A long-standing debate in many audits has centered on records-and the preferred format of those records-that taxpayers and practitioners make available. Tax practitioners have tried to limit the records they provide to the IRS in an audit to control the depth of the IRS inquiry. IRS agents are now starting to request client back-up files from QuickBooks and Peachtree software, and many practitioners are alarmed about how much information the IRS is requesting, and how the IRS is using the information.
This article explores the IRS' legal authority and long-standing use of electronic records in audits and takes a closer look into the practices of the IRS and CPAs in requesting, providing and using electronic files. It offers tips for practitioners in responding to IRS requests for small business accounting files and for their clients in adjusting bookkeeping practices to minimize undue IRS inquiry during a small business audit.
Background
For years, the IRS has used taxpayer electronic files when auditing large and mid-sized businesses that used proprietary electronic accounting systems. Computerized records became the standard in the 1970s, creating the need for the IRS to establish methods to audit electronic records. The IRS employed computer audit specialists, who were large business auditors trained in extracting and examining data files most often obtained from proprietary accounting systems. They streamlined IRS audit processes by creating sophisticated queries and programs that extract and analyze the most relevant data.
As smaller organizations and businesses began to use electronic accounting systems, the need for computerized audit techniques increased. Many small businesses use off-the-shelf accounting software, with reportedly more than 85 percent using QuickBooks. With electronic recordkeeping becoming the norm, the IRS needed to change with the times. This change brought the opportunity to make IRS audits more efficient by accessing and using the most common programs.
In October 2010, partially at the request of tax practitioners during IRS focus groups, the IRS announced it was expanding its audit capabilities by training a cadre of agents to be proficient in auditing QuickBooks and Peachtree accounting files. The IRS said it wasn't favoring any particular software, but QuickBooks and Peachtree were logical choices for the initiative because they were predominant in the small business market and relatively simple to use. According to the IRS, it has trained 1,100 revenue agents and has given them copies of the software to become proficient in using them and other programs in the future. It also encouraged agents to start requesting electronic files from taxpayers and practitioners.
In a March letter to Christopher Wagner, former commissioner of the IRS Small Business/Self-Employed (SB/SE) division, the American Institute of CPAs expressed concerns about the presumption of efficiency in using computer files to audit small business taxpayers. Patricia Thompson, chair of the AICPA Tax Executive Committee, cautioned in the letter that electronic records from large and small businesses are not comparable.
"The large (business) taxpayer undergoing an IRS examination is routinely represented by tax professionals, and the data being turned over in electronic format does not contain extraneous information unrelated to the LB&I (Large Business and International) examination involved," Thompson stated. "By contrast, because the small-business taxpayer often maintains his own accounting software file and is not a trained bookkeeper or accountant, the data in the software file is not necessarily directly relevant to the IRS examination."
IRS Authority to Request Electronic Records
It's clear in IRS regulations and precedent that electronic records can be requested and used in audits.
Internal Revenue Code section 6001, Treasury Regulation 1.6001-1(a), and Revenue Procedures 71-20 and 98-25 provide the IRS with broad authority to examine electronic records to establish the taxpayer's correct tax liability. Regulation 1.6001-1(e) requires the taxpayer to make these records "at all times available for inspection by authorized internal revenue officers or employees, and shall be retained so long as the contents thereof may become material in the administration of any internal revenue law."
Revenue Procedure 98-25 allows for a small business exception ($10 million and less in assets) to the recordkeeping requirements. But the exception does not apply if "all or part of the information required by section 6001 is not in the taxpayer's hardcopy books and records, but is available in machine-sensible records (electronic books and records)." Because most small businesses store all or part of their information electronically, the exception is obsolete.
The IRS set precedent for requesting and using these files in 1971 with Revenue Procedure 71-20. Revenue Procedure 98-25 removed any confusion about whether the IRS has a right to electronic records. If these records exist, the taxpayer must provide them upon request. These administrative precedents for electronic files in audits have been consistent for the past 40 years.
Be Careful What You Ask For
According to the IRS, the push to start using small business accounting files in audits originated with feedback from tax practitioners in 2008 focus groups. Practitioners indicated they wanted the IRS to be more efficient in examining records and reduce the volume of paper involved in audits. The IRS saw this as a win in making audits more efficient for its agents. Also, IRS auditors prefer reviewing and assessing the original books of entry-not translated or interpreted versions-to evaluate audit trails and the reliability of records.
The push for more electronic records in the hands of IRS agents has not been entirely driven by CPAs and tax practitioners. On May 27, the IRS modified its Internal Revenue Manual (IRM) to provide guidance and rules on how revenue agents should evaluate taxpayers' electronic books and records. The IRS description of electronic books and records also includes taxpayer websites, e-commerce activities and web marketing material, which the IRS finds useful for audit trails in tracing income, such as e-payments.
The recent IRM update also provides insight into how the IRS views electronic records. In the IRM 4.10.4.3.7.5(6), the IRS expresses some skepticism about the reliability of electronic records and provides guidance to agents on what to look for in evaluating these records.
"Electronic records are, in general, considered less reliable than paper counterparts due to the ease at which they can be manipulated," the IRM states. "Software may include features to create a second set of books and records, or allow manipulation of sales by reducing and/or deleting of sales transactions entirely."
This IRS perception is feeding practitioner concerns about how the IRS will review taxpayers' electronic records. Many practitioners question how, if the IRS is skeptical of small business electronic records, the records could make IRS audits more efficient.
CPA Jason K. Hamilton of the firm Decosimo, CPAs, in Knoxville, Tenn., points out this concern. "SaaS applications like QuickBooks and Peachtree have taken the bookkeeper out of the process - and business owners do not necessarily make good bookkeepers," he said.
Hamilton pointed out that he has to correct many entries made by business owners who try to keep their own records. "As a result, the QuickBooks file looks like the client is a poor record keeper or is trying to change what actually happened when, in fact, they just did not understand how to account correctly for some transactions," he said. Hamilton is concerned that the IRS will jump to conclusions by perceiving these errors as clients attempting to manipulate books and records.
F. Whit Addicks, a CPA in the firm of Addicks CPA, has received an IRS request for QuickBooks records in a small business audit. He said his firm wants to supply the IRS agent with the information needed, but that he shares the concern of many practitioners about providing the entire back-up file to the IRS. In response to IRS Information Document Requests, Addicks said that he has provided only summaries of information that was outside the year under audit. "We explained what we gave to the agent and how we summarized the prior year information, and the IRS appeared to be OK with it," he said.
The IRS has commented publically about taxpayers providing redacted prior year files. On April 20, Wagner addressed the redaction issue in a letter to the AICPA. In the letter, Wagner confirmed the long-standing position of the IRS to have original documentation in an audit.
"It is important an exact copy of the original electronic data file be provided to the examiner and not an altered version. Only an exact copy of the original file includes the unaltered metadata which allows examiners to properly consider the integrity and veracity of the electronic files through use of such means as reports generated by the software program that may help to identify deleted or altered entries. For example, the original data file may provide the date a transaction was originally created, dates of subsequent changes, what changes were made, and the username of the person who entered or changed that transaction. This type of information is directly relevant to the evaluation of the taxpayer's internal controls."
Wagner said that it's acceptable for practitioners to "condense" prior-year information "as long as the condensed data does not include transactions created or changed for time periods under audit, or for transactions from prior years that have an effect on the years under audit." That is exactly what Addicks did, he said. "We gave the auditor condensed versions of the prior years' data, and they seemed fine with it," Addicks said.
Wagner also noted a software limitation best solved by software companies - allowing single-year files in the back-up process. Wagner suggested that before a long-term solution is found, taxpayers and practitioners should consider making their own back-up files for individual years.
CPA Danny Snow, who chairs the AICPA IRS Practice and Procedure Committee, eagerly awaits the IRS position on redacted files. "We are aware that CPAs are providing selective data using vendors such as QB or not QB," he said. "We are waiting to see if the Service challenges the altered files because critical audit trails may be deleted when providing the selective data." Snow said that the IRS has used restraint so far and that the new SB/SE Commissioner Faris Fink appears to want to work closely with the AICPA on this issue.
Hamilton, who sits on the Tennessee Society of CPAs Federal Tax Committee, said that some Tennessee CPAs have been hiring firms to parse only the data needed for the year in question. "It costs about $300 to have it done, but it comes down to a liability issue for the CPA," he said. Hamilton said that if CPAs disclose more than necessary in an examination, they could expose themselves to professional liability.
In fact, practitioners have raised that concern with the IRS. In the IRS Issue Management Resolution System (IMRS), IRS stakeholder liaisons have been pondering the malpractice question from practitioners. In March, as a result of inquiries by practitioners, the IRS posted IMRS Issue 11-0001433, Disclosure of excess information when QuickBooks provided during audit.
Specifically, the IRS liaisons were asked to comment on the question of practitioner liability when turning over electronic records, and whether practitioners can obtain assurances that the IRS will not use or view other years' information. But the IRS has made no comment. In the June 2011 IMRS Quarterly Review, released July 5, the IRS did not comment on or address the QuickBooks issue-nor was it listed as a "hot" issue topic.
The IRS in Training?
For most IRS revenue agents, using electronic records in small business audits is a relatively new approach, becoming increasingly prevalent since October 2010. The IRS has more than 14,000 agents, and only 1,100 have been trained in the use of QuickBooks and Peachtree. Clearly, this IRS audit technique is in its infancy. There's evidence in current audits that the IRS is still learning how to use these electronic files and, as a result, has not established a standard operating procedure.
Some CPAs are optimistic that using electronic files could streamline the audit process. Hamilton is optimistic, but proceeds with caution for his clients. "If the IRS uses discretion and understands that the QuickBooks data may not be complete, then use of these files may actually make a more efficient audit," he said. "However, until CPAs are assured that the IRS will not make premature judgments and look at more than the year under audit, we must take precautions for our clients." Hamilton advocates written communication with the auditor to be clear about which electronic records are being delivered to the IRS and the scope to which the IRS is going to use them.
Other IRS audit activity also suggests that the IRS is still training on the issue. Most of the requests for electronic files have been informal requests or on Information Document Requests. Neither Addicks nor Hamilton is aware of the IRS pursuing QuickBooks files via summons. However, neither is aware of CPAs denying the IRS access to these files. Hamilton said that it appears the IRS and CPAs are trying to feel each other out on the details.
"We are trying to comply. Our goal is the same as the IRS: Get the audit done as efficiently as possible," Addicks said. He said that auditors are reconciling the electronic files to the tax return, but they have also recognized that other records are necessary to fully explain the tax return. "My clients may only use QuickBooks for payables - the IRS needs to understand that this electronic file does not make up the entirety of my client's books and records," he said.
In North Carolina, CPA Susan Allen has experienced an IRS learning curve with her small business clients who have had audits. "We cannot tell how the agents have been using the files. There appears to be no changes to their current procedures yet. The process appears new to them, and the agents I have dealt with appear to be using restraint in how they are using the records," Allen said. "I do not think the IRS will push the issue unless they have some indication of wrongdoing and want to get the entire picture, such as unreported income."
That's good news for now. Still, some CPAs want to proceed with caution when it comes to electronic records in audits.
"We have not heard of agents abusing their discretion on this issue - but currently there is no way to tell if they are reviewing records besides the year under audit," Snow said.
Representing Your Small Business Clients
The 2001 tax gap study concluded that the non-farm small business compliance rate was only 43%, and that small business underreporting of income contributed $109 billion annually to the US Treasury shortfall. As a result, practitioners can expect their small business clients to encounter more IRS scrutiny, especially in the form of audits.
To protect clients from unnecessary inquiry and audit depth, here are some tips:
• Provide the IRS only the data needed for the year under audit by condensing transactions in non-audit years. In the future, create separate back-up files for each year. Be clear when responding to the IRS Information Document Request about exactly what data you are providing and not providing. If you use QuickBooks utility programs such as QB or not QB to remove prior-year data, explain exactly what you did, in writing, to the agent when you provide the file.
• If your client is a poor bookkeeper, request that he or she relinquish that duty to someone who is more qualified. You can encourage your client by explaining that the IRS may review every right, wrong or erroneous keystroke in an audit. Legitimate errors may cause undue scrutiny. Follow a good, old-fashioned cliché: "Measure the transaction twice, post the entry once." This also makes the CPA year-end audit easier.
• If possible, consider consolidating your client's electronic systems into one complete system. Use of several systems confuses the IRS and adds complexity in an audit. One system to record revenue and another to record payables is confusing for everyone. Consolidate them.
• If the electronic file cannot be provided in a format limited to the year and transactions under audit or the electronic records do not provide a clear financial picture, ask the IRS agent whether he or she will accept an alternative, such as printouts of accounts with detailed explanations. Before 2010, that was the method used in most SB/SE audits. Explain to the agent why it is a better approach; after all, it is how the return was prepared.
• Snow said practitioners call him with the same concerns: "What should I do and what can I do?" Snow said there's not much that can be done, given the IRS' summons powers, but he suggested that practitioners visit with the IRS group manager to discuss the need for the electronic files, and if your client is adamant about not turning over the files - meet with the territory manager. If your client authorizes providing the electronic files, Snow suggested noting the authorization in the engagement letter. "If you're representing a client who does not want to turn software files over to the IRS, be sure you don't violate Circular 230," Snow said.
Among other things, the AICPA is monitoring the program and how agents are applying it in the field. If a CPA has reached a loggerhead with an agent, or thinks the agent has stepped outside of the rules of the program and thinks the AICPA would benefit from having knowledge of the issues, he or she can contact Benson Goldstein at This email address is being protected from spambots. You need JavaScript enabled to view it..
As the IRS use of small business electronic records evolves, the standards for how to represent our clients will become clearer. Currently, it appears the IRS is using restraint in how it examines electronic files. However, practitioners should always exercise caution in representing their clients. As audits on small businesses continue to increase, practitioners will need to closely monitor entries on their clients' books and records to protect them from unnecessary inquiry by IRS agents. Practitioners should also carefully observe how the IRS uses these files as agents become more comfortable using electronic records in small business audits.