New law prohibits IRS summons of tax software and source code.

The IRS Restructuring and Reform Act of 1998 (IRSRRA) provides major protection to corporations using commercial tax software. In the recent past, the IRS has aggressively sought full access to commercial tax software used by taxpayers in preparing taxpayers' returns. In many instances, the Service has issued summonses to obtain this software, including its source code. (This source code is the programming language underlying the software.)

The IRS's ability to obtain a taxpayer's commercial tax software and source codes for purposes of assisting its field agents with the examination of taxpayers' tax returns has spawned significant litigation. For example, in Norwest Corporation, 111 TC No. 5 (1998), the Service sought to enforce a designated summons directing Norwest to produce tax preparation software licensed from Arthur Andersen LLP. The court denied Norwest and Arthur Andersen's motions to quash the summons, compelling them to hand over the tax software. Similarly, in Caltex Petroleum Corp. (DC Tex. 1998), the IRS sought to enforce a designated summons issued to Caltex to produce tax software licensed from Price Waterhouse LLP. Although the Service's summons was prima facie valid, the court granted Caltex's motion to quash. In denying access to the computer source code, the court used its equitable powers to prevent undue burden and hardship, as well as to protect Price Waterhouse's competitive position in the marketplace.

The IRS's recent zeal in this area has caused concern in the tax community and Congress. One problem in granting the Service access to the tax preparation software is that it could easily allow it to perform "what if" computations, comparing different potential tax adjustments. Another problem is that most commercial tax software licensing agreements prohibit users from providing copies to anyone (including the IRS). While the Service wants access to these computer programs, it does not wish to purchase the software outright and otherwise be limited by the typical licensing agreement. In addition, software creators have concerns about losing their intellectual property rights through uncontrolled distribution of their products.

Congress responded to all of these issues in the IRSRRA. Specifically, the IRS is now prohibited from issuing or beginning an action to enforce a summons to obtain any portion of computer source code unless it satisfies specific requirements. The IRSRRA provides exceptions to this general prohibition for criminal matters, for software created by a taxpayer or a related party and for situations in which the IRS is unable to otherwise reasonably ascertain the correctness of an item on a return, after making a good faith, bona fide effort to ascertain correctness.

The IRSRRA also protects against disclosure and improper use of trade secrets and confidential information incident to the examination of any summoned computer software program or source code. For example, the IRS must account for all software use and copying. In addition, the software or source code must be maintained in a secure area, generally may not be removed from the owner's place of business and may be examined only in connection with the examination of the return summoned. The IRSRRA specifically provides that computer software or source code obtained by the Service in the course of the examination is included and protected under the definition of return information under Sec. 6103.

FROM DANIEL C. BRAUWEILER, CPA, AND JEFFREY M. WRIGHT, J.D., HOUSTON, TX