Implications of IRS examination of accounting software data.

• Author: Morris, Donald

PREVIEW

* It is important to understand the expanded scope of "books and records" in the context of taxpayers using accounting software.

* Training clients on accounting software but turning a blind eye to its misuse can spell trouble.

* Using accounting software correctly in some cases can bolster a taxpayer's case with the IRS.

* Caution must be exercised when attempting to limit access to data to which the IRS believes it Is entitled, including metadata.

Changes in the law often follow innovations in technology. Before the age of computers, accounting books and records meant paper documents. Now books and records include data files stored on a computer's hard drive or in the cloud. The Code's recordkeeping requirements are prescribed by Sec. 6001, which authorizes the IRS to issue rules and regulations to carry out the provision.

In addition to its obvious importance to practitioners and their clients, accounting software has taken on an important role in taxpayers' dealings with the IRS in court. QuickBooks accounting software claims the lion's share of the small business recordkeeping market, (1) and because QuickBooks is used so widely, all of the cases discussed in this article involve that software, but the issues apply to all accounting software packages.

This article reviews recent court decisions illustrating the importance of how taxpayers use their accounting software. In addition, one case demonstrates that when taxpayers try to leave a trail for the IRS, they may leave more information than they meant to, and another demonstrates that when taxpayers are trying to delete a trail, their efforts may not be fully successful or may be viewed as a badge of fraud.

In dealing with the IRS, it is important to understand the expanded scope of "books and records" in the context of taxpayers' use of accounting software. The IRS can request not only taxpayers' paper documents but also their data and backup files as well as information on who kept the records and when changes were made to those records. (2) This means that accountants and their clients need to know not only how to use the accounting software, but also what they can and cannot do with the computer records when a client is audited.

Blaming the Tools

There is an adage that a good worker does not blame the tools. In Ganias (3) not only did the taxpayer attempt to blame QuickBooks for his inaccurate records, but the trail of false entries in Quick-Books was an important factor the IRS used to defeat the taxpayer's argument that his underreported income was due to his innocent reliance on the accounting software. In attempting to exonerate himself by providing the IRS with key journal entries, Stavros Ganias unwittingly provided important metadata that proved his undoing.

Metadata "is information that describes how, when, and by whom a particular item or set of electronic information was collected, created, accessed, modified, and formatted." (4) This information may be important to the IRS because it "identifies the original date a transaction was entered in the electronic records, the dates of any changes to the entries, and the username of the person who made the entries." (5)

At his 2011 fraud trial, Ganias testified that he maintained his books and records for 2003--the year under examination--on QuickBooks and attempted to use this fact as part of his defense. Since 1985, Ganias had been the owner-operator of a bookkeeping, accounting, and tax preparation service. Before that, he had been an IRS revenue agent for 14 years. In 2003, Ganias used QuickBooks to maintain his own accounting records from which he prepared his 2003 federal income tax return, which significantly understated his income for that year. Upon an examination of his 2003 tax return, the IRS determined that he had violated Sec. 7201 (attempt to evade or defeat tax) by willfully evading his tax obligations for the year.

At trial, Ganias explained that in preparing his records using QuickBooks, he inadvertently entered several payments from a major client into his "owner's contributions" account rather than into a revenue account, which caused his QuickBooks statement of revenues and expenses to understate his net income. These figures, in turn, had been used to prepare his tax return for 2003.

According to the court, "for the government to convict a defendant of willfully attempting to evade or defeat any tax," it must prove "(1) willfulness, (2) the existence of a tax deficiency and (3) an affirmative act constituting an evasion or attempted evasion of the tax." (6)

Ganias's defense was that his admitted error in making the bookkeeping entry--that resulted in his underreported income--was not willful but was the result of using QuickBooks. This "good faith" defense sought to deflect the IRS's charge of fraud by undercutting the requirement for willfulness. To establish fraud the IRS must establish "that the law imposed a duty on the defendant, that the defendant knew of his duty, and that he voluntarily and intentionally violated that duty." (7) To overcome the taxpayer's claim that he had a "good faith" belief that he was in compliance with the tax laws, the IRS must prove, beyond a reasonable doubt, that the taxpayer did not hold such a belief.

In his defense, Ganias claimed that when he realized that he had made the coding error (entered the wrong account name/number in QuickBooks), he subsequently made a correcting journal entry to reclassify the payments to revenue; this entry, however, was made two days after a search warrant was executed at his office and a mirror image was made of his computer hard drives. Once the IRS obtains accounting software records, agents are instructed by the Internal Revenue Manual (IRM [section] 25.5.4.3) to make a copy of the computer files, in the event the taxpayer or its representative asks that the records be returned. (8) Sec. 7612(c)(2) provides for certain protections for the software copied, such as numbering copies and storing the software in a safe place.

The court noted "that, despite the corrections, when [Ganias] used QuickBooks to determine his income and prepare his 2003 tax return, the payments still did not show up on his profit and loss statement." Ganias further claimed that "even in making the corrections, he did not input the payments properly," and, as a result, "he innocently relied upon the incorrect profit and loss statement to prepare and pay his taxes."

The court was not persuaded by Ganias's testimony, pointing out that he was "hardly a neophyte with regard to the use of QuickBooks, bookkeeping principles generally, or the tax laws of the United States." The court noted that he was a "decorated and oft-promoted" IRS agent who had been responsible for auditing a number of large corporations during his time at the IRS.

For these reasons, he would have known that QuickBooks uses an account coding system with asset, liability, equity, income, and expense items grouped into easily recognizable blocks of numbers. For example--using a default chart of accounts--all equity accounts are grouped in a block with accounts numbered from 30000 to 39999, and all income accounts are grouped in a block with accounts numbered from 40000 to 49999. In addition, QuickBooks users must specify the type of account each time an account is created. It was therefore impossible for the court to recognize Ganias's bookkeeping errors as "good faith."

The final blow to Ganias's defense came, however, when the IRS introduced evidence "demonstrating that Ganias had previously improperly recorded payments in QuickBooks in such a way that the payments did not show up as income" and that "2003 was not a mistake, but rather, part of a larger pattern of willful evasion," (9) extending back at least to 1999, 2000, and 2001. In light of the file retention capabilities of QuickBooks (e.g, its Audit Trail Report and Voided/Deleted Transactions Summary Report), file...