Normally the IRS has 3 years from the date your tax return is filed to assess you a tax liability. However, there is an extended six year statute of limitations that applies to taxpayers that grossly underestimate their income.
Extended Statute Of Limitations
The IRS will extend its statute of limitations from 3 years to 6 years if it finds out you have omitted gross income on your return by 25%. This extra time is given to the IRS to go back and investigate the amount of missing income that was not reported. The extended statute is not only limited to just the missing income but to the whole year of your filed return.
Since the IRS is given an extended statute of limitations that encompass the entire year of your return, they can use the time to do a full investigation of your tax return.
This extended statute of limitations allows the IRS to assess you an additional tax liability for six full years if you are found to have not honestly stated your gross income.
Income From A Trade Or Business
If your income is derived from a trade or business, it can become complex to determine your gross income according to the IRS standards. Recently, new legislation has been enacted to clear up some of the confusion.
Generally speaking, gross income from a business is the sale price minus the cost of the sale. There has been a lot of debate over whether overstating an assets tax basis constitutes an omission of gross income. The Supreme Court ruled that overstating the basis of an asset does not constitute omission of gross income in regard to the six year extended statute of limitations. Therefore if you understate your gross income through overstated asset basis you would not be subject to the extended six year statute of limitations.
Capital Gains & Capital Losses
In terms of capital gains and capital losses, there are two things to remember. Not reporting capital gains is considered omission of gross income from your tax return. However, if you do not report capital losses it is not considered omission of gross income. There are restrictions to this though. If you go beyond the loss limit and it results in a gain then you would have missing gross income on your return and the IRS could issue an extended statute of limitations.
Burden Of Proof
In this situation it is the responsibility of the IRS to prove that you have omitted 25 percent or more of your gross income. They are required to do an investigation and gather evidence for their accusations.
Other Situations That Should Be Avoided
There are a few other situations where the IRS can use the six year extended statute of limitations. These include:
1. If you don’t report gross income of $5000 or more that is tied to a foreign asset. This situation does not take into account the ceiling over $5000.
2. If you do not report 25% or more of gifts on a gift tax return.
3. If you do not report 25% or more of items that should be reported on an estate tax return.
Amended Tax Returns
In situations where you file an amended return and report the income that you omitted from the prior return, the IRS is still allowed to use the extended statute of limitations. They state that they do not view amended returns as disclosure of missing income.