IRS Outlines Legal Basis for Demanding Small Business Client Data Files in Examination

The IRS Chief Counsel’s office in CCA 201146017 has provided a legal analysis of the rights of the agency to demand electronic data files from small business clients.  The IRS project, focused primarily on providing agents with access to Quickbooks and training on using the program, has generated some concern among small business advisers.

In conducting the analysis of what the IRS may force a taxpayer to produce under the threat of summons, the memo lays out three tests the IRS has to demonstrate regarding the information:

• Whether this data is within the scope of “books, papers, records and other data” as it appears in IRC §7602(a)
• Whether the specific information in question “may be relevant” to the examination in question under the standard provided in IRC §7602(a)
• Whether the IRS already possesses the information being requested

The memorandum focuses on answering five inquiries, the first being whether the IRS examining agent has the right to insist on the electronic file, with associated data, if the taxpayer and the taxpayer’s adviser provides the agent with paper printouts or spreadsheets of the data without all associated data (referred to as “metadata”).

The analysis begins by noting case law that has provided that electronic records fall within the “books, papers, records and other data” definition of IRC §7602(a), citing case law in support of a broad reading of that term.

The analysis continues that under IRC §7602(a) the IRS must only show that data “may be relevant” to the examination in order to summon the data.  The memo points out that the metadata contained in the file that most often would not be in printed reports include items such as original date the entry in question was made (as opposed to the date the entry is assigned for printing in reports), the dates of any changes made to that entry, and the username of the person that made the entries in question.

Such information, the memo concludes, may be important to either support or undermine the credibility of the underlying records.  Therefore, the memo argues, the metadata meets the “may be relevant” standard that allows the IRS to demand production of that data.

The memo continues to note that since the metadata is not contained in the spreadsheets or printouts, the IRS is not asking for duplicate data and therefore has the right to obtain that data in addition to printouts or extracted data in a spreadsheet.  Thus all requirements are met and the IRS can pursue the electronic file itself.

The second question posed is whether the IRS can pursue the original file if the taxpayer provides a truncated or altered copy of the file that removed the metadata.  Not surprisingly, the memo concludes that the same analysis applies to this question as the first one, and that the IRS has right to pursue the full electronic file in this case.  Advisers should note, though, that the question included the stipulation that the truncation or alteration had removed the metadata.

If the truncated file (such as an extraction of the entries applicable to and/or made in the year under examination) retained all metadata that was in the original file, then it would appear that the analysis would determine that the full file would be duplicative and the IRS would need to offer an additional reason for asking for the data—a reason that would indicate the agent wished to look beyond entries applicable to the year in question and/or entries made during that period.  Just as the memo notes that metadata provides information on the credibility of the entries, asking for this “metadata” from the agent to overcome the duplication argument would clearly provide useful information on the agent’s motivation.

The third question addresses this point, asking if the agent can obtain the original files to look at information for entries recorded and associated with periods outside the period under examination.  In this case the memo decides that the IRS can do this if, again, the data “may be relevant” but the answer specifically cautions the agent that “If the summons must be enforced or defended, the examiner must be prepared to describe in an affidavit the potential relevance of the information sought from periods before or after those being examined.”

As was noted above, the adviser should consider requiring the agent to make that case (in writing) for the potential relevance of the data before advising the client to acquiesce to the request.  This Chief Counsel Memorandum would prove useful in persuading the agent about the necessity to outline that position. By reducing the information to writing, it would prove useful in showing both what the IRS is thinking regarding expanding the scope of the information request and to help put a check on a never ending examination where issues are continuously raised and then dismissed with no change.

The fourth question asked if the IRS may obtain the information from the client’s accountant if the accountant has such records.  The advice concludes the IRS may do so under the authority of §7602(a)(2) to obtain that information from a third party in possession of the books.

However, CPAs should be aware that such a request would be limited by various potential privilege issues (such as preparer privilege under §7525 or work product privilege) in some circumstances.  Thus, a CPA receiving a request or, more ominously, a formal summons of such data should both advise the client of this matter and seek legal counsel regarding potential defenses against production in such cases.

While Circular 230 §10.20 does require the CPA to promptly submit information to the IRS, the provision specifically limits such production to a “proper and lawful request”  but indicates the request does not need to be complied with if the CPA “believes in good faith and on reasonable grounds that the records or information are privileged.” [Circular 230 §10.20(a)]

The fifth question discusses what the IRS should do with the data if a taxpayer voluntarily turns over the information via a flash drive, CD, etc.  The advice indicates that if such an item is voluntarily turned over to the IRS in an exam, the taxpayer has the right to demand the return of that item at any point.  For this reason, the agent is cautioned that he/she should make a backup copy of the data once it is received and that the original CD or flash drive will not become part of their examination file, but rather this backup electronic information.

Advisers should be aware that this admonition to the agent means that if a client does turn over files to the agent, the adviser should expect the IRS will immediately make backup copies of all data turned over.  Thus care needs to be taken to insure that only the electronic information covered by the document request and which the taxpayer and adviser have decided either must be turned over or which it is decided it is in the best interests of the taxpayer in this exam to turn over is included, as any additional data included will likely be retained by the IRS if the agent follows the outlined procedure.

The final question deals with application of these rules to cases at trial under Federal Rules of Civil Procedure.  To introduce the evidence at trial, the IRS would have to clear a bar that is higher than the “may” standard (the IRS now has to demonstrate relevance), but otherwise the analysis concludes that if the relevance standard is met, the data is required to be produced at trial in the format requested.

This memo provides a fairly comprehensive overview of what the IRS sees as the legal authority for their program to obtain electronic data and, if read critically, also outlines what the agency tacitly admits are the limits of the program.  Advisers working with small business clients in examinations need to become familiar with the general program, the IRS’s authority to move in this area and the limits of such authority.

The IRS appears determined to push forward with this initiative and advisers will likely find that IRS is not necessarily going to simply accept substitutes for the electronic file.  However, advisers should insure an agent makes clear the justification for why the requested item “may be relevant” if the client objects to providing such data or the adviser has concerns about the data to be provided (including privacy concerns for the customers of the taxpayer).  Certainly it appears that some level of redaction or modification would be acceptable and, in some cases, may be required by other regulations on release of confidential information imposed on the taxpayer.

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