Out With the Old? Not So Fast When It Comes to Disposing of Tax Records

During the COVID-19 pandemic, most people have spent a lot of time at home, inspiring many to clear out some of the clutter in their living spaces. If you have decided to tackle the boxes, bins or drawers full of paper files that have accumulated over the years, you may be wondering when it is safe to dispose of tax records.

General rules

Generally, you should keep tax records — at a minimum — until the statute of limitations has expired. During that time, you can amend your return to claim a credit or refund (or correct an error) and the IRS can audit your return and assess additional taxes. In either case, it is critical to retain all of your tax forms and supporting documentation, including receipts, canceled checks and bank and brokerage statements.

When does the limitations period expire? As a general rule, it runs for three years from the date you timely file your return or the original due date, whichever is later. For example, if you filed your 2020 return on March 1, 2021, the limitations period expires on April 15, 2024. But, if you applied for an extension and file your return on September 30, 2021, the limitations period expires on September 30, 2024.

However, do not get out the shredder just yet. In some cases, the statute of limitations stretches beyond three years. For example, it doubles to six years if you have understated your adjusted gross income by more than 25%, which does not necessarily mean you failed to report items of income.

An understatement can also result if, for example, you overstate the basis of property sold, thereby underreporting your gain. Also, the IRS is never barred from auditing your return and assessing tax if you do not file a return or if the IRS alleges that your return was fraudulent.

To be safe, it is advisable to keep tax records for at least six years; indefinitely if you do not file a return for a particular year or if you have taken any aggressive tax positions that the IRS might later characterize as inappropriate.

Exceptions for certain records

Special rules apply to certain types of records. For example, retain:

• Tax returns for at least six years, in case the IRS later claims that you failed to file a return.
• W-2s at least until you start receiving Social Security benefits, in case a question arises about your work record or earnings in a particular year.
• Real estate-related records until the limitations period (three or, preferably, six years) has expired for the tax year in which the property was sold. Original closing documents, plus records of capital improvements over the years, will help you substantiate your adjusted basis in the property and, therefore, the amount of gain on the sale.
• Investment records until the limitations period has expired for the year in which you disposed of the investments.
• Any relevant records that are related to retirement accounts until the limitations period has expired for the year in which you emptied an account.

Also, the IRS recommends that you retain records for at least seven years if you claim a loss for a bad debt or worthless securities.

Consider going paperless

Scanning original records and storing them on external hard drives, CD-ROMs or in the cloud can be a great way to declutter without destroying records. The IRS permits you to store tax records electronically, so long as they are accurate and readily produced if needed. Your ORBA  tax advisor can help you determine whether your electronic storage system meets IRS requirements.

Better safe than sorry

Before you dispose of any tax records, find out whether your state has document retention rules that differ from IRS requirements. And be sure you do not need the records for non-tax purposes — requirements imposed by your insurance company or lender, for example.

Do Not Overlook Tax Considerations When Selling Your Business

When the COVID-19 pandemic first hit, economic uncertainty caused many business owners contemplating a sale — as well as many prospective buyers — to put their plans on hold. Now that there is some light at the end of the pandemic tunnel, interest in buying and selling businesses seems to be picking up.

If you are thinking about selling your business, be sure you understand the tax implications. The way that your business (as well as the transaction) is structured can impact your tax bill and, therefore, your net proceeds from the sale. Here are some issues to consider.

Stock sale versus asset sale

If your business is a corporation (either an S corporation or a C corporation), deciding whether to structure the transaction as a stock sale or an asset sale may have a significant impact on its tax treatment. Generally, a stock sale is preferable from the seller’s perspective. That is because when shareholders sell their stock, the profits are generally taxed at favorable long-term capital gain rates — currently a top rate of 20%, compared to a current top rate of 37% on ordinary income. In contrast, asset sales usually generate a combination of ordinary income and capital gains, depending on how the purchase price is allocated among the business’s various assets.

From the buyer’s perspective, on the other hand, an asset sale is usually the structure of choice. A buyer of stock generally inherits the corporation’s basis in its assets. If the corporation has already taken significant depreciation deductions on those assets, there may be little or no basis for the buyer to write off. But a buyer of assets generally receives a basis equal to the portion of the purchase price allocated to each asset, generating valuable tax write-offs.

Entity type

The seller’s form of business is another important consideration. If the seller is a C corporation, for example, a potential drawback of an asset sale is double taxation.

First, the business pays corporate tax on any gains from the sale. Then the shareholders are subject to a second tax when the sale proceeds are distributed to them as dividends. (Note: It may be possible to defer the second tax by having the corporation hold and invest the sale proceeds.) Double taxation is not an issue for stock sales. The buyer acquires the stock directly from the shareholders, so there is no entity-level tax.

Double taxation usually is not a concern for S corporations. As pass-through entities, their income is taxed directly to shareholders at their individual tax rates. So, there is no entity-level tax, even if the transaction is structured as an asset sale.

There is a possible exception for a business that had previously been taxed as a C corporation, but later elected S corporation status. Depending on how much time has passed, asset appreciation during the company’s time as a C corporation may be subject to two levels of tax.

Partnerships (including limited liability companies taxed as partnerships) do not have stock, but it is possible for the owners to sell their partnership or LLC membership interests to a buyer. However, it is important for the sellers to understand that this is not the same as selling stock for tax purposes. A sale of partnership or LLC interests is treated essentially as a sale of the underlying assets, typically resulting in a mix of ordinary income and capital gain to the sellers.

Allocation of the purchase price

When a transaction is structured as an asset sale, the allocation of the purchase price among various assets has significant tax implications for both buyer and seller. Often, the parties have conflicting interests, which can lead to intense negotiations on this issue. Keep in mind that the parties’ allocation of the purchase price is not binding on the IRS, though the IRS generally will respect the parties’ agreement so long as it bears a reasonable relationship to asset values.

Sellers generally prefer to allocate as much of the purchase price as possible to goodwill and other intangible assets that generate lower-taxed long-term capital gains. And they prefer to allocate as little as possible to equipment and other depreciable assets. Why? Because previous depreciation deductions taken on these assets are subject to “recapture” at ordinary income tax rates. Buyers, on the other hand, prefer to allocate as much of the price as possible to these assets because they can depreciate them quickly or, in some cases, claim 100% bonus depreciation in the first year.

Knowledge is power

To successfully negotiate the sale of your business, it is critical to understand the tax implications. Armed with this knowledge, you can assess the impact of various transaction structures and purchase price allocations on your net proceeds from the sale and potentially adjust the purchase price accordingly. Your ORBA tax advisor can help guide you through the sale of your business.

Sidebar: What about state taxes?

Business owners usually focus on the federal tax implications of a sale. But do not ignore state taxes. Now that federal tax rates are lower than they have been in the past, state taxes may take on added significance. If you are contemplating relocating or retiring to another state, it may make sense to consider moving before you sell the business, especially if the new state has low, or even no, income tax.

Before you attempt this strategy, however, be sure to consult your tax advisor. Changing your domicile and residence for tax purposes is not like flipping a switch. You will need to take several specific actions to demonstrate your intent to establish a permanent place of abode in the new state, such as obtaining a driver’s license, registering to vote and becoming involved with local organizations and activities.

Keep in mind, that there may be rules about the number of days spent in the state, so if you do all of the above to show that you are a resident of your new state, there are other factors. For instance, if you live in your “old” state most of the year and spend only a few months in your new state, you could find that, at least for tax purposes, you are deemed as a resident of both states.

For more information, contact Rob Swenson at [email protected] or 312.670.7444. Visit ORBA.com to learn more about our Tax Services.