IRS Audit Requests for Electronic Files Generates Fear of Fishing Expeditions among Small Businesses

Controversy continues swirling around an Internal Revenue Service (IRS) decision requiring small businesses undergoing an IRS audit to turn over exact copies of the electronic records stored in their business-software programs. 

The IRS says the requirement will accelerate the pace at which audits are completed.  Small businesses fear it will expose sensitive information or data from years not subject to the audit – raising the prospect of fishing expeditions to find problems beyond the scope of the formal inquiry.

“There can be too many years in a file and, within the context of one year, there could be more information than what is necessary to cover a traditional IRS audit,” said Benson Goldstein, senior technical manager of taxation, American Institute of Certified Public Accountants (AICPA).  “…Many preparers fear the IRS Revenue Agent assigned to the case might launch into a fishing expedition, although Section 6103 prohibits the Revenue Agent from going beyond the scope” of the audit.

The requirement only affects small businesses (revenues under $10 million) that have implemented electronic accounting software.  Originally announced in 2009, the program rolled out gradually as revenue agents completed training, and is now active nationwide. 

As the number of small businesses subjected to the new reporting requirement grew, so did their concerns.  Small business accounting software generally contains both tax and non-tax related information, as well as information that may not be relevant to the tax year being audited.  This may include customer lists and personnel files.  In the case of some businesses, such as law firms or physician offices, it could also include legally confidential information.

These fears prompted the AICPA to submit a letter to the IRS in March 2011 urging the agency to allow small businesses to protect the private information in the electronic files that were requested for audits.

“Once the software file of a small business taxpayer is requested by the IRS for examination purposes, the AICPA believes the taxpayer should have the right to ‘redact’ the software file and turn over only the data that is responsive and relevant to the examination – but no more,” wrote the AICPA.

In its April 2011 response, the IRS noted that the general concept of requesting taxpayer books and records has not changed.  However, as more businesses adopt financial software, its practices must follow suit.

“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,” wrote the agency. 

Thus, small businesses and their tax advisors are left with few options.  They can turn over the requested information and risk exposure of unrelated data or they can refuse and risk a summons.

“If you turn it over, the one positive is that you hopefully continue to be in the good graces of the revenue agent…The other option is to refuse and offer an alternative, such as providing the requested documents or information on paper.  The agent may accept [that alternative] or issue a summons.  At that point, most tax professionals would recommend turning the files over,” said AICPA’s Goldstein.

He noted that while some businesses have fought the request, lower courts have tended to rule in favor of the IRS. 

“In the supermajority of situations, the counsel to the business would be that it is best to turn it over once the summons is issued,” Goldstein added.  “No matter what you do as a tax representative, before you decide anything you need to talk to your client and lay out all the options.  It has to be the client’s decision on how to respond to an IRS summons.”

While the IRS hasn’t changed its position, it has released new field guidance and updated the FAQs on its website.  It has also entered a dialog with the AICPA and software developers to identify modifications that could protect private information while still providing the IRS with access to the data it needs to conduct the audit.

Such modifications might include making it easier for a business to separate tax years or including a means for locking down certain types of information within the context of a specific year.

“Our stance is that we will continue to work with the IRS to provide more guidance, and they have been very open to that.  We are also working with software developers to find ways to make it easier for the customer to provide appropriate data to the IRS and nothing more,” said Goldstein.

One of those software developers is Sage Peachtree, which has been working closely with the AICPA and IRS to come up with a solution that “meets audit requirements while protecting our customers’ data,” said Andrea Moe, senior director of product marketing, Sage Peachtree.  “…We would like to see a mutually acceptable resolution that addresses small business concerns while supporting the needs of the IRS.”

In the meantime, Sage encourages small businesses to take several steps to safeguard the integrity of their data.  This includes backing up files at the end of each tax year, which can lessen the amount of data provided to the IRS should the company be subjected to an audit.  Many software programs, including Peachtree, offer the option of setting up automatic backups and also make backups mandatory before a fiscal or payroll year can be closed.

Moe also recommends companies utilize the internal accounting review function, which helps customers pinpoint and resolve mistakes or issues that could be revealed in an external audit.  Also important is use of the program’s audit trail function to keep tabs on activity in company data and following smart accounting practices such as separation of duties. 

“If there is concern about data that isn’t required for an audit, the company data file can be backed up and then purged for dates prior to the year(s) under audit, as long as they do 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,” said Moe.

She adds:  “Sage encourages small businesses to comply with IRS requirements and discuss data concerns with the IRS examiner conducting the audit.  And even if you expect your audit to go smoothly, it is still a good idea to enlist the services of an experienced tax professional to help you through the process.”

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