It is not always easy to follow the advice you give others. A common question I get is "how long should I keep my tax records?" My somewhat snarky reply is “as long as you need to.” The response is not entirely snarky because even though each tax year stands alone, events that occur in one year might have tax repercussions many, many years later.
In Betty Amos v. Commissioner, T.C. Memo. 2022-109 (Nov. 10, 2022) (Judge Urda), the taxpayer failed to keep records as long as she needed to is. It is an object lesson for all of us. Ms. Amos was a highly successful tax practitioner, a CPA, who had decades of high-level business experience. On her 2014 and 2015 returns she reported about $100,000 of IRA income against which she claimed over $4 million of net operating losses (NOLs) that dated back to 1999. While she could produce her 1999 tax returns showing the NOLs, she could not produce the underlying records substantiating what she had then reported, causing Judge Urda to write “It beggars belief that she would be unaware...[of] her responsibility to demonstrate her entitlement to the deductions she claimed.” Op. at 11. Details below the fold.
Law: Finding Closure
Generally, tax years are considered closed three years after a return has been filed. On the government side §6501 gives the general rule that “the amount of any tax imposed by this title shall be assessed within 3 years after the return was filed.” Similarly, on the taxpayer side, §6511(a) provides that any claim for a refund of tax “shall be filed by the taxpayer within 3 years from the time the return was filed.”
These statutes reflect a very strong Congressional policy of closure. Once closed, a tax year is gone, forgotten, vanished. These are not mere statutes of limitations on remedies; they are statutes of repose on rights and obligations. I explain more in Bryan Camp, Tax Return Preparer Fraud and the Assessment Limitation Period, 116 Tax Notes 687 (Aug. 20, 2007).
If all events that affected the tax liability for a given period occurred within that same period, then this strong closure policy would mean taxpayers would need to keep records for only three years ( ... or perhaps longer if a taxpayer is worried about the six year period in §6501(e)). So my answer to the common question might be “keep your records three years or six years if you are cautious”).
But we all know that events in one year may have tax repercussions many, many years later. So how long you need to keep records really depends on what you need to keep records about.
Basis is perhaps the most common example of why taxpayers need to keep records far beyond the normal three-year period. For example, a taxpayer who buys a home in year one and sells it ten years later needs to keep records of all transactions that affect the basis during all ten years. Even with the §121 exclusion, appreciation may well take the fair market value way over the permitted exclusion if one relied on original cost basis. That may not be so true here in flyover country, but might well be true on the coasts. Thus taxpayers are best advised to keep records of all capital expenses during that period so that the taxpayer can properly prove up basis in the year sold. This is even more blindingly true for taxpayers who own rental property for long periods of time.
For today's lesson, Net Operating Losses (NOLs) are another area where taxpayers need to keep records for much longer than the normal three years.
The basic idea of the §172 NOL deduction is that a business that incurs overall losses in one year ought to be able to reduce income in adjoining years since each one year period is, in some sense, artificial. For reasons I confess not to understand, Congress has stretched that basic good idea beyond recognition by permitting taxpayers to carry NOLs back two years and forward for up to 20 years. See §172(b). Professor Adam Chodorow gives a useful legal history about the shifting rationales for these NOL rules in Lost in Translation, 97 Taxes, The Tax Magazine 117 (Mar. 2019).
Regardless of the rationale, Treasury recognizes the importance of cross-year record-keeping for NOLs. Treas. Reg. § 1.172-1(c) requires a taxpayer claiming an NOL to file with the return “a concise statement setting forth the amount of the net operating loss deduction claimed and all material and pertinent facts relative thereto, including a detailed schedule showing the computation of the net operating loss deduction.”
In addition, if called upon to substantiate the NOL, a taxpayer must be prepared to not only prove their entitlement to the NOLs in the tax year the NOLs arose (which could be up to 20 years earlier remember) but also prove how those NOLs were or were not used in the years between that year and the tax year in question. See Power v. Commissioner, T.C. Memo. 2016-157.
So if your client is claiming NOLs, you had better tell them to keep those records for....up to 20 years. And if YOU, dear reader, are claiming NOLs, you had be sure to follow your own advice. That’s our lesson for today. Let’s check out the facts first.
Betty Amos (now apparently retired) was a highly successful CPA, but was a less successful entrepreneur. From 1984 through the late 1990’s she profitably ran a total of 15 Fuddrucker’s restaurants in Florida and Tennessee. Op. at 3. Then the business started to go bad. She closed one location in 1999 and reported an overall NOL carryforward that year of $1.5 million (she elected to forgo the 2 year carryback).
On her 2000 return she reported the carryforward and also reported additional NOLs that increased her carryforward to $1.8. The IRS audited the 2000 return and issued a no-change letter. More on that later.
Over the next decade, Ms. Amos’ Fuddruckers business continued tanking. She continued to close locations and the business continued to produce losses. By 2008 the NOL carryforwards had increased to $5.4 million. Op. at 4. By 2011 she had closed her last location. Op. at 3. By the time she self-prepared and filed her 2014 and 2015 returns the NOL carryforwards had dropped to about $4.3 million. They were absorbing income of about $100,000 per year, most of that apparently from IRA distributions.
During this time the IRS audited her 2009 return but the NOLs for that year were not an issue and the Tax Court issued a stipulated decision “with Ms. Amos reserving the right to claim such NOLs in future years and the IRS reserving the right to challenge any such claimed losses.” Op. at 4, note 5.
That challenge came when the IRS audited her 2013 and 2014 tax returns, disallowed the NOL carryforwards and dinged her for the tax resulting from the improperly sheltered IRA income. Oh, and it also asserted accuracy-related penalties.
Ms. Amos petitioned Tax Court. Over the IRS objection, Judge Urda permitted her to introduce as evidence copies of her 1999 tax returns. It really did not matter, and that’s our lesson.
Lesson: Keep Records As Long As Needed
A taxpayer who is claiming an NOL is, by definition, claiming a loss stemming from some prior tax year where the NOL originated. It is only common sense that such a taxpayer needs to be prepared to substantiate the entitlement to that loss in the year it originated. If the IRS does not take issue until year 14, the taxpayer still needs the records to show the entitlement back in year 1.
Ms. Amos was not prepared to do that. First, while she had kept her the tax returns from 1999 and 2000, they proved nothing. They were simply documents claiming the loss. Like pleadings in a lawsuit, they were not proof. What Ms. Amos needed to have kept were the underlying records substantiating the positions taken on those returns. Judge Urda notes that the best she could do was produce only “some documents...that support her claim of losses” but that “fragmentary record before us is inadequate to establish her 1999 and 2000 income and deductions so as to substantiate the NOLs at issue.” Op. at 8.
Second, even if she had established the 1999 NOLs, she needed to have kept records for every single subsequent year to show the tax history of the NOL carryforward. .... Very much like tracking basis. She did not do that, either.
So what do you do when you have failed to keep adequate records?
First, you could ask for mercy. Ms. Amos tried that. She argued that she had produced at least enough documentation for the Court to estimate her NOLs. Judge Urda agreed that the Court could do that in certain cases—kind of like a Cohan rule for NOLs—but this was not such a case: “Given the dearth of evidence in this case, we have no basis upon which to make an estimate and, therefore, decline to do so.” Op. at 9, note 7.
Second, you could point the finger at the IRS and say your lack of records was its fault because it had previously agreed to the tax position now being disallowed. That’s called “estoppel.” Ms. Amos tried that too. She pointed to the no-change letter regarding her 2000 return and said that estopped the IRS from now disallowing the 2014 and 2015 NOLs carryforwards since the IRS had not disallowed the 2000 Carryforwards.
Nope. Judge Urda rejects that argument, primarily because Ms. Amos’ attorney only raised that issue at the last minute and was therefore (ironically enough) estopped from raising estoppel. But Judge Urda notes that even if the argument had been properly raised, he would still reject it because “the IRS’s prior allowance of a deduction does not bind the agency with respect to other years.” Op. at 8, note 6. And each year stands alone. So the IRS’s failure to contest the NOL carryforward in 2000 when it issued the no change letter did not prevent it from challenging it in 2014 and 2015. Sure, if the IRS had challenged the NOLs during an audit and had lost on the issue, that would preclude (not estopp) any further debate on the issue. But the legitimacy of these NOLs had never been tested before. I would further observe that Ms. Amos was hardly in a position to claim surprise or prejudice (part of what creates estoppel). Both she and the IRS had expressly reserved the NOL issue in the 2009 stipulated decision. Op. at 4, note 5
Ms. Amos had a long and successful career as a CPA doing high-level tax work. I am sure she had clients who asked her how many years they needed to keep records. And I am equally sure she would have told them some version of my snarky answer “as long as you need to.” But she did not follow that advice herself and so, sadly, provides us all with the lesson.
Coda 1: Misleading Headline? The Tax Analysts headline for this case is “Court Knocks CPA for Claiming Deductions for Nonexistent NOLs.” I think that misreads the case. And it’s kinda mean. I saw no judgment or finding that Ms. Amos did not actually have NOLs in 1999 or other years. The judgment is that she failed to adequately substantiate the NOLs. The NOLs may well have existed. She just did not keep proper records. Or am I being naive?
Coda 2: Effect of Ruling. Has Ms. Amos lost the ability for a tax-free retirement? That is, she was born in 1941 and so if she had $4.3 million NOLs in 2015, those would be more than enough to shelter her roughly $100,000 yearly IRA distributions for the rest of her life. Considering it that way, if you were giving return preparation advice to a client in Ms. Amos’ position, would you advise them to claim NOLs on their 2022 return? After all, each year stands alone. I would not advise such a client to continue claiming NOLs. It seems quite unlikely that such a client actually has the needed records if they could not produce them during four years of litigation with the IRS (Ms. Amos filed her Tax Court petition in 2018). But I invite reader comments.
Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law. He invites readers to return to TaxProf Blog each Monday (or Tuesday when Monday is a Federal holiday) for another Lesson From The Tax Court.