How to Screw Up an IRS Audit (Record Retention)

What qualifications do you need to become a sports talk radio host? Apparently a triple digit IQ isn't one of the them. Last week, a talking head from ESPN980 lamented the Redskins release of Chris Cooley and Tim Hightower. Cooley was a tight end for the Skins for eight years. He was a very good player on teams that lacked very many other good players. However, his legs gave up on him last year, and he never recovered. What do you call a tight end with bad legs? Waiter. Cooley, hopefully, will fare better than that in retirement. He is a smart guy, who probably planned for life after football.

Tim Hightower, a running back, played four season with the Arizona Cardinals before signing with the Redskins last year. He played five games before injuring his knee and missed the rest of the season. He played in one preseason game this year before aggravating last year's injury. What do you call a running back with bad legs? I think you get it. A running back, who has survived four years in the NFL is ninety years old in running back years. Hightower got cut, because the Redskins have three younger, faster, and healthier running backs. Sports talk radio hosts are morons.

Here's how you screw up an IRS audit. Throw out your records and then call the IRS auditor an incompetent idiot. Find the two serious errors in the last sentence. Yes, I had a client do those two things in an audit. Weeks of absolute joy followed.

My client, Pete, built and sold a house a couple years ago. There was just one problem with the transaction. The house cost $200K more to build than his sales price. Since he was in the home building business, the loss was deductible as a business loss. I'm not kidding. He was really in the home building business. I didn't say he was any good at it.

When you claim a $200K loss on an income tax return, you just might get a gentle letter from the IRS asking for a friendly meeting, called an audit, to review the transaction. Pete got just such a communique. To substantiate the deduction, we needed to give the IRS auditor proof of what Pete paid to build the house and proof of his sales price. The sale price part was easy. We had the settlement statement for the sale. The problem was proving the cost to build the house.

Pete threw out his records, when he moved, the year after he sold the house for a loss. Based on his throwing out the records, he felt justified in calling the auditor an incompetent idiot. Worse, he said it to her face. As a reward for this, the auditor not only disallowed the loss on the house sale, but she also assessed a fraud penalty against Pete.

I have never personally seen a fraud penalty assessed in an audit. She undoubtedly assessed it as a little thank you for Pete's fine behavior. The penalty won't stand on appeal, because there was no fraud involved. However, when you insult an IRS auditor, expect some consequences.

From Pete's story, you have justifiably concluded that throwing out your tax records can be a bad idea. However, you should throw out your tax records at some point. How do you know when it is safe? Let's illustrate this with an example.

Assume you bought some Facebook stock during the initial public offering. Poor you. I wish I could be sympathetic, but when you pay more than one hundred times earnings for a stock, you deserve a good financial beat down. I'm not here to make fun of you, however. Let's further assume that you rightly conclude that the stock is a smelly turd and sell it in 2013. How long do you need to keep records for the transaction.

First, there are two transactions here. You must keep documentation showing your purchase date and purchase price as well as proof of your selling price and the date sold. Since you sold the stock in 2013, your ugly loss will be recorded on your 2013 tax return. The tax return will be due April 15, 2014.

That due date is the date that determines when you can toss both the stock purchase and sale documentation. The statute of limitations on a transaction runs three years from the date the transaction is reported on a tax return. Therefore, you can shred the records three years after April 15, 2013. That date is April 15, 2016. After that date, the transaction is beyond audit. I am not only telling you that you can shred the records, I am telling you that you should at that point.

You might ask, Frank, what is wrong with keeping your records longer than required. There aren't many consequences to keeping stock purchase and sale documentation longer than required. However, the same statute of limitation applies to a lot of business transactions as well. If you find yourself in a lawsuit and keep your records longer than required, those records can be subpoenaed. If you don't have the records, you can't and don't have to produce them. Thus, you should shred unneeded records as soon as possible.

What happens if you don't file your 2013 tax return by the due date? Bad things. The statute of limitations on your stock sale does not begin to run until you actually file the tax return. If you file your return five years late, the three year period doesn't start until you file the return. You are leaving the transaction available to be audited for eight years instead of the normal three. The same principle applies when you ask for a filing extension. The three year time period doesn't start until you file your return. Minimize your exposure to IRS audits by filing your return on time and shredding tax records as soon as possible once the statute of limitations has expired.

The above isn't a complete look at statute of limitations issues. Nothing involving the IRS is that simple. If you have specific questions about statutes of limitations or how long to keep your records, ask your CPA, or send me a message at fstitely2@gmail.com. I'll do my best to give you a good answer.

This week, several members of the DeMatha High School football were expelled and several more face expulsion for inviting prostitutes to their hotel rooms after a road game. They would have gotten less punishment for beating the crap out of dweebs or molesting cheerleaders. The adults involved need to show a little restraint. All these kids did was embarrass themselves and the school. If you know anything about Bill Gates and Steve Jobs, they may not have solicited hookers, but they certainly screwed a lot of people.

These kids evaded late night bed and hall checks to sneak hookers into the hotel at 5 AM. This is the sort of “don't raise the bridge, lower the river,” out of the box thinking that has made American entrepreneurship great. Instead of ruining these kids' lives, water their creativity and redirect it in a more productive direction.

I'm OK with kicking them off the team for a year. Sit them down individually, and tell each that he is on double secret probation. If they don't achieve high GPA's and stay out of trouble, they'll be out of school like shit through a goose. Yes, that's two “Animal House” references.

As always thanks for reading and your comments. For real tax and accounting information, please visit the main S&K web site at www.skcpas.com.