United States

Guidelines for tax record retention

FINANCIAL INSTITUTIONS INSIGHTS  | 

The cornerstone of successful management of an IRS examination for financial institutions is a sound records retention policy. The failure to maintain records for the proper amount of time and in the right format can lead to increased tax liability, penalties and interest. Generally, any business record that supports or proves an issue on the institution's tax return should be kept. This requirement is stated in section 6001 of the Internal Revenue Code, which also stipulates that records must be available at all times for inspection by the IRS. Although section 6001 may sound simple and straight-forward, it can be complex to implement in the real world. The burden of proof is placed on the taxpayer to determine the length of time to keep the record, in what format, whether facsimiles are acceptable as proof, whether backup files are necessary, and a host of other issues relating to management of records. The issue becomes even more complex with a corporate merger, where conflicting record systems and obsolete technologies raise new questions on how to interpret the law.

In terms of what to keep and for how long, section 6001 requires that the records must be maintained so long as they may be material in the administration of the tax law. The general rule is to keep any record that supports an item of income or deduction until the statute of limitations expires (generally three years from the date the return is filed). Typically, the IRS can audit a return and assess additional tax only during the statutory period. Thus, such information as sales, cost of goods sold and inventory would need to be kept only as long as the statute of limitations for that particular return has not expired. However, there are exceptions to this rule. Institutions must keep records of their basis in assets (e.g., buildings, land, fixtures) almost indefinitely to substantiate capital gain or loss on the asset's final disposition. Net operating losses and other carryback items can often extend the time frame that records are kept for the carryback years. Employee wage and salary information provided to the Social Security Administration, other federal agencies and to state tax administrations must also be kept for many years.

Another key issue is the format or storage medium of the record, and whether it will meet the requirements of section 6001. Whether the records are electronic records, databases, microfilms, scanned images, hardcopy or are kept on external storage media, a number of questions can arise as to how these records should be maintained to support information on the tax return. The IRS has issued detailed guidance on this issue in the form of Revenue Procedures, three of which are discussed in this article.

External storage media and scanned images

Revenue Procedure 97-22, 1997-1 C.B. 652, establishes guidelines for taxpayers whose hard copy original records are scanned into an electronic storage system, or whose electronic records are transferred to an external storage medium, such as laser or optical disks. In order to meet the requirement, the scanned or transferred image must reliably transfer, store, preserve and reproduce the original record, and must have "a high degree of legibility when reproduced". Legibility and readability is required for both paper reproductions and for records displayed on a video display terminal.

Additionally, the electronic storage system must have an indexing system that allows retrieval of the records and the ability to reproduce the record in hard copy form upon the request of the IRS. If the financial institution maintains a separate set of records or source documents, whether in hardcopy or in an automated data processing system, the two information systems must be cross-referenced in a way that creates an audit trail between the two. A procedural manual which explains the use of the electronic storage system must be made available to the IRS during an audit, as well as any other resource needed to access the documents (e.g., software, trained personnel). Moreover, the IRS is authorized to test equipment for compliance with section 6001. If a deficiency is found in the electronic storage system and no backup documents exist, the officer may issue a Notice of Inadequate Records. Such a notice would present difficulties for companies that issue audited financial statements in reliance on the integrity of financial records. Furthermore, the failure to maintain adequate records could support the imposition of the accuracy related penalty under section 6662 of the Code, and, in certain circumstances, criminal penalties.

These rules raise a number of questions for financial institutions. For example, can the records be kept in data compression formats? Generally yes, according to Rev. Proc. 97-22, which accepts this practice as long as the compressed information can be retrieved and reproduced during an audit. Another question is whether to keep the originals or hardcopies of books and ledgers, as well as the original source documents, where a microfilm copy exists. Generally, these backup documents do not need to be kept, as long as the electronic storage system is in compliance with the key requirements (legibility, readability, accessibility, etc.) of section 6001.

Another problem occurs where records reside on an obsolete technology or one that is no longer actively maintained. This is a common dilemma facing financial institutions after an acquisition, where the institution decides to retire or deactivate the acquired company's systems or software. Once again, the key consideration is to ensure that such records are available and reproducible in the event of an IRS exam. To meet this requirement, the institution should take steps to convert or transfer the information, maintain the older technology, or initiate whatever solution is deemed cost-effective and appropriate for their situation. If this is not done and the records reside on systems or software that are no longer supported by the institution and hence, are not accessible to auditors, then from the IRS' viewpoint, the records will be "deemed destroyed by the taxpayer", a determination that could lead to the issuance of a Notice of Inadequate Records and potential penalties associated with the inability to substantiate items on the tax return.

Electronic and automatic data processing system records

Revenue Procedure 98-25, 1998-1 C.B. 689, deals with records kept on an automatic data processing (ADP) system, defined as a financial or accounting system that processes transactions on a non-manual system. In practice, this usually refers to some sort of database management system, mainframe computer system or network of microcomputers. It may also include Electronic Data Interchange technology, defined as a computer-to-computer exchange of information. In Rev. Proc. 98-25, the term "machine-sensible record" is defined as any electronic record that is created, stored or intended to be used on a computer, which would preclude microfiche, scanned imaging, optical or laser disk and paper/hardcopy storage media.

For IRS' purposes, machine-sensible or ADP System records must be maintained if their contents support the information on the financial institution's tax return. The key requirement here is that the relevant information must be "capable of being processed", i.e., that it can be accessed, retrieved and reproduced in paper copy or on electronic storage media upon request by the IRS during an examination. The records must have transaction-level detail, and must show a clear audit trail between the electronic record and the underlying source document. Rev. Proc. 98-25 allows for the computer system on which the electronic records reside to be discontinued, so long as the electronic records are retained in processible form and are available to the IRS. For example, a set of files can be created solely for the IRS's use by creating and retaining a sequential file that contains transaction-level detail from the database management system that is being discontinued. If this option is followed, the process of creating the sequential file must be documented such that the relationship between the sequential file and the original database management system records is established.

If electronic data interchange (EDI) technology is employed, the system may not capture all data required to substantiate items that are reported on a tax return, and thus, may not satisfy all the requirements of section 6001. Thus, supplemental records should be maintained.

Microfilm records

Microfilm records, which include microfiche, magnetic tape and other micrographic systems, are not commonly used for today's storage needs, but many older generation records still reside on the medium. Last updated in 1981, Revenue Procedure 81-46, 1981-2 C.B. 621, offers guidelines on this topic. Microfilm records are considered to be in compliance with Section 6001 if they are exact duplicates of the original ledgers or books (e.g., journal, cash books, voucher registers), and are readable and legible. Similarly, it is the responsibility of the taxpayer to develop a set of operating procedures for the microfilm records, which can be provided to the IRS during an examination. A workable microfilm reader and printer must be available for the use of the IRS. Operating procedures should include inspection and quality assurance procedures, and should establish a clear audit trail linking the original documents to the microfilm version. Furthermore, the taxpayer is required to maintain detailed indices of all microfilm information, so that any record can be immediately retrieved or accessed by the IRS. The financial institution must use the microfilm system regularly in the course of their business.

Finally, it's important to put the recordkeeping issue in perspective. Records retention is essential for compliance with the tax law. However, since records management can be a costly process (in terms of warehouse space, systems maintenance and operational personnel), financial institutions should not feel compelled to retain records longer than is reasonable and necessary to comply with the law. A prudent corporate policy is to regularly review recordkeeping budgets and practices against IRS guidelines. Overall, records management may have complex tax, accounting and budgetary implications.

For more information or assistance with this topic, please contact your local financial institution specialist, or either Patti Burquest, Managing Director, Tax Controversy Services, McGladrey at 202.370.8236 or Bob Adams, Managing Director, IRS Practice and Procedure, McGladrey, 202.370.8215.

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