New opportunity for businesses to limit IRS recordkeeping.

One side effect of the information technology revolution has been the need for businesses to manage the enormous increase in information generated. One key concern relates to retaining records no longer needed for day-to-day operations, but that could prove critical if past transactions must be reviewed at some time in the future.

For Federal tax purposes, Sec. 6001 provides that taxpayers must keep such records as the IRS prescribes. Rev. Rul. 71-20 establishes that all machine-sensible data are records within the meaning of Sec. 6001. Rev. Proc. 64-12 provided the first guidelines for taxpayers maintaining records in an automatic data processing (ADP) system; Rev. Procs. 86-19 and 91-59 revised these guidelines. Most recently, the Service issued Rev. Proc. 98-25; as expected, taxpayers and practitioners now are asking what the new procedure means.

Shift in IRS Approach

Rev. Proc. 98-25 presents taxpayers with new opportunities for reducing record retention costs, including the costs of providing a secure storage environment, creating backup copies and testing to confirm record integrity. While Record Retention Limitation Agreements (RRLAs) were referenced in Rev. Proc. 91-59, the new procedure provides, for the first time, that taxpayers may request them. According to IRS officials, the new procedure is intended to be more user-friendly. In addition to authorizing taxpayers to request RRLAs, Rev. Proc. 98-25 provides more specific examples of what records taxpayers should maintain.

From the taxpayer's perspective, however, Rev. Proc. 98-25 may not seem quite as friendly as the Service has suggested. It opens with a requirement that the taxpayer maintain all machine-sensible records that support and verify entries on the return and that are necessary to determine correct tax liability. Failure to comply could result in the imposition of applicable penalties, including the Sec. 6662(a) accuracy-related civil penalty and the Sec. 7203 willful failure criminal penalty. At the same time, the availability of RRLAs is an opportunity to limit the records that must be retained and the attendant costs of maintaining those records.

Over the years, the IRS has done an "about-face" as to its evaluation of a taxpayer's records. In the past, the Service would conduct evaluations of a taxpayer's records to determine exactly which records the taxpayer should maintain. In recent years, however, because of the explosive growth of ADP systems, the IRS found that it did not have enough computer audit specialists (CASs) to conduct these evaluations. Therefore, beginning with Rev. Proc. 91-59, the Service shifted its approach; instead of evaluating a taxpayer's records to determine what should be retained, the IRS now requires the taxpayer to conduct the evaluation and request that specific records be excepted from the requirement. This clearly saves the Service's, but not the taxpayer's, resources.

While taxpayers bear the burden of convincing the Service that certain records do not need to be retained, IRS officials recognized that there may be instances when retention is not necessary. The expansion of the RRLA provision in Rev. Proc. 98-25 reflects this recognition.

Requesting an RRLA

A business should begin the process of requesting an RRLA by performing an analysis of its systems to target specific records that may be candidates for an RRLA. From the taxpayer's standpoint, cost is an important factor (although this would not be a criterion used by the Service). The IRS will make its determination solely on the basis of whether the records are necessary to verify entries on the taxpayer's Federal tax returns.

Caution: Companies must keep in mind that even if the Service agrees that specific records need not be retained for tax purposes, retention may be required by other Federal, state and/or local government agencies. Dealing with the IRS when requesting an RRLA is generally no different than dealing with the Service on any other matter; it requires negotiation, patience and persistence. While the resources required for the IRS to do an RRLA are considerably less than those that were once required for a records retention evaluation, the Service is still concerned about its resource use, because a CAS will have to be used.

At the same time, IRS policy gives appropriate consideration to a taxpayer's request for an RRLA. Thus, if the Service initially rebuffs a business, the business should elevate its request to a higher level within the Service. For example, if the CAS is reluctant to enter into an RRLA, the taxpayer should talk to the CAS'S manager and the case manager. If unsuccessful, the taxpayer may want to meet with the branch chief, division chief or even the district director. At each level, the taxpayer should emphasize that it is trying to comply with the law and is seeking IRS assistance to do so.

There is no "cookie-cutter" format for RRLAs; each one is unique to a taxpayer's circumstances. The Service will look at records on a file-by-file basis, ensuring that it has the data (not necessarily the software or hardware) used to create the tax return. The Service can access the data on its own computers; if the data is converted to a different medium enabling the taxpayer (and the IRS) to access it with a new system, the old software and hardware may not have to be retained. If the taxpayer adds a new system subsequent to entering into an RRLA, Rev. Proc. 9825 provides that the RRLA does not cover the new system (unless otherwise specified in the RRLA); the taxpayer would have to request a new RRLA for the new system.