Maximizing gains from Qualified Small Business Stock (QSBS) involves an understanding of the applicable tax laws. One key factor is the time period the IRS is allotted to retroactively audit reported QSBS, also known as the statute of limitations.
What is a Statute of Limitations?
Broadly speaking, a statute of limitations is a law that defines the maximum time after an event within which legal action can be taken. For the IRS, the statute of limitations refers to “a time period established by law to review, analyze and resolve taxpayer and/or IRS tax related issues” (I.R.C. § 25.6.1). Once a tax return is accepted, the IRS has a certain amount of time within which they can audit that return. After this period expires, no additional tax can be assessed, refunded, or collected.
How Long is the Statute of Limitations for the IRS?
Typically, the statute of limitations for an IRS audit is 3 years from the due date if the return was submitted on time (otherwise, the limit begins on the filing date). However, if a tax return is deemed to have a substantial understatement of reported gross income, then the limit can be extended to 6 years.
For individual taxpayers, the IRS considers an understatement “substantial” if it exceeds either 10% of the tax required to be shown on the return or $5,000—whichever is greater (I.R.C. § 6662). For corporations, the amount is 10% of tax required or $10,000.
How might this impact QSBS holders? Remember that when you sell QSBS, that profit is subject to capital gains tax. Since the gain is usually a one-time lump sum, a taxpayer may be able to exclude some or all of the gain if requirements are met. The current rules (under I.R.C. § 1202) state that a taxpayer can exclude 100% of capital gains on QSBS if:
- QSBS was acquired after September 27, 2010*
- QSBS has been held for at least 5 years
- The stockholder is a person (not a company)
*QSBS issued before Feb. 17, 2009 was eligible for a 50% exclusion, and QSBS issued after Feb. 17, 2009 but before Sept. 28, 2010 was eligible for a 75% exclusion.
Understanding current tax rules is essential to ensuring that you qualify for an exclusion. Otherwise, this may appear to the IRS as a substantial understatement, opening up the opportunity for the IRS to audit up to 6 years of previous taxes.
What is the Maximum Penalty for an Incorrect Return?
In most cases, a substantial understatement will result in a penalty of 20% of the underpayment of tax. Additionally, in the event of an audit, the taxpayer needs to be aware of late payment deadlines. A late penalty will be issued if a taxpayer fails to pay tax that is not reported on their original return within 21 days of the notice date (or 10 business days if the amount in the notice is $100,000 or more). Depending on the situation, the penalty will amount to:
- 0.5% of tax not paid by due date in notice
- 0.25% during approved installment agreement (if return was filed on time, and taxpayer is an individual), or
- 1% if tax is not paid within 10 days of a notice of intent to levy
The taxpayer will also incur a monthly charge on the remaining unpaid tax until it is fully paid.
Did you know that tax return preparers can also incur penalties? The IRS defines a tax preparer as anyone who prepares a “substantial portion” of a tax return or refund claim for compensation or who hires others to prepare returns for compensation.
Current tax rules (under I.R.C. § 6694A) indicate that a tax preparer may not have contributed to a “substantial” portion of the return if:
- The gross income, deduction, or basis for a credit is less than $10,000
- The gross income, deduction, or basis is less than $400,000 and also less than 20% of the gross income on the return
- The tax preparer provided advice before the transaction that led to the position on the return
- After the transaction occurs, less than 5% of the aggregate tax advisory time on the transaction is provided by the preparer
If a return includes an understatement that is deemed unreasonable, the tax preparer must pay a penalty of either $1,000 or 50% of the compensation received by the preparer for this return —whichever is greater.
What are the Chances of an IRS Audit?
The answer to this question will vary based on the taxpayer’s circumstances, especially income level and filing status. Understanding how the IRS audit process works and which red flags they look for can help you avoid examination. Since the IRS has limited resources, they tend to focus attention on higher-income taxpayers who are more likely to have questionable items on their tax returns.
For recent tax audit trends, you can review the 2019 IRS Data Book. Below are notable statistics on returns filed for tax years 2010 through 2018:
- The IRS examined 0.6% of all individual returns and 0.97% of all corporate returns
- The IRS examined 9.26% of taxpayers whose individual returns reported total positive income greater than $10 million
- In FY 2019, the IRS audited 771,095 tax returns and recommended $17.3 billion in additional tax
- In FY 2019, 73.8% of audits were completed via mail (correspondence audit), while 26.2% were done face-to-face (field audit)
What is the Statute of Limitations for State Income Taxes?
Though many states follow the federal 3 year rule for tax audits, there are a number of exceptions. Below are some notable examples of differing state guidelines:
- Oregon: 3 years from the filing date
- Louisiana and New Mexico: 3 years from December 31 of the year your taxes are due
- Kansas: 3 years from the filing date or due date (whichever is later)
- Tennessee: 3 years from the filing date or due date (whichever is later) unless you claim a refund (up to 3.5 years) or the IRS changes your federal return (up to 5 years)
- Minnesota: 3.5 years from the filing date or due date (whichever is later)
- Arizona, California, Colorado, Kentucky, Michigan, Ohio, and Wisconsin: 4 years from the filing date or due date (whichever is later)
- Montana: 5 years from the filing date or due date (whichever is later)
The statute of limitations for the collection of unpaid state taxes also varies by state, ranging from 3 to 20 years for states that levy income tax.
Do I Need to Have Strict Documentation of my QSBS Exclusion?
In the case of an audit, having documentation that your tax returns accurately reflect your financial situation is crucial. Good record-keeping means having proof of when you filed your returns and which forms or figures were included in your returns. If you filed electronically, you will want to keep track of all your electronic data and print a hard copy of your return.
Many tax experts recommend keeping all receipts and backup data for at least seven years, after which they can be destroyed. However, you should never destroy old tax returns or old legal documents that relate to the basis of a company or stock purchase. Even if the company in question was incorporated over a decade ago, be sure to hold onto things like articles of incorporation, operating agreements, and documents for conversion of a legal structure.
Do I Need to Keep Records of my QSBS Exclusion?
The IRS will not require you to report documentation, but the wise course of action is to plan as if an audit is possible and ensure you can substantiate all of your claims. Our article on QSBS documentation lists examples of the documentation you will want to collect when you elect the capital gains tax exclusion.
If you are looking to streamline the documentation of your QSBS qualifications on a company, stockholder, and security level, QSBS Expert provides an assessment tool to help you do just that. We prepare QSBS Corporate Summaries which provide for you and your tax accountant the confidence and evidence you need to take the QSBS exclusion.