IRS’s Legal Authority for Requesting Electronic Accounting Records and Software

Introduction

For federal tax purposes, taxpayers can choose recordkeeping and accounting systems that suit their individual and business needs, satisfy their tax compliance obligations, and clearly reflect on their tax returns their income, expenses, deductions, and credits. Although the types of records that taxpayers maintain vary, and in limited cases they might maintain their records in paper format, it is customary for the majority of taxpayers to maintain their records in electronic format such as in an Excel spreadsheet or an accounting software program. Information maintained in electronic format is generally referred to as electronically stored information or ESI.

Business entities generally can choose from a wide variety of accounting software programs for their preferred recordkeeping system. Programs such as Intuit QuickBooks, Peachtree, Quicken, FreshBooks and other accounting software programs are examples that vary in capability and complexity. Selecting a program is generally based on the needs and reporting requirements of a taxpayer’s business. Essential and basic components of accounting software programs generally include modules to record cash receipts and disbursements, accounts receivable, accounts payable, payroll, fixed assets, and general journal entries. Eventually, transactions entered in an accounting software program’s modules are summarized in a business entity’s detailed general ledger, balance sheet and income statement which form the basis for the business entity’s financial information to report on its financial statements and tax returns.

Maintaining records in paper or electronic format merely summarizes the financial information. Taxpayers are required to maintain their supporting documents to substantiate the items reported on their tax returns and in their financial statements. Generally, supporting documents are considered primary evidence because they substantiate the transactions that the business entity enters and records in its recordkeeping and accounting system. The types of records that individuals and business entities maintain as primary evidence include bank statements; cancelled checks; credit card receipts and statements; sales and purchase invoices; interest, dividend and miscellaneous reporting forms; charitable donation receipts; brokerage statements and legal documents.

Statutory Framework – The Legal Authority to Request Records

The IRS has the legal authority in IRC Sec. 7602 “to examine any books, papers, records, or other data which may be relevant or material” for the purpose of ascertaining the correctness of any return and making a return where none has been made.¹

The legal authority the IRS has to request any books, papers, records, or other data whether in paper or electronic format, including electronic accounting records and software, is IRC Sec. 6001. IRC Sec. 6001 requires every person liable for any tax imposed by the IRC to “keep such records, render such statements, make such returns, and comply with such rules and regulations as the Secretary may from time to time prescribe.”²

IRS Summons Authority

On November 18, 2011, the IRS issued Chief Counsel Advice 201146017³ (CCA) that responded to a series of questions pertaining to whether an IRS examiner may summon a taxpayer’s original electronic data files or the backup files to obtain the associated metadata embedded in ESI. The reason why IRS issued this CCA was because taxpayers offered to provide paper printouts of their data files or spreadsheets that did not contain the metadata.

In a series of questions and answers in the CCA, the IRS responded to each of the facts and circumstances stated in the questions by concluding an “IRS examiner can summon taxpayer’s original electronic data files containing unaltered metadata as long as information in metadata ‘may be relevant’ within broad meaning of IRC Sec(s). 7602(a)(2), to proper purpose for which examination is being conducted, such as correctness of return. And, taxpayer’s offer to provide copies that omit metadata or actual production thereof doesn’t restrict IRS’s authority to summon original, unaltered metadata.”

In responding to two of the questions in the CCA, the IRS Chief Counsel concluded the IRS may summon (1) “information, including metadata, concerning transactions and events that occurred before and after the periods under examination so long as that in formation ‘may be relevant,’ and (2) a third-party witness, such as the taxpayer’s accountant, to give testimony or produce information that may be relevant to the examination, including electronic data files and the associated unaltered metadata.”

What is ‘metadata’?

The IRS defined metadata as “information that describes how, when, and by whom a particular item or set of electronic information was collected, created, accessed, modified, and formatted. The questions above arise in the context of examinations of taxpayers that keep their business records electronically with metadata automatically created as an integral part of the records. In many instances, the Service’s examinations would be advanced by accessing metadata that identifies the original date a transaction was entered in the electronic records, the dates of any changes to the entries, and the username of the person who made the entries. The value inherent in an examiner’s ability to obtain the date and source of recorded entries is self-evident; the information tends to support or undermine the credibility of the entries in the business records.”

What comprises “books, papers, records, or other data”?

CCA 201146017⁴ (CCA) addressed the meaning of the phrase “books, papers, records, or other data” in the context of IRC Sec. 7602. The CCA stated “the Eighth Circuit held in Norwest⁵ that the phrase ‘records, or other data’ encompassed tax preparation software containing a series of coded instructions enabling a computer to generate tax returns…. Given these expansive precedents, it is readily apparent that the phrase ‘books, papers, records, and other data’ is more than broad enough to encompass the compelled production of the metadata associated with electronic documents.”

What is the meaning of the phrase “may be relevant or material”?

Following its meaning of the phrase “books, papers, records, or other data,” the CCA addressed the legal concept of the phrase “may be relevant” in Powell⁶ to the tax inquiry related to summoned information. The court’s holding in Powell is commonly referred to as the “Powell Doctrine.”

The CCA stated “The Powell relevance requirement has its statutory basis in IRC Sec. 7602(a), which authorizes the Service to examine and summon any books, papers, records, or other data to take testimony which ‘may be relevant or material’ to ascertaining the correctness of a return or any of the other proper purposes listed in section 7602(a) and (b). The widely accepted standard used by the appellate courts to determine whether summoned information ‘may be relevant’ is whether it ‘might throw light upon the correctness of the return.’”

“Therefore, the statute-based ‘may be relevant’ requirement stated in Powell will be satisfied when the Service seeks information that may throw light on the tax inquiry at issue. The Service need not show that the summoned information will be relevant; it need only show that the nature of the information is such that it may potentially be relevant.”

For summoned information to comply with Powell, the IRS must not already possess the summoned information. In the event the IRS were to summon metadata that may be relevant to the tax inquiry summoned, and the summoned person fails to produce the metadata, the courts will enforce the summons.⁷

IRS Requests for Electronic Accounting Records and Software in Audits

When the IRS Small Business/Self-Employed (SB/SE) operating division first began requesting electronic accounting records and software in conducting audits, taxpayers and their representatives pushed back for several reasons related to potential privacy issues, relevancy, and whether the requests to produce ESI were overly broad and burdensome notwithstanding taxpayers had the legal obligation to comply with IRC Sec. 6001 and the IRS had the legal authority to enforce in IRC Sec. 7602. In addition, ESI as a recordkeeping system by business entities in the private sector became the standard to record transactions and maintain books and records. Therefore, it became more difficult for taxpayers and their representatives to credibly argue that the IRS’s request was overly broad and burdensome.

As a result, the IRS believed relying on electronic accounting records and software enhanced its audit of tax returns. In other words, what the private sector viewed as beneficial to maintain an electronic recordkeeping system was also beneficial to the IRS to audit taxpayers.

The IRS previously published 17 FAQs and answers for electronic accounting software records that was last reviewed or updated on April 12, 2021.⁸ The IRS stated in Q1 specific reasons to justify the requests. The IRS believed a taxpayer’s electronic accounting records and software (1) reduced its burden to produce information in paper; (2) provided a complete set of the taxpayer’s accounting record; (3) decreased the number of items included in the initial document request (IDR) and follow-up requests; and (4) increased efficiency of the examiner’s analysis of the books and records.⁹

Among the questions published in the FAQs that the IRS answered in addition to Q1 are the following:

• How and when will the IRS request electronic accounting software records (Q2.)?
• What is the IRS doing to address concerns about sharing the accounting software administrator’s username and password for the audit (Q3.)?
• How will the electronic data be used (Q6.)?
• What if a taxpayer refuses to provide the IRS with an electronic accounting software backup file or any other type of electronic data file (Q8.)?
• What if the taxpayer’s representative refuses to provide a copy of the taxpayer’s electronic accounting backup file (Q9.)?
• The accounting software backup file can contain transactional data for several years that are outside the scope of the audit. What, if anything, will the IRS do with that information (Q12)?
• What if the accounting software backup file contains privileged information or information that is protected from disclosure by statute (Q16.)?

Before a taxpayer or non-attorney representative such as a CPA or enrolled agent responds to answer any of the FAQs or provides information or documents where the response or answer is free from doubt, or may require legal advice or contain privileged communications, the taxpayer or representative should consider seeking advice of counsel.

Conclusion

Although taxpayers can choose a recordkeeping system that suits their individual and business needs to satisfy their tax compliance and filing obligations, Congress established a statutory framework that gives IRS the legal authority to request taxpayer records including the authority to summons taxpayer’s books, papers, records, or other data. The legal and judicial authority and administrative guidance are in IRC Secs. 7602 and 6001, established case law precedent and IRS Chief Counsel Advice.

It is well-established that books, papers, records, or other data include a taxpayer’s original electronically stored information or data containing unaltered metadata. The IRS need only show that the information sought “may be relevant” by showing that it “might throw light upon the correctness of the return.” The information sought by the IRS could be made in an Information Document Request (IDR) or summons.

Most experienced tax practitioners who represent taxpayers before the IRS are familiar with IRS protocols and procedures pertaining to electronic accounting software records requests and submissions during an audit. As a result, taxpayers and their representatives should familiarize themselves with the FAQs, the relevant statutory authority, case law, and authoritative IRS guidance to ensure compliance with their legal, ethical, and professional responsibilities.

When in doubt, taxpayers and non-attorney representatives should consider obtaining competent legal advice in response to requests for information or documents where the response might be free from doubt or might contain privileged communications.

¹IRC Sec. 7602(a)
²IRC Sec. 6001, Regulation 1.6001-1(a) and (e), Revenue Ruling 71-20 and Revenue Procedure 98-25.
³FN 1.
⁴CCA 201146017, 11/18/2011.
⁵United States v. Norwest, 116 F.3d 1227, 1233-1234 (8th Cir. 1997).
⁶United States v. Powell, 379 U.S. 48, 57 (1964).
⁷United States v. Administration Co., 94-2 USTC (1994).
⁸See IRS.gov.
⁹https://www.irs.gov/businesses/small-businesses-self-employed/use-of-electronic-accounting-software-records-frequently-asked-questions-and-answers

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