Nullifying IRS access to tax preparation software.

A U.S. magistrate judge recommended that the U.S. District Court for the Northern District of Texas quash three summonses the IRS issued to obtain access to tax software programs on the grounds that their enforcement would constitute an abuse of the court's process (United States v. Caltex Petroleum, et al., no. 3-96-CV-2726-X, April 16, 1998).

Caltex has undergone a five-year audit of foreign tax credits claimed for 1987-1990. The IRS issued summonses for copies of the international and foreign modules of the Tax Management System (ITMS/FTMS), now owned by Computer Language Research Inc. (CLR), as well as the source code and related documentation used in computing foreign tax credits. Although Caltex and CLR claimed they had gone to some lengths to provide the IRS with other software and materials it could use to audit Caltex's data, the IRS insisted that they provide, in executable and readable formats, the software used in the original computations.

Magistrate Jeff Kaplan applied the legitimate purpose and relevancy tests set forth in United States v. Powell (379 U.S. 48, 1964) to determine whether to enforce or quash the summonses. Citing the Eighth Circuit's decision in United States v. Norwest (116 F3d 1227, 8th Cir. 1997), the magistrate concluded that the summonses had at least one legitimate purpose--helping the IRS determine Caltex's liability--and that the summonsed information was relevant to the audit because Caltex used the ITMS/FTMS program to calculate foreign tax credits. Kaplan also concluded that the source code could be summonsed because Caltex adopted the computer's computations.

Nonetheless, the magistrate recommended quashing the summonses because enforcement would constitute an abuse of process. According to Kaplan, the evidence showed that the IRS issued the summonses for an improper purpose--gaining unrestricted access to the source code for all tax preparation software programs. According to the magistrate, the IRS did not need the ITMS/FTMS source code to audit Caltex's returns, it ignored all other means of obtaining the information necessary to complete the audit and it refused to use its own computer program to verify Caltex's foreign tax credits.

Observation. Kaplan took the debate over IRS access to tax software to a new level by accepting the "abuse of power" argument put forth by Caltex and CLR. The many taxpayers who also face IRS demands for access to software should welcome this decision with caution. The magistrate's recommendations face challenges before the district court and, probably, the Fifth Circuit.

The IRS Restructuring Act of 1998 (H.R. 2678) would impose limits on the IRS's ability to issue summonses for software source codes and would safeguard source codes provided under summons.

Tracy Hollingsworth, Esq., staff director of tax councils at Manufacturers Alliance, Arlington, Virginia.