BASIS REQUIREMENTS OF IRS WHERE TAXPAYER RECORDS MAINTAINED WITHIN AUTOMATIC DATA PROCESSING SYSTEM

Rev. Proc. 86-19

SECTION 1. PURPOSE

01 The purpose of this revenue procedure is to update Rev. Proc. 64-12, 1964-1 (Part 1) C.B. 672, and Rev. Proc. 80-42, 1980-2 C.B. 776, and to specify the basic requirements that the Internal Revenue Service considers to be essential in cases where a taxpayer's records are maintained within an Automatic Data Processing (ADP) system. Rev. Proc. 64-12 provides guidelines for record requirements to be followed in cases where part or all of the accounting records are maintained within an ADP system, and Rev. Proc. 80-42 extended the ADP requirements to the windfall profit tax under section 4997 of the Internal Revenue Code. References here to ADP systems include all accounting and/or financial systems that process all or part of a taxpayer's transactions, records, or data by other than manual methods.

02 The technology of automatic data processing has evolved rapidly, and new methods and techniques are constantly being devised and adopted. The requirements set forth in Section 5 of this revenue procedure are intended to ensure that all machine-sensible records generated by a taxpayer's automatic data processing system are retained so long as they may become material in the administration of any internal revenue law. These requirements will be modified and amended as the need indicates to keep pace with developments in automatic data processing systems.

03 This revenue procedure pertains to taxpayers with assets of $10 million or more. For the purpose of this revenue procedure, a controlled group of corporations will be considered to be one corporation and the assets of all members of the group will be aggregated.

04 The District director has the authority to enter into an agreement with the taxpayer to modify or waive any or all of the specific requirements of this revenue procedure. The taxpayer remains subject to all requirements of this procedure that are not specifically modified or waived by the agreement.

SEC. 2 BACKGROUND

01 Section 6001 of the Code provides that every person liable for any tax imposed by the Code, or for the collection thereof, shall keep such records as the Secretary may from time to time prescribe.

02 Rev. Rul. 71-20, 1971-1 C.B. 392, establishes that all machine-sensible data media used for recording, consolidating, and summarizing accounting transactions and records within a taxpayer's automatic data processing system are records within the meaning of section 6001 of the Code and section 1.6001-1 of the Income Tax Regulations and are required to be retained so long as the contents may be material in the administration of any internal revenue law. Accordingly, a taxpayer is required to retain all machine-sensible files generated by its automatic data processing system unless a retention agreement is reached with the District Director to limit the retention to certain specified records.

SEC. 3. SCOPE AND OBJECTIVE

01 Modern data processing accounting systems are capable of recording business transactions much more rapidly and accurately than manual systems, and they are capable of retaining and producing vast amounts of data. The ability to produce in legible form data necessary to determine at a later date whether or not the correct tax liability has been reported must be carefully considered in designing and programming an ADP system. This factor may add to the complexity of the system and require additional cost, but this cost may be negligible in comparison to the expense that may be incurred at a later date if the system cannot practically and readily provide the information needed to support and substantiate the accuracy of the previously reported tax liability. This revenue procedure encompasses all types of data processing systems, including those using a Data Base Management System.

02 The requirements of this revenue procedure pertain to income, windfall profit, excise, employment, and estate and gift taxes.

03 The requirements of this revenue procedure are applicable to the machine-sensible records generated by a Controlled Foreign Corporation (CFC), since the definition of "records" in section 964(c) and 982(d) of the Code and the regulations thereunder has the same meaning as "records" as used in section 6001 and section 1.6001- 1(a) of the regulations.

04 Machine-sensible records used by an insurance company to determine its loss deduction under section 832(b)(5) of the Code must be retained in accordance with the requirements of this revenue procedure and Rev. Proc. 75-56, 1975-2 C.B. 596. The machine-sensible file(s) for a particular taxable year include(s) that year and the seven preceding years, all of which must be retained so long as they are material to the examination of the return. Normally that materiality continues until the expiration of the statute of limitations (including extensions) for the tax year under examination.

SEC. 4. MACHINE-SENSIBLE RECORDS EVALUATION

01 A record evaluation may be conducted by the District Director to determine if a taxpayer may limit its retention of machine- sensible records. This evaluation of the data processing and accounting systems may be initiated by the District Director or requested by the taxpayer and is not an "examination," "investigation," or "inspection" within the meaning of section 7605(b) of the Code, since such an evaluation is not directly related to the determination of tax liability for a particular taxable period.

02 The District Director may periodically initiate tests to establish the readability and completeness of the machine-sensible records retained under a retention agreement. Such tests are not an examination of the books and records within the meaning of section 7605(b) of the Code, since they are not directly related to the determination of tax liability for a particular taxable period.

SEC. 5. REQUIREMENTS

01 All machine-sensible records must be retained by the taxpayer. The retained records must be in a retrievable format that provides the information necessary to determine the correct tax liability. The utilization of a service bureau or time-sharing service does not relieve the taxpayer of its responsibilities as described in this revenue procedure.

02 Documentation that provides a complete description of the ADP portion of the accounting system and those files that feed into the accounting system must be retained. The statements and illustrations as to the scope of operations should be sufficiently detailed to indicate: (a) the application being performed, (b) the procedures employed in each application, and (c) the controls used to insure accurate and reliable processing. The following specific documentation for all files must also be retained:

(1) record formats (including the meaning of all "codes" used to represent information);

(2) flowcharts (system and program);

(3) label descriptions;

(4) source program listings of programs that created the files retained; and

(5) detailed charts of accounts (for specific periods).

Major changes to the ADP system, together with their effective dates, should be noted in order to preserve an accurate chonological record. This record should include any changes to software or systems and any changes to the formats of files. Audit trails should be designed to insure that details underlying the summary accounting data, such as invoices and vouchers, may be easily identified and made available to the Service upon request.

03 The records are required to be retained so long as their contents may become material in the administration of any internal revenue law. At a minimum, this materiality is possible until the expiration of the statute of limitations (including extensions) for each tax year. In certain situations, files should be retained for a longer period (for example, fixed assets and insurance loss reserve).

04 The provisions of this revenue procedure do not relieve taxpayers of their responsibility for retaining hardcopy records. The hardcopy records may be retained in microfiche or microfilm format in accordance with the requirements outlined in Rev. Proc. 81-46, 1981-2 C.B. 621. These records are NOT a substitute for the machine-sensible records required to be retained as described in section 5.01 above.

05 All retained records must be clearly labeled and stored in a secure environment. For example, supplemental labels with the statement, "Retain for IRS until __________" or "Retain for IRS, Consult Tax Manager Before Releasing" should be used and affixed to each tape reel, disk pack, or diskette being retained, with a retention date on the internal label. Back up machine-sensible files being retained for the Service should be stored at an off-site location.

06 The taxpayer must have the capability to access the retained records at the time of a Service examination. When the data processing system that created the records is being replaced by a system in which the records would not be compatible, the taxpayer must convert them to a compatible system. Any changes in the accessibility of the retained records must be reported to the Service. The District Director has the authority to enter into an agreement with the taxpayer to modify or waive any or all of the requirements for conversion or to approve substitute procedures. The taxpayer remains subject to all requirements that the agreement does not specifically modify, waive, or replace.

07 The limitation pursuant to a retention agreement on machine- sensible records to be retained does not apply to subsidiary company acquired, or accounting and tax systems added, subsequent to the completion of the record evaluation or re-evaluation. All machine- sensible records produced by these companies or systems must be retained until such time as a reevaluation is conducted by the District Director. On disposition of a subsidiary the files being retained for the Service by, or for, the disposed subsidiary should be retained until a new evaluation can be made by the District Director. A reevaluation can be requested by the taxpayer.

08 The taxpayer should make periodic checks on all files being retained for use by the Service. if any machine-sensible records required to be retained are subsequently lost, destroyed, damaged, or found to be incomplete or materially inaccurate, the taxpayer must report this to the District Director and re-create the files within a reasonable period of time.

09 The use of Data Base Management Systems (DBMS) necessitates the implementation by the taxpayer of appropriate procedures to ensure that required records and other needed documentation are retained to comply with this revenue procedure. A taxpayer is in compliance if it creates, for Service use, a sequential file(s) that contains all detail transactions necessary to create an audit trail to trace back to the underlying source documents. All necessary fields must be identified and the file documentation must follow the rules in section 5.02 above. This process should be reviewed by the Service prior to creation. These sequential files must be processible by conventional means. As a minimum, the following documentation must be made available:

(1) Data Base Description (DBD);

(2) Record layout of each segment with respect to the fields in the segments;

(3) Systems Control Language;

(4) Program Specification Block (PSB);

(5) Program Communication Block (PCB).

Any taxpayer that has questions or is uncertain as to its responsibilities within respect to the retention of data when utilizing a DBMS should contact the District Director.

SEC. 6. PENALTIES

Failure to comply with the provision of this revenue procedure may result in the assertion of the addition to tax under section 6653(a) of the Code, a civil penalty. The criminal penalty under section 7203 may also be applicable. See Rev. Rul. 81-205, 1981-2 C.B. 225. In addition, the District Director may issue a Notice of Inadequate Records if machine-sensible records were not properly retained as required by this revenue procedure.

SEC. 7. COMMENTS OR INQUIRIES

Comments or inquiries to this revenue procedure should be addressed to the Assistant Commissioner (Examination), Attention: OP:EX, Internal Revenue Service, 1111 Constitution Ave., N.W., Washington, D.C. 20224.

SEC. 8. EFFECTIVE DATE

This revenue procedure is effective April 7, 1986, the date of publication.

SEC. 9. EFFECT ON OTHER REVENUE PROCEDURES

Rev. Proc. 64-12 and Rev. Proc. 80-42 are superseded.