The IRS usually has 3 years to audit a tax return. However, if there is a 25% or greater understatement of income, the IRS has up to 6 years to audit. If the taxpayer has committed fraud, the IRS can go as far back as it wants. The IRS has a policy of NOT going back more than 6 years, but this is just policy–it can be changed at any time.
To ensure that you have support for your income and deductions, you should generally keep records for 7 years (the maximum six years the IRS can go back, plus 1 year for good measure).
If you don’t keep adequate records, the IRS can reconstruct your income using various methods including:
- The Net Worth Method: The IRS determines your net worth at the beginning of the tax year and at the end of the tax year. The difference is income. The IRS then adds nondeductible expenses, payments of federal income tax, and gifts paid to others. The IRS will then tax you on this sum.
- The Expenditures Method: The IRS looks at your expenses for the year and compares them to your income. If the expenses exceed income, the IRS assumes the excess is income and applies a tax.
- The Deposits Method: The IRS assumes that your bank deposits are income and applies a tax unless you can prove that the source of the deposits was tax-exempt.
So, what type of records should you keep and for how long?
These items should be kept for 7 years:
- cancelled checks
- credit card receipts
- paid invoices
- bank deposit slips
- bank statements
- tax returns (uncomplicated)
- employment tax returns
- expense records
- inventory records
The following items should be kept for the life of the asset (or business) plus 7 years:
- corporate minutes
- depreciation schedules
- real estate records
- general ledgers
- home purchase & improvement records
- investment records
The following items should be kept permanently:
- complicated tax returns
- contracts
- corporate stock records