Tax Collectors vs. Your Digital Records

Can the IRS Obtain Original Computerized Bookkeeping Files?

As more businesses and individuals turn to computerized recordkeeping systems, the IRS is working to scrutinize those records more closely. As part of its routine records requests in audit cases,
the IRS asks for the production of original computer files (not just the paper printouts) from programs such as QuickBooks, Quicken, MS Money, Peachtree, etc., and in some cases, tax preparation software, such as TurboTax.

Why does the IRS want the computer files? Aren’t the printouts sufficient to provide the needed data?

In addition to the printouts, the IRS is looking for the so-called “metadata.” This is the behind-the-scenes data generated by the software (not the operator) that records how, when and by whom a particular item or set of information was collected, created, accessed, modified and formatted. This data is automatically created as the software is accessed and used in the day-to-day course of operations. QuickBooks stores this metadata in what it calls an Audit Report file.

Why Seek the Electronic Records?

The IRS summarizes the need to review such data as follows:

In many instances, the Service’s examinations would be advanced by accessing metadata that identifies the original date a transaction was entered in the electronic records, the dates of any changes to the
entries, and the username of the person who made the entries. The value inherent in an examiner’s ability to obtain the date and source of recorded entries is self-evident…
” (IRS Chief Counsel Advice Memo. 2011-46017, November 11, 2011, pg. 3.)

It should come as no surprise that the IRS’s position is that a taxpayer must release a copy of the original computer files generated by the accounting software. As stated in the Chief Counsel Advice Memo quoted above, if an examiner can point to changes, additions or deletions in the computer file, that might somehow undermine (or support) the correctness of the tax return.

It should also not surprise anyone that the IRS believes it can summons the data if the taxpayer refuses to produce it. Code §7602(a) gives the IRS the authority to summons “any person” in connection with “ascertaining the correctness of any return, making a return where none has been made, determining the liability of any person for any internal revenue tax or the liability at law or in equity of any transferee or fiduciary of any person in respect of any internal revenue tax, or collecting any such liability…

“Any person” can be not only the taxpayer, but the taxpayer’s bank, investment manager, employer or employees, business partners and associates, tax return preparer, attorney, even friends and neighbors.

Moreover, the summons authority extends not just to obtaining the testimony of such persons. The law goes on to give the IRS the authority to “examine any books, papers, records, or other data which may
be relevant
or material to such inquiry
” (emphasis added). I’m sure you’ll agree that this is very broad language indeed.

The “may be relevant” language is the key to the broad sweep of the law. For example, it is not necessary that the IRS prove—or even allege—that there is a mistake, discrepancy or even so much as a
potential error in the return. The law allows the IRS to summons for the purposes of “determining the correctness of any return.”

What You Have to Show to
the IRS and What You Don’t

Most small business owners using the likes of QB make numerous errors in their accounting processes and most have no idea they’re doing so. I can take a look at a QB profit and loss statement prepared by an uninformed small business owner and spot several errors right off. Why show such a document to the IRS, especially in a collection situation where the IRS is trying to determine one’s collection potential?

IRS auditors are quick to threaten summonses whenever a taxpayer “fails to cooperate” precisely because they know that the summons authority is very broad, as I explained above. Therefore, you
cannot flatly refuse to provide information. But that doesn’t mean you necessarily have to provide the specific information the agent asks for.

If you produce source documents and make it clear that the source documents are complete and accurate records that correctly show the receipt of income, I believe you can avoid the summons
confrontation in the first place.