension. You can ask that Form 872 consent be limited to specific items – those on which the auditor has more work to do. Also, it’s generally wise to agree to no more than a 6-month extension. It’s a reasonable amount of time to get everything done without IRS mucking about in your affairs.
Sometimes, I see people hesitate to reduce, defer, or even eliminate taxes on the sale of their assets because they’re worried about audits. What if the strategy is too unusual? What if the IRS flags it because it just doesn’t like it?
In normal circumstances, it’s only a three-year ASED. And if you’re still losing sleep at night, I hear a new mattress can do wonders … Imagine That™!
Imagine That!™ is a complimentary monthly newsletter provided by Wealth Legacy Group®, Inc. that addresses various topics of interest for high-net-worth and high-income business owners, professionals, executives and their families. Sign up to receive our monthly newsletter here.
R. J. Kelly, Wealth Legacy Group®, Inc. – April 2024
Header image on Canva, one design use license