Tax planning keeping records

To report what you owe and defend against a possible audit, you need a year’s worth of records.

Just after the start of the new year, you’ll begin receiving a host of tax documents. These include official third-party notifications, such as a W-2 that reports your salary or wages and a full range of 1099 forms that show your investment, retirement, and miscellaneous income. You may also receive a 1099-Q that reports tuition payments, and Schedule K-1s or Form 1065s that report partnership gains or losses.

The IRS expects you to report the information shown on these documents, which it matches to copies of its own. In addition, you must keep your own records of earnings from other sources, such as rental income, freelance work for which you don’t receive a 1099, or royalties. Similarly, you must have back-up for your expenses if you plan to itemize deductions or claim adjustments or credits.

Expense records should include the person or organization that was paid, date, type of expense, and business purpose. Regular entries in an electronic or paper expense log are a valid record in most cases, though there are special recordkeeping requirements for tips, business use of a car, travel and entertainment, and non-cash charitable contributions. You’ll also need receipts for expenditures over $75 if the IRS asks for them.

There are individual IRS publications dealing with most recordkeeping topics, which you can find using the search function on the IRS website.

What’s an audit?

An audit is an IRS examination of your tax return and supporting records to determine if you’ve reported your situation correctly. The agency’s going-in position combines a strong suspicion that you owe additional tax with the belief it will recapture substantial revenue. Otherwise, the IRS probably wouldn’t bother. IRS computers score all individual returns using a complex, secret discrimination index deduction (DIF) formula developed by its National Research Program to identify returns that are candidates for audit. There’s also an Unreported Income DIF to identify returns that are likely to be concealing income. Both formulas are based on specific criteria that have been weighed for the probability of error or evasion.

A taxpayer’s bill of rights

IRS Publication 1, “Your Rights as a Taxpayer,” is often described as a taxpayer bill of rights because it spells out the rules the IRS must follow in questioning your return or handling an appeal. It’s worth reading. 

Types of audits

The IRS conducts three types of audits, plus what it calls an adjustment. With an adjustment, you receive a notice – CP-2000 – that you owe additional tax. You have the right to appeal, which you must do in writing within 60 days. If you agree, however reluctantly, that the IRS is right, all you have to do is write a check.

A correspondence audit is done by mail. The IRS asks you to send specific records to back up your return. If the documents support your entries, the matter may be resolved in your favor. But you may well owe additional tax.

An office audit is held in an IRS office with a tax auditor. You are told which areas of your return will be examined and what materials to bring with you.

A field audit is conducted by an IRS revenue agent in your home, office, or tax professional’s office if that person is entitled to practice before the IRS. Your entire return and all supporting documents are subject to examination.

How long should you keep your records?

The IRS usually has three years – called a period of limitations – to audit your return, so you should keep all the relevant records at least that long. But it’s important to keep some records longer.

If you’ve underreported your income by 25% or more, the IRS has six years to audit your return. And if you don’t file, or you file a false return, they have forever.

Who is at risk?

In reality, only about 1% of all tax returns filed in any year are audited, though some groups of people are audited at a higher rate. The IRS focuses on high-income individuals, those with pass-through income from partnerships and S corporations, non-citizens with significant US earnings, and anybody who tries to claim there’s no legal requirement to pay taxes.

Factors that trigger an audit include:

  • Deductions that appear to be too large for your income
  • Income and expenses for which there is no third-party reporting
  • An unusually large tax refund
  • Real estate rental losses
  • Overseas bank accounts

In the past, home office deductions were often questioned. But beginning with returns filed in 2014, there’s a simplified method for claiming the deduction. If you follow these guidelines, you’re much less likely to raise an IRS eyebrow.

The appeals process

You have the right to ask for a review of any audit findings with which you don’t agree. You appeal first to the examiners’ supervisor and then to the IRS Appeals office. IRS Publication 5, “Appeal Rights and How to prepare a Protest if You Don’t Agree,” outlines the process. You can represent yourself, though it may be wiser to use a qualified tax professional to handle the appeal.

As a last resort, you can take your case to court, though most litigation is expensive and slow. Depending on the size of the claim and whether you have paid the disputed amount, the case is heard in tax court, a federal district court, or federal claims court. The court of last resort is the US Supreme Court.

Send no originals

If you’re providing backup documentation of your expenses or deductions, never send your originals to the IRS. Instead, send photocopies. They could get lost and aren’t ever returned. Either could pose a real problem if you need the information in the future.

Type of record

Most records of income and expense

Investment other than real estate

Real estate (initial cost, improvements, cost of selling)

Tax returns

How long to keep it

At least three years, seven if possible

Until three years after you sell

Until seven years after you sell

At least six years, ideally forever



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