Take-Away: In most cases, the time in which the IRS has to audit an income tax return will be either three or six years. However, in some cases, even though the income tax return was timely filed, the statute of limitations may never run with regard to a future IRS audit.

Background: As a general rule, the normal period of time that the IRS has in which to conduct an audit of an income tax return is three years. However, if the tax return omits more than 25% of the individual’s income, then the statute of limitations jumps to six years from the date of filing. The three year statute of limitations is also doubled (to six years) if the individual omits to report more than $5,000 of income, e.g. interest on an overseas investment account, even if that foreign account is disclosed.

  • Omit Effect: For many years there was a debate over what it meant to omit income from an individual’s tax return. Most individuals and a couple of court decisions said that omit meant to ‘leave off’ income from the tax return. The IRS though applies a broader definition of the word omit to include the effect of an omission of income from the tax return. The IRS continues despite  court setbacks to assert its broad definition of omitted income.

Example: Evasive Eliot sells real property for $3.0 million. Eliot claims on his income tax return that his income tax basis in the real property that he sold was $1.5 million. In fact, Eliot’s income tax basis in the real property was $500,000. The effect of Eliot’s basis overstatement was that he paid tax on $1.5 million when he should have reported the tax on $2.5 million of gain. In U.S. v Home Concrete and Supply, LLC, the Supreme Court rejected the IRS’ position, finding that the overstatement of income tax basis in not the same thing as omitting taxable income on the tax return. Accordingly, the Supreme Court held that the 3-year statute of limitations period applied in which the IRS had to audit the tax return (not six years.)

  • When the Statute of Limitations Starts: The IRS audit ‘clock’ starts to ‘run’ when the income tax return is due, not when the return was filed.

Example: Attentive Amy files her income tax return on February 15, 2022.  Amy’s income tax return is due April 15, 2022. The three year IRS audit ‘clock’ starts to run on Amy’s Form 1040 on April 15, 2022, not February 15, 2022. In short, filing ‘early’ will not accelerate the period in which the IRS has to audit Amy’s tax return.

Audit Extensions: There are some situations in which even though a tax return was timely filed, the statute of limitations does not start to ‘run’ for the IRS’ audit of the return, which means the IRS can conduct an audit of the tax return at any time:

  • Unsigned: If the individual forgets to sign his/her income tax return, an audit of that tax return can be conducted at any time. The IRS does not treat an unsigned, but timely filed, tax return as a valid income tax return.
  • Perjury Statement Altered: Some individuals attempt to alter the ‘penalties of perjury’ statement located at the bottom of the income tax return just over the signature space. If they do, that alteration is also treated by the IRS as an invalid income tax return, so that the audit ‘clock’ never starts to run.
  • Overstating Deductions, Credits: Any position taken on an income tax return that has the effect of understating the individual’s reported income by more than 25% will lead to the longer period of time in which the IRS has to audit. The IRS continues to assert this broader interpretation of omit despite its losses in the courts with regard to overstating basis.
  • Foreign Gifts and Inheritances: If an individual receives gifts or inheritances from foreign nationals then he/she must file a Form 3520. The failure to file that Form 3520 does not start the IRS’ audit statute of limitations running.
  • Foreign Assets: An individual must file Form 8938 for any assets that are held abroad. The failure to file this Form 8938 extends the audit period until the correct Form 8938 is filed.
  • Foreign Businesses: If the individual owns part of a foreign corporation, Form 5471 must be filed. The failure to file this Form  5471 also does not start the statute of limitations for an audit to run.
    The failure to file Form 5471 also triggers a penalty of $10,000 per form. Other penalties can also be assessed if Form 5471 is filed late, it is incomplete, or it is inaccurate- penalties that are applied even if no tax is actually due on that return.
    Entire Return Open to Audit: The failure to file Form 5471 results in the individual’s entire tax return remaining open for an IRS audit, indefinitely. The IRS not only has an indefinite period in which to levy and assess taxes on items relating to the missing Form 5471, it can make adjustments on the individual’s entire tax return until the required Form 5471 is filed. This Form is required not only for U.S. shareholders in controlled foreign corporations, it is also required to be filed by a U.S. individual who acquires an interest that results in a 10% (or more) ownership in any foreign company.
  • Unfiled Tax Returns, Criminal Violations and Fraud: For unfiled income tax returns, criminal violations, or fraud, the IRS can take its time to conduct an audit. In most criminal or civil tax cases, though, the practical limit for the audit is six years.

Tax Assessments: If the IRS decides to audit a tax return and does so within the allotted statute of limitations, e.g. 3 or 6 years, the IRS then has another 10 years under its collection statutes to collect the additional tax, penalties and interest. In limited situations, that 10-year collection period can also be renewed. As an example, consider the Tax Court decision in Beeler v Commissioner, where the IRS was able to hold Mr. Beeler responsible for 30-year old payroll tax penalties.

Conclusion: While it is appropriate to consider the normal period in which an individual is ‘at risk’ for an IRS audit to be 3 years, it is fairly easy to ‘trigger’ a 6-year audit exposure merely by omitting to report $5,000 in income (e.g. overfunding a traditional IRA by $5,000) or if the IRS applies its effect of an omission interpretation to an omission under the applicable statute of limitations. Moreover, the failure to file some IRS required Forms will leave an individual’s tax return exposed to an IRS audit for an unlimited period of time. Three years probably, unless….