Taxpayers may make a relatively simple or particularly complex error while preparing their taxes. Years may pass, but an inkling of doubt and anxiety may continue to gnaw at the taxpayer’s mind. The taxpayer may wonder if he or she is likely to be identified and audited by the IRS or FTB. Over the years, the taxpayer is likely to think less and less about the issue, but it still may spring to mind from time –to-time. Then, after a period of several years, the taxpayer may conclude that he or she is unlikely to hear anything about the tax issue.
Unfortunately, this assumption may prove to be false for at least some taxpayers. The IRS and California Franchise Tax Board (FTB) reserve the right to audit taxpayers for certain tax issues for many years. In the case of the IRS, a three to six-year lookback window typically applies, though this period can be extended even further in certain scenarios. However, in an increasing number of scenarios, both the IRS and FTB claim a lookback period lasting at least 6 years.
When Does the Standard 3-Year Statute of Limitation Apply for IRS Audits?
The standard three-year period for the IRS to audit or examine your tax return is the default rule. That is, in most scenarios not involving fraud or a substantial underpayment of tax, the IRS will have three years to correct or otherwise identify errors on your tax return. The three-year period the IRS has to conduct an audit and assess new tax liabilities is measured from the due date of the taxes or from the date the taxes were actually filed, whichever comes later. To illustrate, assume a taxpayer had filed his or her taxes early on April 1, 2010. For the purposes of the statute of limitation, the taxes would be deemed filed on April 15, 2010, and, under normal circumstances, the IRS would have had until April 15, 2013, to audit the taxpayer.
When Does an Extended or 6-Year IRS Audit Lookback Apply?
In 2015, Congress passed legislation that broadened the circumstances where an audit look back period of up to six years could apply. Under §6501(e) of the Surface Transportation and Veterans Health Care Choice Improvement Act of 2015, the IRS may assess a tax deficiency up to six years after the actual or deemed filing date when a substantial understatement of gross income is made by the taxpayer. A substantial understatement of income occurs when the taxpayer fails to report income in excess of 25% of the gross income reported on the return. Section 6501 also provides for an extended statute of limitation for “an understatement of gross income by reason of an overstatement of unrecovered cost or other basis.”
One additional scenario when an extended and potentially indefinite lookback period applies is the case of unfiled taxes. Here, the statute of limitations never begins to run. Therefore the statute of limitations of a subsequent assessment is, theoretically, indefinite. Likewise, tax fraud can also give rise to an open-ended audit period.
Why Are Many Tax Audits in California Open-Ended?
In California, the law seems to hold that the Franchise Tax Board has four years, under regular circumstances, to conduct a tax audit. However, experience and case law seem to dictate that the statute of limitations for the FTB to audit and assess unpaid taxes is actually much more open-ended. While the FTB, like the IRS, can also audit in perpetuity for unfiled taxes or tax fraud, additional California-specific provisions further expand this ability.
Consider the fact that California law actually requires taxpayers to notify the FTB of certain changes to previously filed taxes. If the taxpayer files an amended tax return that creates new tax liabilities, he or she is supposed to notify the FTB. Likewise, if the IRS modifies a taxpayer’s tax return creating a new tax liability, the taxpayer is also supposed to provide notification to the FTB within six months. If a taxpayer fails to notify the FTB in either of these circumstances, the statute of limitations on a subsequent assessment never begins to run and the FTB can theoretically audit at any point in the future.
Has the IRS or FTB Asked you to Agree to an Extension of Time for an Assessment?
If the IRS or FTB have already asked you to extend the amount of time they have to conduct and audit, there are a number of competing schools of thought regarding whether it is prudent to do so. On one hand, some seem to believe that saying ‘no’ will merely cause the tax agency to expedite the investigation while heaping additional scrutiny on the taxpayer. While the idea that those who have done nothing wrong have nothing to hide and should, therefore, agree to the extension has been debunked many times, the tax agencies often still view such an election in an extremely negative light. On the other hand, permitting the FTB or IRS additional time to audit, can allow them time to uncover mistakes or make life generally unpleasant for the taxpayer. A decision regarding which approach is more likely to produce a favorable result for the taxpayer can only be reached after a careful, individualized factual analysis of the situation.
If you are concerned about the potential for an IRS or California FTB tax audit, contact the tax Law Office of David W. Klasing today. From our Los Angeles and Irvine law offices, we have helped Californians with their state and federal tax audits. To schedule a reduced-rate, private consultation please call our law firm at 800-681-1295 today.
