IRS Audits of Small Business Software Files: Practitioners Should Balance Risk for Their Clients
EXECUTIVE SUMMARY * In its examinations of the returns of small business taxpayers, the IRS is increasingly requesting electronic files of accounting programs such as QuickBooks and Peachtree. While taxpayers and their CPA tax preparers must be responsive to these requests, they must also take care to provide no more taxpayer data than a request reasonably covers. * The IRS has instructed its examiners to generally request a copy of taxpayers' original backup files for audits of such potentially wide-ranging items as verifying gross income, although it has indicated a request may not be necessary with respect to a single expense item. Examiners also should limit their requests to the tax year under examination but will request records of other years when needed to verify a current-year item from prior- or subsequent-year accounting. * Although the IRS has issued no specific guidelines regarding privileged information in a file, such as medical records, guidance indicates some redaction may be possible with the consent of the examiner. ********** [ILLUSTRATION OMITTED] Tax practitioners have always been cautious with the records they provide to the IRS in an audit to control the depth of an IRS inquiry. But IRS agents are starting to request client backup files from small business accounting software such as QuickBooks and Peachtree, and many practitioners are concerned about how much information the IRS is requesting and how it is using that information. This article explores the IRS' legal authority and long-standing use of electronic records in audits and takes a closer look into how the IRS requests and uses electronic files. It offers tips for CPA 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. 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 agents to be proficient in auditing information from files of accounting software commonly used by small businesses. 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. 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 making audits more efficient for its agents as well. IRS AUTHORITY TO REQUEST ELECTRONIC RECORDS It's clear in IRS regulations and precedent that electronic records can be requested and used in audits. Sec. 6001, Regs. Sec. 1.6001-1(a), Rev. Rul. 71-20 and Rev. Proc. 98-25 give the IRS broad authority to examine electronic records to establish the taxpayer's correct tax liability. Regs. Sec. 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." Rev. Proc. 9825 clarified that the IRS has a right to electronic records. The taxpayer must provide the electronic records upon request. If a taxpayer attempts to withhold them, the IRS may disallow all of the items that are unsubstantiated as a result of the decision to withhold the files--or it may summon the records. SUMMONS POWER UPHELD In June, the IRS prevailed in a summons enforcement case in U.S. District Court (Rouse, No. 8:11-MC-00046-T-24AEP (M.D. …