Electronic record retention requirements systems.

Editor's note: Mr. Ely is former chair of the AICPA Relations with the IRS Committee. Ms. Totsch, Ms. Butler and Mr. Black are committee members.

The IRS objective under the Internal Revenue Service Restructuring and Reform Act of 1998 is to have 80% of all returns filed electronically by 2007. As a result, an effort is being made to increase dramatically the number of electronically filed returns. This has raised questions about the retention of electronic tax data for individuals as well as for businesses. With the magnitude of transaction detail created by a corporation in the normal course of business, electronic retention of such records becomes absolutely crucial. Further, as companies turn increasingly to Internet-brokered transactions and a paperless environment, if they do not retain detailed records electronically, backup information will not be available to explain or verify transactions.

Retention Requirements

The recordkeeping requirements of Sec. 6001 apply to all taxpayers (including businesses), regardless of whether returns are filed electronically. Under Regs. Sec. 1.6001-1(a), taxpayers must keep all books and records (including inventory) sufficient to document the income, deductions, credits and other items included in a tax return. Under Regs. Sec. 1.6001-1 (e), taxpayers must retain books and records as long as the contents might become material to the administration of any internal revenue law.

Rev. Proc. 98-25 amplifies Sec. 6001 by giving taxpayers comprehensive guidance on requirements for keeping electronic tax records and providing the Service access to them. The procedure applies not only to electronically maintained income tax records, but also to excise, employment and estate and gift tax records, as well as tax records for employee benefit plans and exempt organizations. Citing Regs. Sec. 1.6001-1(e), Rev. Proc. 98-25 requires taxpayers to retain electronic or machine-sensible records used to record the business activities of a venture. Such materiality would continue at least until the end of the statutory period of limitations (including extensions) for each tax year. When considering a net operating loss carryforward (up to 20 years) or fixed-asset information until its disposal or full depreciation (up to 40 years for certain real property), the period for some data retention goes well beyond the basic three-year statute of limitations for a standard tax return.

Rev. Proc. 98-25 provides that machine-sensible records must provide sufficient information to support and verify entries made on the taxpayer's return and to determine the correct tax liability. This requirement is met only if the electronic records reconcile with both the taxpayer's books and return. The electronic records must also contain adequate transaction-level detail so that the information and the source documents supporting the records can be identified.

All machine-sensible records that require retention must be capable of being processed. The revenue procedure defines "capable of being processed" as the ability to retrieve, manipulate, print hardcopy and produce output on electronic media. Additionally, such records must be capable of being produced on the IRS's request.

As companies continue to emphasize operational productivity and administrative efficiency to maintain competitiveness, they require increasingly sophisticated tools to support their internal business processes. This often entails the implementation of new technologies, including the update of enterprise resource planning (ERP) systems. Failure to cover all bases during conversion to new systems, which includes assurance that prior system data is available, could prove costly.

Under Rev. Proc. 98-25, if any machine-sensible records are lost, stolen, destroyed, damaged or otherwise no longer capable of being processed, the taxpayer must promptly notify the District Director (or the equivalent under the new IRS structure) and provide a plan that demonstrates how it will continue to meet all of the requirements of Rev. Proc. 98-25 for the affected records.

Unfortunately, companies that replace obsolete and outdated hardware and software systems with the latest ERP systems do not always consult their tax department. Although not an easy task, companies must maximize interdepartmental coordination between tax and information technology to reduce the risk of not complying with electronic record retention requirements. In addition, proper configuration of the system for tax purposes can be done only prior to ERP implementation. This saves a considerable amount of money, as fewer adjustments would have to be made to a fully operational system.

If the new system cannot process the machine-sensible records maintained by the original system, the taxpayer must notify the District Director and propose a plan for assuring that the electronic records created and maintained by the original system continue to be capable of being processed. If the data is not accessible, the Service could require the taxpayer to recreate or reprocess a complete set of accounting records on a compatible system or to reformat the data.

If the IRS discovers on audit that the taxpayer could not trace electronic transactions back to their original source documents, it could theoretically disallow many business expenses for lack of documentation. In addition, taxpayers incur penalties for failure to comply with Rev. Proc. 98-25, including the Sec. 6662(a) accuracy-related civil penalty and the Sec. 7203 willful failure criminal penalty.

Record Retention Agreements

Rev. Rul. 71-20 offers taxpayers the potential to alleviate some of the electronic record retention burden with a Record Retention Agreement (RRA), limiting the responsibility to a select list of records. Rev. Proc. 98-25 modified the RRA procedure, substituting a Record Retention Limitation Agreement (RRLA) in most cases for an RRA. Like an RRA, the RRLA provides for the maintenance of electronic records as agreed on by the District Director and the taxpayer, but it reverses the concept. While it can specifically eliminate retention of machine-sensible records not pertinent to Federal tax matters that may surface in future IRS examinations, by default it requires retention of everything else. The taxpayer initiates a request to the IRS to enter into an RRLA, identifying all records that it feels should not be retained and explaining why those records will not become material to the administration of any internal revenue law. The District Director decides whether or not to enter into an RRLA with the taxpayer.

Companies should analyze the need to address their data archival requirements for tax purposes. If a company implements an ERP system without IRS electronic record retention in mind, it may not be in compliance with Rev. Proc. 98-25. A tax record retention solution must select and extract complete content, and provide mechanisms to store and retrieve data. It is imperative that record retention services be considered when:

1. The company's Federal (and state) returns are prepared from summary computer-generated financial reports, such as a general ledger and an income statement.

2. There is potential difficulty in tracing specific account or return line items back to original detailed source documents.

3. The company has implemented an ERP software package.

4. The company's internally developed financial system is based on relational database technology.

Conclusion

Taxpayers' electronic record retention responsibilities are in addition to their responsibility to retain hardcopy records created or received in the ordinary course of business, as required by long-standing law and regulations. Companies may retain hardcopy in microfiche or microfilm format in accordance with Rev. Proc. 81-46. Alternatively, Rev. Proc. 97-22 addresses the use of an electronic imaging storage system. While they may contain automated or electronic features, these other storage arrangements are not a substitute for the machine-sensible records that companies must retain under Rev. Rul. 71-20 and Rev. Proc. 98-25.

FROM MELISSA W. TOTSCH, CPA, ERNST & YOUNG LLP, DALLAS, TX

Mark H. Ely, J.D., CPA
Partner
Washington national Tax
KPMG LLP
Washington, DC