IRS Audits and your QuickBooks Data File

The IRS has been training revenue agents on how to use QuickBooks, and they may request your QuickBooks company file as a part of an audit. What does this mean to accounting professionals and their clients? This has been a hotly debated topic – let’s take a look at the facts.

The first I heard that the IRS might be asking for a copy of the QuickBooks data file was in a June 2010 message to one of the tax study groups in Yahoo Groups. A group member reported to the others on one of the topics discussed at an IRS liaison meeting:

QuickBooks rolled out to all of their revenue agents recently.

At first I was concerned, but as I thought about the implications I realized that taxpayers have always been required to retain the records backing up their tax returns, and IRS has always been able to ask to examine those records.

About a year has passed now and there have been more discussions and more releases from IRS on the subject.

Preserving Records

Internal Revenue Code§ 6001 requires a taxpayer to maintain books and records that substantiate income, deductions, and credits, including adequate records to substantiate deductions claimed as trade or business expenses. Along with loss of deductions, negligence penalties may also be assessed if a taxpayer has failed to maintain required copies of historical records to substantiate a tax return

To quote a statement from an IRS liaison officer -

“IRS has found that many taxpayers do not save hard copies of their records or the copies they have are incomplete.”

As a matter of fact, in a quick review of a handful of record retention guidelines that can be easily found with Google on some CPA and other accountant’s websites, it is clear that keeping a copy of the general ledger, whether in printed form or as an electronic data file, is not always included in the lists of things to keep. Bank statements, invoices, paid bills, etc. and all that are mentioned consistently but not always general ledgers and trial balances.

This may be due to an impression that small businesses and in particular small business software were exempt from some of the electronic recordkeeping requirements that big corporations have long been living with. But it is becoming clearer that it was a false impression.

Revenue Procedure 1998-25 states in part:

“(2) A taxpayer with assets of less than $10 million at the end of its taxable year must comply with the record retention requirements of Rev. Rul. 71-20 and the provisions of this revenue procedure if any of the following conditions exists: (a) all or part of the information required by § 6001 is not in the taxpayer’s hardcopy books and records, but is available in machine-sensible records; (b) machine-sensible records were used for computations that cannot be reasonably verified or recomputed without using a computer (e.g., Last-In, First-Out (LIFO) inventories); or (c) the taxpayer is notified by the District Director that machine-sensible records must be retained to meet the requirements of § 6001.”

A too-quick read of those words would focus on the $10 million cutoff and skip over the qualifications. But the IRS web site states (see Q6):

“Revenue Procedure 1998-25 does not exempt a taxpayer from providing electronic records, if such records exist.”

In early 1999 an analysis and critique of Revenue Procedure 1998-25 in The Tax Executive magazine pointed out that:

“A taxpayer is required to promptly notify its District Director in the event that records are lost, stolen, destroyed, damaged, or otherwise no longer capable of being processed.”

How many small businesses notify IRS if their computer crashes and they lose their data? Or if they update software and the data file has to be reformatted to work with the new software?

This represents one of the great opportunities for the tax professionals: Helping clients to make sure that they have the records that they are required to keep, and that they keep them as long as they should. This is not to say that it hasn’t always been important, but additional publicity can make the advice more effective. It is certainly getting more notice now because the press releases and other things are specifically mentioning the accounting software applications. And because QuickBooks is predominant that is the one that is getting the most air-time.

The requirements for preserving electronic records potentially include more than just the transactions stored in the accounting software. The history of IRS rules is that Revenue Rule 71-20 addressed the existence of computerized records – punch cards, mag tape, etc. – and Notices 1996-09 and 1996-10 come along and give recognition to the growing practice of scanning and destroying documents and only keeping the images in the paperless environment. The point here is that the regulations on what records to keep have expanded to include not only the accounting transaction files – general ledger and related subledgers – but the scanned documents that are part of some business’ paperless management practices as well.

Locating copies of notices, revenue procedures and revenue rulings dealing with electronic record keeping would add very valuable resources to anyone’s tax library. Many of these relevant documents have been collected and made available on the University of Iowa website.

I should point out that while QuickBooks is frequently mentioned in any discussion of this topic, Peachtree, MAS 90, Dynamics GP, BusinessWorks, and any other brand of software, are equally subject to the same rules and regulations.

Responding to Requests

When a QuickBooks user reports that there is an examination by IRS and a copy of the data file is requested, a common response has been to say variously that a new file can be created and then transactions for the relevant year transferred, or that the transactions can be exported to Excel or that the reports can be printed to paper and given to IRS instead of a copy of the data file.

A better response would be for the taxpayer representative to talk with the requestor about whether that is necessary or whether some other format or a more limited collection would be acceptable.

In a worst case scenario, an insistent request for a copy of the data file that is met either with flat refusal or by handing over something that was altered or newly created in response to an Information Document Request could be interpreted as one of the “Badges of Fraud” that leads to further investigation.

The IRS says, in a FAQ page:

“If the taxpayer or representative creates or reconstructs a new company file, for example, by re-inputting the transactions for only the year under examination, this new file does not satisfy the requirements or needs of the IRS. The new or modified company file is not a copy of the books and records of original entry. The altered electronic file would not meet the requirements of the Information Document Request or a summons and the taxpayer’s representative could be in violation of Circular 230.”

That being said, there is no information yet that IRS will ask for a copy of a computer data file in all cases. Nonetheless small business taxpayers should be staying in compliance by keeping the required records as described in these new IRS documents so they will be ready if questions do come. The policies and procedures that IRS is applying to small business audits and electronic records are developing as you read this, but it would be risky at this point to parse the requirements too finely, and not take the words in their plain meaning.

See our Resource PDF file for a complete list of useful resource links on this topic.

Tags: Company File, IRS, QuickBooks

Category: For Consultants/Accountants, For Small Business Owners, Working with QuickBooks