After every tax season, it’s tempting to do some spring cleaning, which often includes a massive dump of recently filed tax data.
While many firms have migrated to paperless records, many still grapple with the issue of tax record retention. One of the most confusing questions clients ask their accountants is: what do I do with my tax records and how long do I need to keep them?
Keep in mind that compliance includes federal (IRS) guidelines as well as state guidelines, as there is often a difference in the statute of limitations for both. For example, while the IRS has a three-year statute, the state of California has a four-year statute. Being caught throwing out 2013 tax data this year (even though it was filed in 2014) could be a real issue in the case of a state audit.
In the electronic age, firms and clients have typically already developed a system for scanning documents, receipts and emails after the year ends for easy access. Revenue Procedure 97-22 provides that the IRS accepts scanned documents. The burden of proof for an item of income or expense rests with the taxpayer, and keeping paper documents may not be an option. However, technology does change and data retrieval may be required years later. Therefore the method of storage and retrieval must be taken into account. Electronic records must be as accurate as paper records and taxpayers must be able to index, store, preserve, retrieve and reproduce the records (in order to produce a hard copy if needed). Further, in business, accounting software changes regularly and access is required at all times.
According to the IRS, how long to keep a document depends on the action, expense or event recorded by the document. Generally, keep records that support an item of income, deduction or credit shown on the tax return until the period of limitations for that tax return runs out. The IRS has provided the following guidelines:
Period of limitations that apply to income tax returns:
1. Keep records for three years if situations (4), (5), and (6) below do not apply.
2. Keep records for three years from the date of filing the original return or two years from the date the tax was paid, whichever is later, if filing a claim for credit or refund after filing the return.
3. Keep records for seven years if filing a claim for a loss from worthless securities or bad debt deduction.
4. Keep records for six years if income that should been reported was not reported, and it is more than 25 percent of the gross income shown on the return.
5. Keep records indefinitely if not filing a return.
6. Keep records indefinitely if filing a fraudulent return.
7. Keep employment tax records for at least four years after the date that the tax becomes due or is paid, whichever is later.
Typically, a firm will have a seven-year retention policy and will be called upon to advise their clients in this area. There are a few caveats when applying the general rules above. For both individuals and businesses, keep records relating to property until the period of limitations expires for the year in which property is disposed. The client must keep these records to determine any depreciation, amortization or depletion deduction and to figure the gain or loss when selling or otherwise disposing of the property.
In addition, if property was received in a nontaxable exchange, the basis in that property is the same as the basis of the property given up, increased by any money paid. It’s important to keep the records on the old property, as well as on the new property, until the period of limitations expires for the year in which the new property is disposed. The IRS can, and does, request the original purchase documents.
To complicate the issue further, there are non-tax reasons to keep certain records that clients may not be aware of. For example, if employed in a job that does not pay into social security, like a teacher, one might assume Social Security Administration benefits are a non-issue. But let’s assume the client earned social security work credits outside of the teaching job and the SSA has no record of this. Do not assume the IRS will have a copy or transcript from 20 years ago. For this reason, it’s advised to keep the actual tax return, W-2 or 1099 forever.
As mentioned above, states typically have a longer statute. In addition, there is no statute when a return is not filed (same with the IRS). As states scramble for money, it’s entirely possible for the state to raise easy money by reviewing K-1s, W-2s or 1099s and issuing assessments. These assessments are then turned over to the IRS, at which point people often find their current IRS refund has been turned over to the state. Being able to prepare a state return for an old year using the federal return is critical in this situation.
For business clients, good records help monitor the progress of the business, prepare financial statements, identify sources of income, keep track of deductible expenses, keep track of basis in property, prepare the tax returns, and support items reported on the tax returns. Business owners should develop a good record retention system. This may include the Obamacare requirements—until those rules are changed. Records on providing minimum essential health insurance coverage will need to be maintained.
In addition to a scanner, it’s important to have a good shredder as well. In the age of identity theft, bear in mind these records contain personal information. Be sure this information is not readily available in a trash bag! Lastly, there’s always Murphy’s Law. The minute something is thrown away, even after decades, fate has a way of demanding it.