How long does the IRS have to audit you?

September, 13 2019 by Jean Lee Scherkey, EA

Since it’s the good ole summertime, there’s no better way to illustrate how long the IRS has to audit your individual income tax return than by describing the angst one feels waiting for ketchup to come out of a glass bottle during a backyard picnic. A long time ago, when pink neon shirts, leg warmers, and mullets reigned supreme, hamburger enthusiasts had to wait, and wait, for the tomato and vinegar goodness that is ketchup to arrive on their burger. In this instantaneous age when ketchup seems to magically appear with a squeeze on a plastic bottle, it is easy to assume that once your tax return is efiled, and your refund is deposited, or the tax due is withdrawn from your bank account, the IRS has officially approved our return. But just like the slow ketchup pouring days of yore, the IRS needs some time to process and contemplate your individual income tax return.

Like ketchup slowly meandering its way out of a glass bottle, so does a filed return go through a series of reviews at the IRS. Generally, the IRS has three years form the date the return is filed to conduct an audit. This period is known as the statute of limitations, or SOL. Typically, once the statute of limitations has passed, the IRS may not go back and assess any additional taxes on that return.

As with everything in life, there are exceptions to this three-year rule. If the gross income, before any adjustments or deductions are applied, is understated by twenty-five percent or more, the IRS has a total of six years to audit the return. The twenty-five percent understatement does not have to be deliberate for the IRS to extend the review period to six years. The most common ways an understatement occurs is when a taxpayer had multiple jobs and unintentionally forgot to enter all their W-2 income on their return. Another prevalent error that can cause income to be underreported by twenty-five percent or more is not entering all the zeros to the end of an amount. For example, instead of entering on a return $12,500, people will enter $1,250.

Sole proprietors report income and expenses from their business on Schedule C of Form 1040. For statute of limitation purposes, when a business understates their gross income by twenty-five percent or more, the statute of limitations increases to six years for that return. For this purpose, gross income is the total income a business received during the year before subtracting the cost of goods sold or any expenses. Here’s an example of how the statute of limitations would increase from three to six years due to a misstatement of gross receipts reported on Schedule C.

Example
Jay Wellywood owns a food truck and slings hamburgers across Wellington, Indiana. On his 2017 Schedule C, Jay had food sales of $100,000 and cost of goods sold in the amount $60,000. For tax purposes, Jay had gross income before any expenses of $40,000 in 2017. However, for statute of limitation purposes, Jay had $100,000 of gross income during 2017. If Jay understates his business income by $25,000 or more, the statute of limitations on his entire 2017 From 1040 Individual Income tax return will go from three to six years.

U.S. citizens and residents are taxed on their worldwide income. So, if more than $5,000 of income from a foreign financial asset is missing on a return, the statute of limitations for auditing that return is extended to six years.

There are instances when the IRS has an unlimited amount of time to audit a person’s tax year. If someone never files a return, the IRS has an unlimited amount of time to assess any tax for that year. The IRS may construct an income tax return for that person with the information they received from their employer through the filing of Forms W-2 or 1099. They will also include any income that was reported to them by financial institutions. When the IRS prepares an income tax return on behalf of a taxpayer, it is called a Substitute for Return or SFR. Unless the taxpayer signs the substitute for return the IRS prepares, the statute of limitations on assessing further tax on that year will not begin. For this reason, it may be prudent for a person to file an income tax return if they are just under the filing requirement so that the statute of limitations starts. Another area where there is no statute of limitations is if a person files a return with false or fraudulent information on it in order to evade tax. If your return is fraudulent, the IRS has unlimited time to assess additional tax.

Just like in those good old days when you had to take the time to shake and tap the glass bottle for the ketchup to pour out, the IRS needs time to make sure a taxpayer reported and paid all of their tax. However, just like that first bite from your hamburger told you the ketchup was worth the wait, so will ;the relief and joy you will feel once the statute of limitations passes on your income tax return. Happy grilling to one and all!