IRS Issues Guidance on Maintenance of Electronic Tax Records

The IRS has issued a Revenue Procedure providing guidance to taxpayers that maintain electronic or "machine-sensible" tax records. The Internal Revenue Code and Treasury Regulations require that taxpayers maintain and keep books and records sufficient to establish the amount of gross income and deductions required to be shown on their tax returns. Such records must be kept available at all times for inspection by the Internal Revenue Service and must be retained until the contents of those records are not material to the administration of any internal revenue law. This will be referred to hereinafter as the Retention Requirement. Records generally must be kept until the expiration of the statute of limitations for the tax year to which they apply (i.e., generally three years after the date on which the tax return is filed, but increasing to six years in certain cases). For records relating to fixed assets and LIFO inventory, however, the retention period will be longer.

The IRS has previously ruled that all machine-sensible data used for recording, consolidating and summarizing accounting transactions and records within a taxpayer's automatic data processing ("ADP") system are records that must be retained under the Retention Requirement. Except as provided in the new Revenue Procedure, the Retention Requirements that apply to hard-copy books and records apply equally to machine-sensible books and records that are maintained within an ADP system.

The Revenue Procedure applies to all taxpayers with assets of $10 million or more at the end of any taxable year, and to taxpayers with less than $10 million of assets at the end of any taxable year if: (i) all or part of the tax information required to be maintained is maintained only in electronic form; (ii) electronic data was used for computations that cannot reasonably be verified or recomputed without a computer (e.g., LIFO inventories); or (iii) the taxpayer is notified by the District Director that electronic data must be retained in order to comply with the Retention Requirement.

Electronic Data Retention Requirements

The Revenue Procedure provides that machine-sensible records (i.e., data in an electronic format that is intended for use by a computer) must be retained in accordance with the Retention Requirement. A taxpayer's disposition of a subsidiary corporation does not relieve it of its record maintenance requirements with respect to the electronic data. The IRS may conduct a records evaluation at any time to review the taxpayer's record retention practices. In addition, the IRS may periodically test the authenticity, readability, completeness and integrity of the taxpayer's electronic data retained in conformity with the Revenue Procedure.

Machine-sensible records must provide sufficient information to support and verify the entries made on the taxpayer's return and the taxpayer must be able to verify that the machine-sensible records reconcile with the taxpayers books and tax return. The Revenue Procedure provides guidance for demonstrating this relationship.

All machine-sensible records required to be retained in accordance with the Revenue Procedure must be made available to the IRS upon request and must be capable of being processed (i.e., able to be retrieved, manipulated, printed on paper, and used to produce output on electronic media). A taxpayer may create files solely for the use of the IRS. For example a taxpayer using a database management system ("DBMS") may create and retain a sequential file that contains the transaction level detail from the DBMS and otherwise meets the requirements of the Revenue Procedure. The taxpayer must be able to document the process used to create the sequential file to demonstrate the relationship between the file created and the original DBMS records. A taxpayer that uses EDI technology (i.e., computer-to-computer exchange of business information) must retain electronic data that alone or in conjunction with other records (e.g., contracts, price lists, etc.) contains information that satisfies the Retention Requirements. For example, if the electronic data retained does not itself include complete data regarding the transaction, the taxpayer must supplement it with data (either electronic or hard-copy) that provides complete information.

Documentation of Business Processes

The taxpayer must maintain and make available to the IRS documentation of the business processes that: created the electronic data; modify and retain the data; satisfy the Revenue Procedure requirements that the electronic data support and verify the entries made on the taxpayer's return; and evidence the authenticity and integrity of the taxpayer's records. This documentation must adequate to identify how the data is processed by the taxpayer's system (i.e., what functions are performed), the internal controls used to ensure accurate and reliable processing and prevent unauthorized changes to the records, and the charts of accounts and detailed account descriptions. This includes information regarding formatting, field definitions, and file descriptions.

Resources Made Available to IRS

If the taxpayer is being examined, the taxpayer must provide the IRS with resources that are necessary to process the taxpayer's electronic data. This includes appropriate hardware and software, terminal access, computer time, and personnel. The taxpayer may be permitted to convert the electronic data to a different medium (i.e., from mainframe files to microcomputer diskettes), and may satisfy the IRS processing needs during off-peak hours or with third party equipment. Taxpayers' ADP systems may not be subject to any agreement (e.g., contract or license) that would limit the ability of the IRS to access and use the system on the taxpayer's premises (or other location where the system is maintained).

Maintenance of Electronic Data

The Revenue Procedure does not require any minimum maintenance procedures, but does recommend practices such as labeling of records, providing a secure storage environment, creating back-up copies, selecting an off-site storage location, and testing to confirm records integrity. The National Archives and Record Administration Standards for the Creation, Use, Preservation, and Disposition of Electronic Records is cited as an example of a records management resource.

Loss of Data

The Revenue Procedure requires that taxpayers notify the IRS if any electronic data is lost, stolen, destroyed, damaged, or otherwise no longer capable of processing, or is found to be incomplete or materially inaccurate. The loss of only a portion of data from a particular storage unit need not be reported. The notification given to the IRS must identify the affected records and include a plan describing how and when the records will be recovered or replaced.

Record Retention Limitation Agreements

Taxpayers maintaining electronic data may request to enter into a record retention limitation agreement with the IRS. Such an agreement provides for the establishment and retention of electronic data in accordance with the agreement, and may waive compliance with requirements of the Revenue Procedure.

Maintenance of Hard-Copy Records

Hard-copy records that are created in the ordinary course of business must be retained in accordance with the Retention Requirement regardless of the taxpayer's compliance with the electronic data retention requirement of the Revenue Procedure.

Penalties for Noncompliance

The IRS may issue a notice of inadequate records if a taxpayer fails to comply with the Revenue Procedure. Such notice would require that the taxpayer keep records in accordance with the notice and the Revenue Procedure. Taxpayers failing to comply with the Revenue Procedure may be subject to accuracy-related penalties under the Internal Revenue Code, and if there is willful failure to comply, criminal penalties may be imposed.

For further information, please contact Kirk H. O'Ferrall at our New York office.