ERP Systems and Record Retention

The enterprise resource planning (ERP) revolution has brought about sweeping changes for businesses worldwide. ERP systems capture and manage efficiently more information than some ever thought possible, and the ability to access this data has changed the way businesses make decisions. However, while these systems capture information at an amazing rate, many companies do not have a means of maintaining access to the data for as long as it takes the IRS to audit the applicable tax years.

IRS Guidance

Early guidance. As early as 1971, the Service addressed record-automation issues. Rev. Rul. 71-20 held that punched cards, magnetic tapes, disks and other machine-sensible data media used for recording, consolidating and summarizing accounting transactions and records in a taxpayer's automatic data processing (ADP) system were records within the meaning of Sec. 6001 and Regs. Sec. 1.6001-1, and had to be retained as long as the contents may become material in the administration of any internal revenue law.

Rev. Proc. 91-59. This addressed all types of ADP systems, including microcomputer systems, data base management systems (DBMSs), and electronic data interchange (EDI) systems. Rev. Proc. 91-59 gave district directors authority to require smaller taxpayers to retain machine-sensible records, and to enter into record retention limitation agreements (RRLAs) with taxpayers.

Under Rev. Proc. 91-59, records retained should be in a retrievable format that provides the information necessary to determine correct tax liability. The taxpayer must ensure that the details and the source documents underlying any summary accounting data can be easily identified and made available to the IRS on request. A materiality standard for machine-sensible records, applicable at least until the expiration of the statute of limitations (including extensions) for each tax year, was established. Rev. Proc. 91-59 also states that in certain situations, some records (e.g., those pertaining to fixed assets, losses incurred under Sec. 832(b)(5) and LIFO inventories) should be kept for a longer period.

Rev. Proc. 91-59 provided further that use of a DBMS necessitates implementing procedures to ensure that appropriate records and documentation are retained. A taxpayer would meet this requirement if a sequential file exists and contains the detail necessary to identify the underlying source documents.

The Service also requires taxpayers using EDI to retain machine-sensible records that, in combination with any other records (e.g., the underlying contracts, price lists and price changes), contain all the detailed information required by Sec. 6001. Rev. Proc. 91-59 did not relieve a taxpayer of the responsibility of retaining hard-copy records created or received in the ordinary course of business and required by existing law and regulations.

Rev. Proc. 98-25. According to this revenue procedure, in general, all Sec. 6001 requirements that apply to hard-copy books and records apply as well to machine-sensible books and records maintained within an ADP system.

Rev. Proc. 98-25 was specific about the Service's expectations. Not only must a taxpayer's machine-sensible records provide sufficient information to support and verify entries made on returns and determine the correct tax liability, but those records will meet this requirement only if they actually reconcile with the taxpayer's books and return. Rev. Proc. 98-25 provided that a taxpayer establishes this reconciliation by demonstrating the relationship (i.e., audit trail):

• Between the total of the amounts in the taxpayer's machine-sensible rec-ords by account and the account totals in its books; and
• Between the total of the amounts in the taxpayer's machine-sensible rec-ords by account and its return.

Rev. Proc. 98-25 also provided that taxpayers may create files solely for the IRS's use. A taxpayer that creates such a sequential file must document the process, to establish the relationship between the file created and the original DBMS records.

Under Rev. Proc. 98-25, taxpayers must maintain and make available to the Service on request documentation of the business processes that:

• Create the retained records;
• Modify and maintain records;
• Satisfy the requirement to support and verify entries made on returns and to determine correct tax liability; and
• Provide evidence of the authenticity and integrity of records.

Under Rev. Proc. 98-25, a new standard requires taxpayers not only to identify records that have been lost, stolen, destroyed or otherwise damaged, but also to describe how and when the taxpayer proposes to replace or restore them, in a way that assures the records can be processed accurately.

Rev. Proc. 98-25 established a new standard for RRLAs, which taxpayers view as an opportunity to identify records that specifically do not have to be maintained. Rev. Proc. 98-25 also granted district directors formal authority to initiate a "records evaluation."

Meeting the Requirements

The most widely used ERP system, SAP, does not provide a means to store files sequentially once removed from the live system (such as during archiving). A retention solution developed by the Americas SAP User's Group meets these requirements. It provides a means by which files can be copied from the live system, as long as the relevant transaction details are copied to secure sequential files that can then be reviewed during tax audits. Although this solution was designed to meet the basic record-retention requirements established in Rev. Rul. 71-20 and Rev. Proc. 91-59 and further clarified in Rev. Proc. 98-25, taxpayer-specific customization may be necessary.

There are many issues to consider in formulating an effective record-retention policy. While the IRS acknowledges that implementation of record-management practices is a "business decision that is solely within the discretion of the taxpayer" (Rev. Proc. 98-25, Section 9), understanding the legal principles on which current guidance is based should be considered when devising a solution. The risks associated with inadequate records can be great when compared to the up-front costs of establishing retention policies, procedures and applications. The basic principle remains clear--when in doubt, keep it. To do otherwise may prove a costly mistake, with ramifications that reach beyond any current-year record-retention policy.

From Nina O'Connor, CPA, Washington, DC, Paul Grupe, Atlanta, GA, and Myrna Arin, New York, NY