Legal reguirements for computer records containing federal tax information: An update

NOTICE: This article contains information related to sensitive and important legal issues. No section of this article should be construed as providing legal advice. All legal decisions related to records and information management should be reviewed by competent legal counsel.

In previous articles, I reviewed the legal requirements related to the legal requirements for computer records,1 generally, and to tax records,2 specifically. The legal requirements related to the admissibility of computer records in evidence have remained the same since the previous article. In 1986, however, the Internal Revenue Service modified its requirements related to computer records maintained for tax purposes. Since many computer records contain taxrelated information, this regulation impacts many computer systems in the United States.

SUMMARY OF COMPUTER REQUIREMENTS FOR TAX RECORDS

Internal Revenue Service Revenue Procedure 86-19 replaced the previous Revenue Procedure 6412 (adopted in 1964) with a new procedure which became effective April 7, 1986. The requirements of this new procedure are substantially different and will necessitate modifications in some existing computer systems. The following summary highlights the key points found in this revenue procedure as contrasted with the previous one:

1. All computer records must be retained by the taxpayer in a retrievable, machine-sensible form.

Previously, taxpayers were not required to maintain the tax information in computer-readable format for review by the Internal Revenue Service. Instead, only visible tax records and audit trails were required to ensure that information was correctly processed.

Under the new regulation, the Internal Revenue Service can request your computer tapes or disks for their analysis and review. The computer-readable information, as indicated below, must therefore be fully documented and maintained in a retrievable and usable form. Even when a service bureau or time-sharing service is used, the taxpayer will still be responsible for maintaining this information as indicated.

2. Documentation must be provided describing the computerized accounting system including record formats, flowcharts, label descriptions, software program listings, software program changes maintained in chronological order, and detailed charts of accounts. Audit trails should be provided to ensure that the steps leading from detailed to summary information can be examined by IRS.

Although the wording for this new requirement is different than the previous one, the nature of the documentation requirement is similar. The reader should note, however, that the IRS specifically requires that major changes in the computer system be documented and preserved in chronological order. This means that each major version of the software programs must be retained for later IRS review. No guidelines are provided, however, to differentiate between a major and a minor software change.

3. The computer records should be retained "so long as the contents may become material in the administration of any Internal Revenue law."

The Internal Revenue Service suggests that the retention period should match the statute of limitations for federal tax purposes (generally three to six years3), but will be extended in certain circumstances such as fixed assets, insurance loss reserve, and voluntary extension of the audit period.

4. The accounting records should also be retained in visible form, either on paper or microfilm.

Although the requirement for creating a visible or hardcopy record has been preserved from the original regulation, the Internal Revenue Service stresses that the maintenance of a visible record does not replace the requirement for the retention of machine-sensible records. Microfilm may be retained in place of paper records.

5. All computer records maintained for tax purposes should be clearly labeled and maintained in a secure environment, with backup files stored off-site.

While this requirement provides details related to the preservation of the computer information, the requirements actually conform to good computer practices for records storage and vital records protection.

6. The computer records must be maintained in a retrievable form for the entire time they are needed for tax purposes. Even if the taxpayer converts to a new computer system, the computer records must be converted to that new format or maintained in some other format that can still readily be retrieved.

This requirement is probably the most difficult and costly one to implement. Whenever an organization converts to a new computer system, the old computer tapes and disks may have tb be converted to the new format. Under the previous regulation, the taxpayers could simply produce visible output from the records and not worry about the various computer tapes or disks maintained in the storage area. Under the new regulation, all computer-readable material relevant for tax purposes must be maintained in a format which is readily retrievable. This will create a tremendous burden for some companies since audits are frequently extended more than ten years while computerized accounting systems change substantially approximately every three years.

The problem becomes extremely complicated in the case of acquisitions and mergers. Until the audit period has expired, the successor company is responsible for the computer records maintained by the previous organizations. Since these computer records are generally in a totally different format than the one used by the successor and are rarely documented properly, the successor might have no choice but to incur the cost of converting the tax records to one standard format.

7. Computer records should periodically be inspected to ensure the integrity of the information. If information is lost or damaged, the taxpayer is responsible for notifying the Internal Revenue Service immediately.

Similar to the provision related to the retrievability of computer records, the actual existence of these records and their continued usability must be carefully controlled by the taxpayer. Under the previous regulation, the taxpayer was only responsible for producing a record in visible form and could ignore the aging computer tapes. The new regulation places additional responsibility on the taxpayer to ensure that all computer records are protected and available. Standard computer practices should, therefore, be followed for periodic inspection, rewinding for tapes, and environmentally-protected storage.

8. Database management systems may be used for maintaining tax records, but additional documentation will be needed. In particular, the taxpayer must maintain a sequential file indicating all transactions that have occurred to the database along with the appropriate documentation for the sequential file and for the database management system.

While many organizations maintain a dynamic database for tax purposes, the Internal Revenue Service requires an audit trail to indicate all transactions, including modifications, that have been made to the database over time. For some organizations, however, this will not be a great burden since the required sequential file and audit trails will be part of a good database management system.

ENSURING COMPLIANCE WITH THE NEW TAX REGULATIONS

This section provides some specific suggestions related to compliance with the new regulation. The following steps should be initiated to ensure that your organization will not be assessed additional tax or be subject to criminal penalties for failing to properly maintain computer records.

1. Conduct a tax audit of your existing computer system based upon the new Internal Revenue Service regulation. While computer systems containing tax information should regularly be audited to ensure compliance with tax laws, the existence of this new regulation highlights the importance of such an audit. During the review, the auditor should focus carefully on system documentation, storage procedures for computer records, and the continued retrievability and reliability of older tax records in machine-readable format.

2. Inventory existing magnetic tapes and. disk files to determine their readability by the current computer system. Many older computer files were created by older versions of a computer system. Some of these records may even have been prepared by outside service bureaus, time-sharing companies, or even other companies which have since been acquired by or merged into your company.

Internal Revenue Service Revenue Ruling 86-19 requires that all computer records still subject to review by the Internal Revenue Service must be available and readable in machine-sensible format. Computer tapes and disks produced by other computer systems may now be totally incompatible and unreadable by your current system. According to this regulation, these computer tapes and disks must legally be converted into a format which can be retrieved at the request of the Internal Revenue Service. This new format may conform to your existing computer system or it may conform to any other available computer system. If the latter option is selected, the user will be responsible to ensure that another computer or service bureau is capable of converting your information to a format usable by the Internal Revenue Service on request.

3. When developing new computer systems, include the Internal Revenue Service requirements in the design. For the most part, the requirements of the Internal Revenue Service conform to good computer practices. Documentation should be provided for all computer systems, not just because the IRS says so, but primarily because this information is needed to analyze problems and facilitate future developments. The specific requirements of the Internal Revenue Service Revenue Procedure 86-19, should be followed, however, for the specific types of documentation, the specific procedures related to audits and media storage, and the retention of computer information in readable format.

IMPACT OF TAX REGULATIONS ON ELECTRONIC IMAGING SYSTEMS AND OPTICAL DISK

The electronic imaging systems or optical disk systems are tools available for storing image information rather than data.4 These systems have some of the qualities of microfilm and some of the qualities of data processing. While the Internal Revenue Service has not specifically indicated whether this technology will be treated under Revenue Ruling 81-46 (Microfilm) or Revenue Procedure 86-19 (Data Processing), the user might anticipate that both requirements should be followed, when appropriate, for this technology.

In terms of microfilm, the user must be certain that an accurate, visible image can be produced from the optical disk on request and that documented procedures are carefully followed to indicate the process for converting the source documents to the digitized format. In terms of data processing, the taxpayer must also maintain documentation related to the computer system and maintain the computer information in a format that can be retrieved at the request of the Internal Revenue Service. This latter requirement may prove to be an extreme hardship for those companies acquiring the optical disk technology only to find that the manufacturer has gone out of business or that their technology has become incompatible with the industry standard. It is therefore necessary to have a method for converting the optical disk image information into a machine-readable format for producing visible records or fulfilling the requirements of an IRS audit.

FOOTNOTES

1. See Skupsky, Donald S., "Legal Status of Microfilm and Other Duplicate Records," Records Management Quarterly, January 1985.

2. See Skupsky, Donald S., "Some Considerations Related to Records Retention Requirements for Tax Records," Records Management Quarterly, July 1985.

3. Ibid. See also Skupsky, Donald S., "Legal Requirements for Personnel Records," Records Management Quarterly, July 1987, for the 4-year retention requirement for employment tax records.

4. See Skupsky, Donald S., "Legal Status of Optical Disk and Electronic Imaging Systems," Records Management Quarterly, January 1986.

DONALD S. SKUPSKY, JD, CRM

Information Requirements Clearinghouse

Denver, Colorado

Copyright Association of Records Managers and Administrators Jul 1998
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