“Audit” is a scary word for most people, because they think it automatically means they’ve done something wrong on their taxes and are going to get penalized. True, sometimes the IRS notices a problem, whether it was intentional misreporting or an inadvertent error. But this is not always the case.
The IRS sometimes uses random sampling of similar returns as a means of comparison and may have found yours “outside the norm” in some way. Additionally, if a business partner of yours is chosen for audit, you may be audited as well, since your finances are tied together to some degree.
The IRS tries to audit as quickly as possible, but as with any large bureaucracy, “quickly” is a relative term. You’re most likely to be audited for a return in the last year or two, and as a general rule, they only look at returns from the most recent three calendar years.
However, if in their audit of three years they notice a substantial misstatement, over 25% of your income, they can look back as many as six years, and on rare occasions, more. “Misstatement” includes not only omitting income but also misrepresenting income. For instance, under-reporting revenue from a sale or over-stating taxes or expenses would be included in that misstatement and could justify auditing you farther back than just the standard three years.
Overseas funds are subject to even closer scrutiny, so keep meticulous records. The IRS can audit you six years back if you omit even $5,000 of offshore income.
In order to cooperate with the IRS to a reasonable extent, while also protecting yourself and your privacy, we recommend keeping all of your tax returns in perpetuity. In addition, keep all of the records used to complete your tax returns for the past seven years. After seven years, feel free to declutter. If the IRS wants to look back farther, you can have the satisfaction of saying “You’re too late.”