In general, the IRS cannot assess additional income tax for a year more than three years after the taxpayer files his return for that year. There are some exceptions that can result in a longer assessment period. The protection afforded taxpayers by the statute of limitations is not well understood. It does not protect against everything that happened in old tax years, as was recently illustrated in the case of Fernandez v. United States, decided by the United States Court of Federal Claims.
In 1999, a year closed by the statute of limitations, the taxpayer participated in the “Son of Boss” tax shelter transaction, which he believed created a high tax basis in certain stock he owned. The taxpayer sold the stock in his tax years 2000–2003. The IRS audited these years in time to keep the statute of limitations open. The IRS took the position that because the claimed basis arose in an abusive tax shelter transaction, the correct basis of the stock sold was zero, and it sought to tax the taxpayer on the entire amount he received for selling the stock in 2000–2003.
Before the court, the taxpayer argued that since the claimed basis arose in 1999 and that year was closed by the statute of limitations, the IRS was precluded from denying him the basis that he claimed. The court held in favor of the IRS, saying that although the IRS could not assess any tax for 1999, it nevertheless could consider facts arising in 1999 to determine the taxpayer’s correct liability for tax years 2000-20003, which were not closed by the statute of limitations.
This case brings up a very important point. People are frequently told that tax records only need to be maintained for some fixed period, typically six or seven years. In fact, any records that could be relevant to the determination of your tax liability in a later year need to be retained indefinitely. The example in this case was the correct basis for an asset the taxpayer sold. The IRS can challenge the basis you claim in the sale year no matter how many years ago the basis arose. The same would be true for a depreciation deduction for a shopping center or an apartment building you may have purchased ten years ago.
An area where taxpayers are often caught off guard is with respect to net operating losses. Let’s say your business incurred a loss in 2000 that you did not carry back. In general, you may carry that loss forward for twenty years. Suppose you used part of that loss as a deduction from business income in 2005 and that return is now being audited by the IRS. The IRS cannot assess any taxes against you for 2000, as that year is closed. However, if it believes the net operating loss that you claim arose in 2000 is not good, it can deny your deduction of the loss carryover for the 2005 year. In effect, you can be required to prove the bona fides of the 2000 loss in any year where you claim a deduction for part of that loss. All this should serve to emphasize the importance of keeping good records and retaining them. There are numerous circumstances where you could be called upon to produce very old records to support a tax position you took in a more recent year.