Record Keeping Requirements For Tax Audit Defense

When to Use

Use this skill when an algorithmic trading operation must be able to substantiate its US federal tax return positions under examination. Active trading generates thousands of taxable events, and IRC § 6001 places the burden of proof on the taxpayer to produce records adequate to establish each position. This engine audits a trade record set for the evidence an examiner will ask for: per-lot cost basis, acquisition and disposal dates, holding-period classification, wash sale determinations, lot-identification substantiation, § 475(f) segregation evidence, and whether any record is about to be purged before its retention obligation has run.

When NOT to Use

• Non-US regimes. Nothing here encodes HMRC, CRA, ATO or any other national rules. See record-retention-periods-by-jurisdiction and multi-jurisdiction-tax-residency-implications.
• Computing tax. This engine checks record defensibility, not liability. For wash sale matching and basis adjustment use wash-sale-rule-tracking-us; for § 1256 contracts use section-1256-contract-tax-treatment-us-futures.
• Broker-dealer books and records. SEC Rule 17a-4 preservation duties are a separate regime binding registered broker-dealers, not taxpayers generally.
• As legal or tax advice. Applicability, elections and limitation periods are fact-specific; a qualified adviser signs off, not this engine.

Prerequisites

• Trade records (trade_id, symbol, side, quantity, price, trade_date, cost_basis_usd, proceeds_usd, acquisition_date, disposal_date, lot_method, lot_identification_date, wash_sale_flag).
• Engine config: retention_years (default 7, a firm policy default — see Workflow step 5), mandatory_fields, accounting_method (CAPITAL or MTM_475F), specific_id_deadline_business_days (default 1, T+1).
• An explicit as_of evaluation date. Omitting it defaults to today and makes audit output non-reproducible run to run.

Workflow

1. Mandatory Field Completeness Audit
   • Flag any record missing a configured mandatory field. Cost basis is the field examinations turn on: without it the IRS may assert a zero basis, taxing gross proceeds rather than gain.
2. Structural Validation
   • Reject unparseable dates, non-BUY/SELL sides, non-positive or non-finite quantities, unknown lot methods, and disposals dated before acquisition. A defective record is reported as data, never raised as an exception — one bad row must not abort an audit run.
   • Flag duplicate trade_ids: a non-unique key means the audit trail cannot tie an entry to a single execution.
3. Holding Period Classification (IRC § 1222)
   • Classify from acquisition_date and disposal_date where both exist. Long-term requires disposal strictly after the one-year anniversary.
   • Where only holding_period_days exists: $\le 365$ is short-term, $\ge 367$ is long-term, and exactly $366$ is ambiguous — that is one year across a leap-day span but more than one year otherwise. Do not guess; resolve it by supplying the dates.
4. Wash Sale Determination (IRC § 1091)
   • Require a recorded wash_sale_flag on every capital-account sell, including a negative determination — silence is not evidence.
   • If the audit runs within 30 days of the sale the replacement window is still open, so any flag is provisional. That is reported as an advisory, not a defect.
   • Skip entirely for securities under a valid § 475(f) election.
5. Lot Identification Substantiation (Treas. Reg. § 1.1012-1(c))
   • Where lot_method is SPECIFIC_ID, require a lot_identification_date no later than the settlement deadline (T+1 for most US securities since 2024-05-28). Absent that, basis reverts to FIFO and the claimed method collapses under examination.
6. § 475(f) Segregation Evidence
   • Where the entity has a mark-to-market election, any security marked held_for_investment must carry an investment_identification_date equal to its acquisition date — IRS Topic 429 requires identification on the day acquired. Such securities stay in the capital account and remain subject to steps 3 and 4.
7. Retention Policy Enforcement
   • The retention clock starts at disposal, not acquisition: IRS guidance is to keep property records until the limitations period expires for the year of disposal. A record with no known disposal date has no purge date at all.
   • Compute earliest_purge_date = disposal_date + retention_years. Flag any record with a pending purge that is not yet eligible, and treat a record under legal_hold as never purgeable.
8. Audit Report Generation
   • Output a TaxAuditComplianceReport separating DEFECT from ADVISORY issues, with per-record RetentionAssessment rationales.

Full procedure: see references/workflows.md. Standards reference: see references/standards.md. Printable pre-flight checklist: see assets/checklist.md.

Common Pitfalls

• Assuming a universal 7-year IRS retention rule. There isn't one. The assessment period is generally 3 years (§ 6501(a)), 6 years where more than 25% of gross income is omitted (§ 6501(e)), and unlimited where no return or a fraudulent return is filed (§ 6501(c)). Seven years is the specific figure for a worthless-securities or bad-debt loss claim.
• Anchoring retention to the trade date. A basis record for a position held ten years is not purgeable after seven — the clock has not started. Purging on record age destroys basis evidence for still-open lots.
• Classifying holding period from a 365-day threshold. Per IRS Publication 550, stock bought 2012-02-06 and sold 2013-02-06 is short-term even though 366 days elapsed. A naive > 365 days test converts short-term gains into long-term ones and understates tax.
• Treating a fresh wash sale flag as final. The § 1091 window runs 30 days after the sale; a determination recorded at trade time can be invalidated by a replacement purchase weeks later. Re-run the determination after the window closes.
• Claiming SPECIFIC_ID without contemporaneous identification. An identification made when the return is prepared is not adequate under § 1.1012-1(c)(1); basis falls back to FIFO, often at a materially worse result.
• Applying wash sale or short/long analysis to a § 475(f) trader. Per IRS Topic 429 neither applies to securities marked to market, and forcing them generates false findings that train reviewers to ignore the report.
• Carrying SEC Rule 17a-4 into a tax retention policy. It binds registered broker-dealers on a 3- or 6-year schedule; it is not an IRS requirement.

Verification

• Instantiate RecordKeepingRequirementsForTaxAuditDefenseEngine. Add 2 complete trade records and 1 record missing cost basis $\implies$ verify AUDIT_ISSUES_FOUND with 1 incomplete record flagged. Add only complete records $\implies$ verify AUDIT_COMPLIANT.
• Holding period regression: classify_holding_period(date(2012,2,6), date(2013,2,6)) $\implies$ SHORT_TERM (the IRS Pub. 550 example), and classify_holding_period(None, None, 366) $\implies$ AMBIGUOUS.
• Retention regression: a BUY dated 2005 with no disposal_date $\implies$ earliest_purge_date is None and purge_eligible is False.
• Run python -m unittest discover -s skills/record-keeping-requirements-for-tax-audit-defense/scripts.

Related Skills

• mark-to-market-election-for-active-traders-us
• wash-sale-rule-tracking-us
• fifo-vs-specific-lot-tax-accounting-methods
• record-retention-periods-by-jurisdiction
• form-1099-b-and-broker-tax-reporting-reconciliation