If you haven’t been traumatized by an IRS audit, you probably don’t keep much financial documentation. If you have, you are probably terrified to part with a single receipt.

The IRS is one of the few courts where failure to produce proof of your claims results in the assumption that you are guilty of tax fraud. Thus you must save all the financial documents you used to create your taxes to defend yourself in an audit.

First, retain a paper copy or receipt of any tax-relevant financial exchange. Scan these documents and archive them electronically, or acquire them in an electronic format. If the purchase has a manual or warranty, store all the documents in the same electronic and physical location.

Sadly, the IRS has ruled bank or credit card records to be insufficient documentation. As a result, just keep your statements long enough to reconcile your account.

If the purchase was a business or tax-deductible expense, record the expense and why it justifies the deduction. Store this information with or on the receipts.

Second, keep brokerage statements indefinitely for taxable accounts. You are responsible for reporting the cost basis of any security you sell to calculate the capital gains tax. For a mutual fund with 30 years of reinvested dividends, each dividend payment is part of the cost basis. As a result, the cost basis can sometimes be computed only if you have the complete transaction history.

Without knowing the cost basis, the IRS could argue that the entire value of the investment be treated as gain.

If you have lost the record of how much you originally paid for an investment, instead of selling and paying 15% or more of the value in taxes, you can use that investment as part of your charitable giving. Gifting appreciated stock avoids the tax owed and still qualifies for a full deduction. Oddly enough, the IRS still asks for the original purchase date and price for gifted securities, but leaving these blank has no effect on your tax owed.

Many custodians keep several years of electronic copies of brokerage statements available. And they are now required to send any known cost basis electronically when you transfer securities to a new custodian. If your current custodian has the correct cost basis of your securities, you probably no longer need to keep brokerage statements. However, better safe than sorry is always advisable with the IRS.

Third, keep IRA nondeductible contribution records forever. You may need those records every year that you withdraw money in retirement to show that a portion of the withdrawal is not tax deductible.

Or to avoid the hassle, clear out nondeductible IRA contributions by converting all of your IRA accounts to Roth accounts.

Fourth, keep partnership documents, contracts, commission or royalty structures forever. This includes property records, deeds and titles, especially those relating to intellectual property. It also includes any transfers of value for estate planning purposes.

Finally, save all of your tax returns. After you file, save the paper and/or electronic copies with the rest of that year’s financial documents.

Once a year, we scan and compile all the records that support our tax returns into PDF documents and send them electronically to the certified public accountant who does our taxes. Having the information scanned gives us an electronic backup of the paper records that we still retain. Storing financial records electronically is one of the only ways keeping them indefinitely seems realistic.

Tax returns and all the supporting documentation must be kept at least seven years. The IRS can audit your return for up to three years from your filing date. However, the three-year limit only applies to good-faith errors.

If the IRS suspects you underreported your gross income by 25% or more, they have up to six years to challenge your return. And because you may file for an extension at the October 15 deadline, you must keep your records for at least seven years.

Regardless of those rules, though, if the IRS suspects you filed a fraudulent return, no statute of limitations applies. Because the IRS has been proven to be malicious, we suggest keeping your tax returns and documents forever.

If you are unfamiliar with the federal tax courts, the interpretation of the law is anything but clear. Consensus grows gradually as practitioners interpret legal and accounting opinions and then wait to see if the IRS notices and subsequently chooses to challenge them. Then they have to wait for a taxpayer willing to go to court to see which interpretation wins.

It is unreasonable to tell people to settle for the most conservative government-always-wins interpretation. Collectively, trillions of dollars are at stake for individual taxpayers, especially small business owners. The annual differences between interpretations are in the hundreds of thousands of dollars.

Unfortunately, whenever the IRS challenges you, the burden of producing evidence that your claims are true rests entirely with you, so you better have your documentation in order.

Taxpayers collectively spend six billion hours or 8,758 lifetimes annually trying to comply with the tax code. That is, IRS legislation kills the equivalent of 8,758 newborns each year. Such an enormous waste of life is completely unnecessary. Were any private companies responsible for such abuse, we would make laws preventing it.

We could easily abolish the Sixteenth Amendment and replace the federal income tax with a tax on consumption or a poll tax. As an added bonus, in a world without the income tax, you would not be obligated to report your private financial matters to the government each year.

Photo used here under Flickr Creative Commons.