Tax examinations sometimes drag on as the IRS requests more documents or the two sides go back and forth over an issue. As time goes by, the examiner may ask the taxpayer to extend the statute of limitations on tax assessments. Deciding whether to extend the statute of limitations can have a significant impact on the results of the exam.
From the time a tax return is filed, the IRS generally has three years to assess any additional tax. During the course of an IRS examination, one of the years under examination may be nearing the end of the three-year period. In that situation, the IRS will ask the taxpayer to sign a statute extension or Form 872.
The statute of limitations on assessments requires the IRS to assess any additional tax within three years of the filing of the return. There are exceptional circumstances that may extend the three-year period:
a) If the tax return has a substantial understatement of income based on the proposed adjustments, the statute may extend up to six years OR
b) If a taxpayer fails to file a tax return, or engages in fraudulent or criminal activity, the IRS has unlimited time to make an assessment of tax.
Should a taxpayer agree to extend the statute of limitations? Taxpayers will often feel frustrated when an examination becomes protracted or the two sides seem far apart on the outstanding issues. In most instances, the IRS will ask the taxpayer to extend the statute of limitations for a year or more. Signing a statute extension may seem counterintuitive, but not extending can lead to unwanted litigation.
The consequences of not agreeing to sign the extension places the IRS in a bind. If the IRS does not assess additional tax within the three-year period, the statute of limitations on assessments will bar the IRS from assessing any additional tax. By refusing to extend the statute of limitations, the IRS must then assess tax before the three-year deadline. The IRS can meet this deadline by issuing a statutory Notice of Deficiency or 90-day Letter. In an incomplete examination, the IRS will propose adjustments on the outstanding issues—often assessing the maximum adjustments to protect the service’s position.
Upon receiving the Notice of Deficiency, the taxpayer has limited options to contest the proposed adjustments. First, the taxpayer can petition the United States Tax Court and go to trial. The Tax Court is a court of limited jurisdiction—it only hears tax cases where the taxpayer has received a Notice of Deficiency and has petitioned the court within 90 days. Petitions filed more than 90 days after the Notice of Deficiency has been issued will be rejected. The second option is to pay the amount of the proposed tax deficiency, and sue for a refund of the tax paid by filing a civil action against the government in the United States District Court or the United States Court of Claims.
From a strategy standpoint, failing to sign the statute extension can result in unforeseen and unfavorable problems. The taxpayer may receive unrealistically large proposed adjustments, as the IRS proposes the maximum tax adjustment on issues that are not fully developed. Receiving a 90-day Letter or Notice of Deficiency effectively forces the taxpayer into litigation.
However, the request to extend the statute can provide taxpayers with an opportunity to control the examination. Although the IRS often asks for at least a year on the statute, the taxpayer can request a shorter period to keep the examination moving along. If there are issues in disagreement and the taxpayer elects to have the case heard in the Office of Appeals, a further statute extension can be executed. The taxpayer can also ask the IRS to include language to limit the issues still under examination. Finally, the taxpayer can give the IRS an unlimited statute extension but retain the right to terminate it at any time.
Making a decision on whether or not to extend the statute of limitations can be a tough one. Each taxpayer must weigh the considerations and should consult with their tax advisor to make an informed decision based on their set of circumstances.