Record retention requirements under Rev. Proc. 98-25 – IRS Revenue Procedure 98-25 concerning automatic data processing systems
June 18, 1999
On June 18, 1999, Tax Executives Institute submitted the following comments to the Internal Revenue Service on Revenue Procedure 98-25, which relates to record retention requirements under section 6001 of the Internal Revenue Code where all or part of the taxpayer’s financial or accounting records are maintained within an automatic data processing (ADP) system. The comments were prepared under the aegis of the Institute’s IRS Administrative Affairs Committee, whose chair is Stephen W. Boocock of Allegheny Teledyne, Inc., and represents the work of an ad hoc working group chaired by Yasmin R. Seyal of Aerojet General Corporation, a vice chair of the committee. The following individuals also contributed to the Institute’s comments, Barbara Barton of EDS Corporation, Robert J. Evans of MCI Worldcom, Sheldon A. Kimel of Brunswick Corporation; and Daniel T. Piekarczyk of Frontier Corp.
On March 16, 1998, the Internal Revenue Service (IRS) issued Revenue Procedure 98-25, 1998-11 I.R.B. 7, prescribing the basic record retention requirements under section 6001 of the Internal Revenue Code where all or part of the taxpayer’s financial or accounting records are maintained within an automatic data processing (ADP) system. The revenue procedure updates and supersedes Rev. Proc. 91-59, 1991-2 C.B. 841.
Tax Executives Institute is the preeminent association of business tax executives in North America. Our more than 5,000 members represent 2,800 of the leading corporations in the United States and Canada. TEI represents a cross-section of the business community, and is dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and government alike. As a professional association, TEI is firmly committed to maintaining a tax system that works — one that is administrable and with which taxpayers can comply.
Members of TEI are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the tax law relating to the operation of business enterprises. We believe that the diversity and professional training of our members enable us to bring an important, balanced, and practical perspective to the issues raised by Rev. Proc. 98-25. Indeed, TEI has had a long involvement in the development and refinement of the IRS’s record-retention rules in respect of machine-sensible records. For example, TEI representatives met with IRS officials during the development of Rev. Proc. 86-19, 1986-1 C.B. 558, as well as its successor, Rev. Proc. 91-59. Moreover, after Rev. Proc. 91-59 was issued, TEI representatives devoted a substantial amount of time to meetings with IRS officials to develop a revised draft of a procedure addressing IRS record-retention requirements. The goal was to develop a procedure that clarified a number of technical and procedural issues under the procedure and to provide a better balance between taxpayer and IRS interests in respect of the heavy administrative and compliance requirements for machine-sensible or electronic records.(1) In short, the redrafted procedure was intended to conform to the views articulated by IRS representatives concerning the procedure’s intent: to empower taxpayers to decide which records to retain rather than to impose a series of arbitrary, rigid, and burdensome requirements.
Hence, we commend the IRS for issuing Rev. Proc. 98-25 to update the guidance in respect of machine-sensible records. The procedure relaxes some of Rev. Proc. 91-59’s more restrictive features(2) and addresses new developments in ADP systems. Nonetheless, Rev. Proc. 98-25 fails to discuss important issues that should be addressed and, regrettably, retains some stringent requirements from Rev. Proc. 91-59 that are unnecessary to safeguard the IRS’s access to books and records under section 6001. Equally important, we do not believe this revenue procedure adequately reflects the IRS’s new Mission Statement to
provide service “by helping [taxpayers] understand and meet their responsibilities and by applying the tax law with integrity and fairness to all.” To advance the goal of providing taxpayers with quality service, we believe the revenue procedure should be revised. TEI’s specific recommendations follow.
Issue Revenue Procedures Affecting Records Retention Every Other Year
The momentum of technological change affecting system software, hardware, and other record-retention technologies and the increasingly competitive environment in which most businesses operate challenges taxpayers to run harder and faster just to keep pace. Indeed, two or more generations of some technologies have been spawned in the nearly six years since TEI submitted its proposed revision of Rev. Proc. 91-59 in late 1993. In addition, IRS computer audit specialists (CAS), whom the Chief Counsel’s Office consults in respect of ADP system record-retention matters, are only now undertaking detailed examinations of the sophisticated Database Management Software (DBMS) systems and Electronic Data Interchange (EDI) technology that many taxpayers implemented or expanded substantially during the 1990s. Indeed, ADP systems and DBMS software, which the procedure addresses, have generally been replaced by even more comprehensive and integrated enterprise resource planning (ERP) software and hardware systems. Hence, the IRS guidance process continually lags behind the development and implementation of efficient and effective record-retention technologies.
The lag in guidance on ADP systems frustrates taxpayers and the IRS alike in their mutual desire to promote an efficient examination process. To address this frustration, we recommend that the IRS consider updating this procedure more frequently than once every six to eight years. Effective and timely guidance on ADP systems is crucial to ensure efficient taxpayer record- retention practices, to minimize taxpayer burdens, and to safeguard IRS access to records. Without timely guidance on new technologies, taxpayers will remain uncertain about their record-retention obligations and, hence, may retain multiple information systems and redundant records thereby substantially increasing their record-keeping costs and diminishing the efficiencies and economies otherwise enabled by the new technology. Alternatively, some taxpayers may inadvertently discard records or change their systems thereby hindering the IRS’s access to information necessary to conduct its examinations. Hence, TEI recommends that the IRS adopt a goal of issuing a revised revenue procedure every other year that addresses ADP systems and electronic record retention requirements. In addition, we recommend that the guidance on imaging systems and other technologies (Rev. Proc. 97-22, 1997-1 C.B. 652) be considered contemporaneously with, or even be incorporated into, the guidance on ADP systems so that the entire spectrum of requirements for electronic record storage and retrieval is addressed comprehensively. Such an approach would serve both taxpayers and the IRS by providing timely guidance on the most effective utilization of technology for tax support.
Establish a Liaison Group To Address Electronic Record Retention Rules
In addition to issuing more frequent updates on electronic record retention guidance, the IRS should develop a process through which taxpayers can routinely provide input about both the technologies and the IRS guidance affecting taxpayer record-keeping procedures and practices. Specifically, the IRS should consider establishing a liaison committee or working group to meet periodically, say, every six months, to identify issues and alternative solutions for updated successor guidance to Rev. Proc. 98-25. For example, the IRS could reestablish the IRS-TEI working group on electronic record retention though the group’s membership should likely be expanded.(3) The 1991-1993 collaborative effort between the IRS and TEI produced a workable — and, in our view, balanced — document. (We believe the IRS National Office and field personnel who participated would agree.) That exercise was productive because it afforded taxpayers and the IRS a nonadversarial setting in which to develop the trust necessary to work cooperatively. While disagreements over particular issues will likely arise — indeed, it is not always possible for members of TEI to agree among themselves on what the best approach to a particular issue may be — an expanded consultative process will prove salutary in educating taxpayers and the government about the others’ concerns. In addition, such an approach will permit the IRS to understand the limitations and capabilities of new technologies so that it can expeditiously identify record-retention issues and develop realistic standards that do not impose excessive taxpayer burdens.
Section 2.03 of Rev. Proc. 98-25 restates Treas. Reg. [sections] 1.6001-1(e) by providing that “books or records required by [sections] 6001 [of the Code] … must be retained so long as the contents thereof may become material in the administration of any internal revenue law.” (Emphasis added.) Likewise section 2.04 cites Rev. Proc. 71-20, 1971-1 C.B. 392, as establishing that all machine-sensible data media and records within an ADP system are records for purposes of section 6001 and Treas. Reg. [sections] 1.6001-1, and are required to be retained “so long as the contents may become material in the administration of any internal revenue law.” (Emphasis added.)
Although we recognize the historical basis for the materiality standard in the procedure, we recommend that the standard be reconsidered and clarified. The current materiality standard may unnecessarily restrict taxpayers from discarding redundant or irrelevant information because there is no temporal or scope limitation in respect of when an item of information in a taxpayer’s records “may become material.” Indeed, almost any record may become material under hypothetical facts and circumstances. Regrettably, the current standard almost invites revenue agents to employ hindsight to aver that taxpayers should have maintained certain records because they should have known that the item “may become material” simply by the agent’s requesting a particular form of documentation or record. In effect, the provision requires taxpayers to maintain all electronic records on a nearly permanent basis. Practically speaking, no company can do this without incurring substantial costs.(4) To prevent this from happening, the IRS should confirm that, although the taxpayer remains ultimately responsible for maintaining records to support the positions taken on the tax return, the purpose of the law’s record retention provisions is to facilitate an examination of relevant issues, not to play “gotcha” with the taxpayer. Hence, revenue and CAS agents should be discouraged from distending the “may be material” requirements but instead focus on securing sufficient information to conduct a high quality examination.
Record Retention Limitation Agreements
Section 10.01 provides the authority for taxpayers and District Directors to enter into Record Retention Limitation Agreements (RRLAs) that specify the records to be maintained to satisfy taxpayers’ obligations under section 6001 and Treas. Reg. [sections] 1.6001-1(e). Under section 10.01(2), a taxpayer’s request for an RRLA must identify and describe the records that it proposes not to retain and explain why those records will not become material for the administration of any internal revenue law. (Emphasis added.)
We believe that RRLAs are beneficial for taxpayers and the IRS alike and, consequently, believe the tone and emphasis of section 10 of the procedure is at odds with the spirit of the IRS Restructuring and Reform Act and the revised IRS Mission. Indeed, we believe the focus of the procedure should be on how the IRS can be responsive to taxpayer’s needs for flexible rules that permit the taxpayer to determine what records are necessary to support the amount of its tax liabilities. One of the Guiding Principles of Commissioner Rossotti’s quest to modernize the IRS is to “[u]nderstand and solve problems from a taxpayer’s point of view.” By relaxing its stringent requirements and constricted view of the utility and benefits of RRLAs, the IRS can simultaneously empower taxpayers to enhance the efficiency of their operations and improve IRS’s own examination practices. Since taxpayers are under an affirmative obligation under section 6001 and Treas. Reg. [sections] 1.6001-1(e) to keep books and records sufficient to establish the amount of items of income, deduction, etc., that establish the amount of the taxpayer’s tax liability, the taxpayer should be empowered to identify the records that are material to an examination and, hence, retained or destroyed. In addition, by approaching RRLAs with a focus on what is to be retained, the IRS will foster voluntary compliance.(5) Regrettably, the procedure reflects a contrary view of the utility of RRLAs. In order to obtain an RRLA, taxpayers are required to prove a negative — that records are unnecessary and that they will, therefore, not become material to an examination. As a result, the procedure sets an unreasonably high, if not impossible, standard for taxpayers to satisfy to obtain an RRLA.
Finally, the century-date change (or Y2K) issue may have an effect on taxpayers’ abilities to process machine-sensible records or retrieve underlying documentation. In order to address this, the IRS should consider broadening the availability of RRLAs.
Documentation of Business Processes
Section 6.01 of the procedure requires taxpayers to maintain and make available documentation of the business processes that (1) create the retained records, (2) modify and maintain its records, (3) satisfy the requirements of section 5.01(2) of the procedure and verify the correctness of the taxpayer’s return, and (4) evidence the authenticity and integrity of the taxpayer’s records. Section 6.02 sets forth four elements that the documentation required under section 6.01 must establish: (1) the flow of data through the system, (2) internal controls that ensure accurate processing, (3) internal controls that prevent unauthorized record changes, and (4) charts of account. Section 6.03 sets forth six specific types of documentation for each retained file: (1) record formats, (2) field definitions, (3) file descriptions, (4) evidence that periodic checks are undertaken to ensure that data remains accessible, (5) evidence that the records reconcile to the taxpayer’s books, and (6) evidence that the records reconcile to the taxpayer’s return. Finally, section 6.04 states that the system documentation must include any changes to the items specified in sections 6.01, 6.02, or 6.03 and the dates the changes are made. (Emphasis added.)
TEI has no comments in respect of sections 6.02 and 6.03. The elements set forth in those sections are essential to satisfying the requirements of section 6001. There is, however, seemingly no scope limitation in respect of section 6.01 and, especially, section 6.04. Notwithstanding the implicit assumption of section 6.01 and the stated requirement of section 6.04, companies rarely have the resources to fully “document” every aspect or change in business processes. That does not mean, however, that taxpayers cannot demonstrate how records are created or maintained, cannot verify the correctness of their tax liability, or cannot evidence the authenticity of their records. Indeed, some system changes are so frequent or minor in scope that the lack of “documentation of a business process” reflects a sound business decision that the item or change (or the documentation of the item or change) is immaterial to the business process itself. Absent an independent requirement, in allocating resources to meet recordkeeping requirements companies seek to satisfy the essential requirements to create, retain, or maintain the records necessary to operate the business, including internal controls appropriate under the circumstances. Upon reaching that objective, however, taxpayers will rarely spend the additional money to document every business process in the fashion that sections 6.01 and, especially, 6.04 of the procedure seemingly contemplate. As a result, many companies will likely not meet the stringent “documentation of the business processes” requirements set forth there. Perhaps more fundamentally, we question whether “documentation” by itself is even relevant in providing “evidence of the authenticity and integrity of the taxpayer’s records.” Notwithstanding that a taxpayer may lack flow charts, descriptive information system manuals, or logs of every system change, the totality of the taxpayer’s system of authorization procedures, checks and balances, processes, controls, and restrictions on access to records and their processing provides the necessary “evidence of the authenticity and integrity of the records.” We recommend that section 6.01 be modified to include a scope limitation so that the taxpayer is required to produce documentation of only its material business processes and, furthermore, that section 6.04 be modified so that the taxpayer is required to document only material (rather than any) changes to the items specified in sections 6.01, 6.02, and 6.03.(6)
No License or Contractual Restriction on Systems
Section 7.02 of the procedure states that “[a]n ADP system must not be subject, in whole or in part, to any agreement (such as a contract or license) that would limit or restrict the IRS’s access to and use of the ADP system on the taxpayer’s premises (or any other place where the ADP system is maintained….” This requirement seemingly conflicts with section 4.02, which does not require that a program or system that creates data be available to process the data unless one of two conditions set forth in section 4.02 are met. Since the IRS’s legitimate concern is ensuring access to the transactional level data reflected in the records, section 7.02 seems overbroad and overreaching.(7) In addition, it is unclear what sanction the IRS contemplates if the taxpayer’s systems are subject to such a license or contract. Seemingly the taxpayer’s ADP records could be deemed inadequate, but the IRS’s authority to make that determination is questionable.
Even more important, TEI questions the IRS’s authority for promulgating the rule set forth in section 7.02 because it makes short shrift of the copyright protections accorded to software vendors and also minimizes legislative and judicial limitations on IRS’s right to obtain copies of or access to licensed software from the software’s users.(8) In particular, section 7612 of the IRS Restructuring and Reform Act of 1998, which was enacted subsequent to the procedure’s release, imposes additional restrictions on the IRS’s access to computer source codes and software. Under that provision, no summons for tax-related software may be issued unless (i) the IRS is otherwise unable to ascertain the correctness of any item on a return from the taxpayer’s books and records of the computer software program and associated data, (ii) the IRS identifies the particular portion of the computer source code needed with reasonable specificity, and (iii) the IRS determines that the need for the source code outweighs the risk of disclosure of trade secrets. (Emphasis added.) If the IRS Restructuring Act does not vitiate section 7.02 altogether, it substantially narrows the IRS’s authority in a fashion that is not reflected in the rule. Hence, we recommend that section 7.02 be deleted.
Database Management System Software
Section 5.02 provides guidance in respect of database management system (DBMS) software systems. During the past decade, most large and many mid-sized businesses have replaced existing financial systems by converting to enterprise resource planning (ERP) software systems, a highly sophisticated DBMS that integrates disparate manufacturing, marketing, human resource, and financial accounting systems (i.e., enterprise resources) in a comprehensive fashion. Hence, notwithstanding the brief two paragraphs devoted to DBMS systems in the procedure, guidance on the record retention requirements for such systems is vital. Under the procedure, the taxpayer must either (1) retain the system (seemingly both the actual data and the processing capability) as it exists at the time the tax returns are prepared or (2) create “fiat file” (or in the parlance of the procedure “sequential file”) extracts of the data. Under either approach, the procedure will likely engender substantial taxpayer burdens that the IRS should first acknowledge and then seek to minimize. As important, the operation of a DBMS system, especially an ERP system, may require the IRS to adopt a wholly different approach in respect of (1) record retention and retrieval requirements and (2) examination techniques.
Under the first approach, taxpayers are required to maintain exact copies of the DBMS software as it exists from the time the records are created until at least the IRS completes its examination of the year in which the transactions are reported. Under such circumstances, the taxpayer may be required to purchase additional hardware to maintain and operate the software exactly as it existed during the year. Indeed, depending on the frequency of operating system or DBMS upgrades or modifications, the procedure could require taxpayers to purchase new hardware systems every year in order to maintain the ability to process the records for a particular year in exactly the same fashion. In addition, as with the conversion of an accounting system, maintaining the legacy system records in a fashion that ensures they are capable of being processed will be difficult since knowledgeable personnel who are familiar with the system may leave the company. Accordingly, the first approach likely imposes too great a burden for many taxpayers to comply with.
The second alternative afforded to taxpayers, creating a sequential or flat file for each year’s records, is more workable than maintaining separate “vintages” of hardware or software systems. Nonetheless, we question whether the IRS appreciates the truly enormous size of the files created and the correspondingly longer period of time the IRS may need to process and examine those records.(9) As a result, the efficiency of examinations may suffer, CAS resources — which are already thin — will be stretched even further, and the time required to conduct examinations will likely expand.
To forestall this result, we recommend that the IRS consider a different approach to record retention requirements for electronic data created and stored in a large-scale DBMS or ERP system. Specifically, we recommend that the IRS work with taxpayers and software vendors to develop a third alternative: an optional annual Tax Database. An annual Tax Database approach would permit taxpayers to store database records from the DBMS software into an archival database. Without any loss of integrity or authenticity of the records, standards can be prescribed for an optional Tax Database that would consist of only a portion of the system supporting the entire business operations. Such a database would include the information necessary to support the preparation of a return as well as all records necessary to satisfy the IRS on examination that the requirements of section 6001 and Treas. Reg. [sections] 1.6001-1(e) are met. In addition, standards can be prescribed for reconciling and accessing the Tax Database. Such a system would be an open architecture system (or be capable of producing files that can be imported by the IRS CAS software) and forward- and backward-compatible with all operating systems and hardware platforms.(10) Finally, the standards might include a model record-retention limitation agreement that could be tailored to each taxpayer employing a Tax Database system. We believe TEI’s recommended approach can be beneficially employed to increase the efficiency of examinations and minimize administrative burdens on taxpayers. TEI would be pleased to work with the IRS to establish such standards.
Increasingly, businesses are eliminating paper-based documentation and using electronic data interchange (EDI) technology to achieve business efficiencies. The growth of electronic commerce has prompted an exponential increase in the scope, degree, and variety of EDI transactions. Section 5.03 of the procedures provides minimal guidance in respect of EDI transactions, and given the explosive growth of EDI technology, the paucity of guidance is not surprising. We commend the IRS for adopting this approach. The tone of the guidance provided in this section is consistent with the TEI-IRS working group recommendations: Taxpayers should be empowered to make the business decisions about the manner and level of EDI transactions that must be retained. TEI is concerned, however, about the level of training provided to computer audit specialists and other IRS personnel concerning EDI. We strongly encourage the IRS to devote sufficient resources to EDI-related training to ensure that the potential technology is not thwarted.
Recovering and Restoring Records
Under section 8.01, 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. The taxpayer’s notice must identify the affected records and include a plan of recovery describing how, and in what time-frame, the records will be restored or replaced. In addition, the notice must specify how the requirements of the procedure will continue to be met with respect to the affected records. Curiously, the examples provided in the revised procedure do not even address lost or destroyed records. Rather, they address situations where the taxpayer voluntarily replaces its hardware or software system with another system that is incapable of processing its prior records.
There are at least two provisions that arguably constitute a substantial expansion of Rev. Proc. 91-59. The first is the requirement of prompt notification of a loss of records, together with a description of a plan of recovery; the second is the requirement to provide “notice” in connection with a voluntary system conversion. We have comments on each.
1. Notice Period. Under the previous procedure, a taxpayer was required to report that it had lost data and subsequently to recreate the lost files within a reasonable period of time. Without a specific period, it is unclear whether the requirement to provide prompt notice under Rev. Proc. 98-25 is intended to accelerate the time for notice to the District Director or is intended to confirm that, as under the previous procedure, what is considered “prompt” is a question of reasonableness that is to be determined based on all the facts and circumstances.(11) Moreover, while the requirement to provide prompt notice to the District Director is not, in and of itself, burdensome, the additional requirement to supply in the same document all the requisite details for recovering the records will likely pose a significant challenge to taxpayers. Developing a plan that describes the manner of recovering historic tax records lost in a catastrophic event could require a substantial amount of time.(12) To be sure, most large companies have established record recovery policies, but taxpayers may require several weeks to assess the extent of their loss and then determine whether the existing plan (if any) will prove adequate for recreating or replacing the affected records or otherwise complying with the procedure or, alternatively, whether the plan must be modified.
As a result, TEI recommends that section 8 be modified to provide that taxpayers shall provide notice to the District Director within a reasonable period of time following the discovery of a loss of records. Except for lost records that respond to a specific information document request (IDR) on examination, taxpayers should not be required to provide such notice in less than 60 days.(13) In addition, the information describing the plan of recovery should not be required to be supplied for at least an additional 60 days following the initial notice. Moreover, the procedure should specify that the taxpayer and the District Director may enter into an agreement to develop a timetable for developing a plan of recovery and prescribe in such agreement the dates at which the taxpayer will supply notice of various components of its plan of recovery (or secure reasonable extensions of the period). We also recommend that section 8 be modified to permit a taxpayer’s plan of recovery or restoration to include such steps as describing alternative files to be created or maintained (i.e., other data files should the original electronic records be incapable of being recreated) or submitting paper records in lieu of electronic records. Finally, the procedure should confirm that, where a taxpayer’s original plan proves unworkable, the plan can be modified with the consent of the District Director.
2. System Conversions. The procedure fails to cite any authority for the proposition that a taxpayer must provide notice of its business decision to replace or upgrade an ADP system. Hence, we question whether the IRS may impose such a requirement in a revenue procedure. At a minimum, the notice should not be required prior to the inception of the examination of the return for the year in which the system conversion takes place.(14) In addition, we question whether the contents of “a plan of recovery” for a conversion would not differ materially from a plan for recovering lost or stolen records. In other words, while the examples provided in section 8.05 are helpful, we question whether illustrative guidance on steps that taxpayers should undertake in order to maintain access to old system records following a voluntary system conversion should be included in the same section as guidance on restoring records that are unaccessible because of unforeseen events. Finally, we question what effect the District Director’s objections to a taxpayer’s plan for recovering records following a system conversion might have, especially where (1) the objections will likely be lodged well after implementation of the new system and, more important, (2) reasonably prudent taxpayers have already undertaken the steps they deem necessary to comply with section 6001 and to maintain the books and records to support the positions taken on the return. As a result, we recommend that the IRS consider removing the guidance on voluntary system conversions from the section on lost or destroyed records and, indeed, eliminate any implication that notice of a voluntary system conversion is required at any time prior to the IRS’s expending its scarce examination resources.
Record Evaluation at Any Time
Under section 10.02 of the procedure, the District Director is permitted to conduct a record evaluation of a taxpayer “at any time.” This delegation of authority — unfettered by any restrictions — has the potential to disrupt a taxpayer’s operations. Absent some event or information from which the IRS might reasonably conclude that its ability to conduct an examination of the taxpayer will be impeded by lack of access to proper records, the District Director should be required to provide taxpayers with reasonable advance notice of any record evaluation.
Penalties and Resources Supplied on Examination
Section 12 states that the District Director may issue a Notice of Inadequate Records pursuant to Treas. Reg. [section] 1.6001-1(d) and that penalties may be imposed if the taxpayer fails to comply with the procedure (including the requirement under section 7 to provide resources to the IRS to process machine-sensible records).
TEI recognizes that Notices of Inadequate Records are rarely issued and that taxpayers are rarely penalized for failure to produce the books and records supporting their tax return positions. Nonetheless, the threat of the penalty provision is often invoked as a bargaining chip with taxpayers, especially in negotiations about the scope of the resources taxpayers must supply in connection with the examination of the taxpayer’s machine-sensible records under section 7.01. Hence, while section 7.01 has been tempered (in comparison with its predecessor) by the incorporation of several of TEI’s 1993 recommendations for alternative means of complying with a District Director’s request for assistance in processing records, the tenor of the procedure generally, and of section 7.01 in particular, remains unchanged. As a result, we remain concerned that a revenue agent or CAS can employ a hypertechnical reading of the procedure’s sometimes unrealistic requirements (e.g., the annual testing described in sections 9.01(3) and the documentation thereof in section 6.03(4)) to threaten penalties and extract unwarranted concessions. In order to minimize the improper threat of penalties, the IRS should optimally revise the procedure to track more closely with TEI’s 1999 recommendations and especially the 1993 recommendations that were developed jointly with IRS representatives. At a minimum, section 7.01(1) should be revised by inserting “reasonably” between the word “is” and the phrase “necessary to process the taxpayer’s machine-sensible books and records.”
Tax Executives Institute appreciates this opportunity to present our views on Rev. Proc. 98-25. If you have any questions, please do not hesitate to call Stephen W. Boocock chair of TEI’s IRS Administrative Affairs Committee, at (412) 394-2828, or Jeffery P. Rasmussen of the Institute’s professional staff at (202) 638-5601.
(1) See letter dated July 15, 1993, from TEI President Robert H. Perlman to IRS Commissioner Margaret M. Richardson, reprinted in 45 THE TAX EXECUTIVE 325 (July-August 1993). Following substantial discussions between TEI and IRS representatives, a revised draft dated November 22, 1993, was submitted to the IRS.
(2) For example, the procedure eliminates the requirement that taxpayers adhere to the standards for records management prescribed by the National Archives and Record Administration (NARA). Section 9 of the procedure acknowledges that record maintenance practices reflect business decisions that are better left to the taxpayer’s discretion. While no longer mandatory, the procedure cites the NARA standards as illustrative of recommended record management practices and adds a safe harbor from penalties for loss of data if the taxpayer demonstrates that its practices conform with NARA.
(3) Notwithstanding the need to embrace a broad group of representative taxpayers, the size of the group should be limited and meeting procedures kept informal in order to keep the discussions focused and productive. In keeping with the nature of the procedure, the focus of the group should be on the needs of system users. Nonetheless, system vendors should be consulted as an additional resource about what is practical and achievable.
(4) Indeed, without some temporal or scope limitation on the records to be retained, the section conflicts with other, permissive provisions of the procedure (e.g., section 5.03, which permits a taxpayer to “capture the required detail of EDI transactions at any level,” or section 10.01, which authorizes record-retention limitation agreements). The focus of the procedure should be on keeping the records necessary to support the taxpayer’s reported position.
(5) Regrettably, there have been inconsistencies in the willingness of various IRS districts to employ RRLAs. We believe that RRLAs should be encouraged generally and hope that the impending IRS reorganization (with its emphasis on taxpayer service and its move away from a geographically based organization) will foster both consistency and greater amenability to employ RRLAs.
(6) RRLAs could be employed to identify specific business processes material for the taxpayer’s systems.
(7) In defining the term “capable of being processed,” section 4.02 states that taxpayers are not required to retain and make available a specific program or system unless such a program is necessary for a tax-related calculation or for the retrieval of data that is not otherwise accessible. This provision rightly focuses the processing requirement on the retention and accessibility of the underlying data. It is the transactional data that forms the basis for information reported on the taxpayer’s return. The accounting program or system that retains and processes the data is generally irrelevant to an examination of the transaction except in limited circumstances, i.e., where the data cannot be accessed without such a program or system or the system will not produce a sequential file. In other words, section 4.02 “gets it right,” but section 7.02 seems gratuitous.
(8) See, e.g., United States v. Norwest Corp., 116 F.3d 1227 (8th Cir. 1997) (courts may impose limitations and conditions on the IRS’s summons authority in order to balance the rights of the copyright holder against the IRS right to access to the information necessary to conduct an examination).
(9) The benefit of large-scale databases is the ability to eliminate — through the use of record keys, pointers, and tables — redundant data. Unraveling a relational database into a sequential file not only mutes the efficiency of the software’s design and operation, but it can create an annual file that is so large that there may not be a system capable of processing it. The relational database permits a taxpayer to access and retrieve data in minutes or hours that might require days from a sequential file.
(10) The standards would likely have to be prescribed in detail and, hence, should be considered optional and not mandatory for DBMS users and vendors. Once developed, however, the standards for an optional tax database would likely become a standard that all systems vendors would strive to satisfy (at least, until the next generation of systems makes the standard irrelevant).
(11) The ordinary dictionary meaning of prompt is “ready and quick to act as occasion demands; responding instantly.” (Emphasis added.) The first part of the definition provides what we view as being necessary: the flexibility to decide whether the notice must be sent “immediately” or may be delayed but supplied “promptly” say, at the opening conference of an IRS examination for the year for which the records were known to be lost. We would reject as unreasonable the notion that notice to the District Director is required to be supplied “instantly.”
(12) Business contingency plans for recovery of records following a disaster are similar to hospital emergency room triage procedures: Provide first for immediate stabilization of the patient (the business) by administering essential treatment to keep the patient alive (recover the most essential records–generally the most recent 12 months’ operating and financial accounting data–and recreate the processes necessary to operate the business). Longer term needs, such as recovery of prior year business and tax return records, are addressed in due course as the goal moves from assuring survival to enabling as full and complete a recovery as possible.
(13) Taxpayers frequently do not discover that data files are lost or destroyed until they seek to produce information in response to an IDR. This is especially so in highly decentralized business operations with multiple ADP systems and numerous personnel responsible for maintaining various recordkeeping functions. Hence, where an IDR is pending during an examination, the procedure’s requirement to provide prompt notice is more relevant. Nonetheless, taxpayers should be afforded a reasonable period of time to assess the scope of lost or destroyed records and to develop alternatives for producing the information or documents. Since taxpayers and the IRS generally agree at the inception of an examination on a time period for responding to IDRs, the period for notifying the IRS of lost records should be no less than such period.
(14) To expedite the planning and execution of an IRS examination, taxpayers often permit CAS examiners to commence their work prior to the formal inception of the examination. The time savings are beneficial for taxpayers and the government. In such case, notice to the CAS examiners would precede the examination.
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