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When Can Tax Cheats Relax?

  • Updated April 13, 2012, 10:24 p.m. ET

Is a tax sin haunting you?

Maybe you paid a baby sitter under the table, or “forgot” to declare income, or deducted personal expenses as business costs. Perhaps you didn’t know a large tax or a form was due and found out only later. Maybe you never filed at all.

Whatever the misdeed, the approach of Tax Day is calling it to

mind, raising an urgent question: When can you breathe easy? When is your offense so old and cold that the Internal Revenue Service won’t care—or can’t?

As is often true with taxes, the answer is complex and full of traps. So we asked experts how tax statutes of limitations work, both in theory and practice. Here is what they had to say:

For garden-variety civil tax issues, such as overstating an entertainment-expense deduction, the statute of limitations is typically three years. It runs either from the April due date or the actual date the return is filed, whichever is later. So if you filed on Jan. 30, the three-year statute begins with the April due date; if you got a six-month extension and filed on July 20, the statute runs from then.

Many exceptions to this rule give Uncle Sam wide latitude, however. If the tax issue involved income greater than 25% of the gross income on the return, the statute of limitations rises to six years. This applies only to unreported income, says Mark Matthews, a former top IRS official now with Caplin & Drysdale in Washington.

A tax-shelter case involving this six-year limit is before the Supreme Court now. United States v. Home Concrete centers in part on “cost basis,” or the amount paid for an investment, which is the starting point for calculating the capital gain after selling the investment. The question is whether a large overstatement that then lowers taxes is grounds for extending the three-year limit to six years. The justices heard arguments in January; a decision is expected in June.

In cases of civil fraud, there is no statute of limitations at all. But proving fraud presents a high hurdle for the IRS, says tax attorney Bryan Skarlatos of Kostelanetz & Fink in New York: “With tax fraud, the government bears the burden of coming up with clear and convincing evidence the taxpayer had willful intent.”

Other crucial tweaks also favor Uncle Sam. The most important is that the statute of limitations doesn’t begin to run until a return is filed. So an unfiled return from, say, 1990 is still fair game.

That rule applies to certain forms as well, even if the rest of the return is filed. Typically the forms report activities on which Uncle Sam wants to keep close tabs. They include Form 5471 for Controlled Foreign Corporations; Form 3520 for Foreign Trusts and Gifts; Form 8621 for Passive Foreign Investment Companies; and Form 8886 for Reportable Transactions.

The statute of limitations also stops running if a taxpayer declares bankruptcy or leaves the country for more than six months. The latter poses a problem for millions of U.S. taxpayers living abroad who haven’t filed foreign financial-account reports, Caplin’s Mr. Matthews notes. He and others are urging the IRS to devise ways of easing this harsh regime while bringing these people into compliance.

Compared with civil tax disputes, there are relatively few criminal cases—but the statute of limitations is typically six years. A conspiracy charge can keep a case open for far longer.

In practice, says Tom Borders, an attorney with McDermott, Will & Emery in Chicago, the IRS rarely goes back more than six to eight years for civil or criminal tax cases: “Usually there aren’t enough records and it’s too hard to prove.”

When an audit is under way, IRS agents often ask taxpayers to sign a waiver extending the statute of limitations until the issues are resolved in full. Taxpayers usually have little choice but to do so, Mr. Matthews says. But if the IRS misses a deadline altogether, which happens, the taxpayer gets a bye.

There is a dual take-away here. “The common advice is that if your return isn’t picked within two years of filing, it won’t be,” says longtime tax preparer Jay Starkman, a certified public accountant in Atlanta.

On the other hand, big tax sins have long lives. “If you really want to sleep at night, don’t pull an ostrich,” Mr. Matthews says. “The longer people delay, the worse the outcome often is.”

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