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Electronic records retention for businesses

File cabinet, courtesy Wikimedia Commons
File cabinet, courtesy Wikimedia Commons

I get this question quite a lot – “Can my business keep copies of receipts and other tax documents electronically and destroy the paper copy?” The short answer is “yes, as long as you meet the rules.”

Where does IRS get off requiring me to keep records?

Congress gave IRS broad authority to require taxpayers to keep records. Internal Revenue Code (IRC) Section 6001 begins: “Every person liable for any tax imposed by this title, or for the collection thereof, shall keep such records, render such statements, make such returns, and comply with such rules and regulations as the Secretary may from time to time prescribe.” If you choose not to keep something IRS says you should, then IRS is allowed to use its own judgement to determine the amount of income or deduction, within reason. Then the taxpayer has to prove IRS wrong. If you keep the records required, the onus is usually on IRS to prove you wrong.

Requirements for imaging hard copy records

The IRS has quite a few regulations and pronouncements on the records to keep and of course Congress has added some requirements directly into the IRC. The one this post is interested in is Revenue Procedure 97-22 (PDF), an almost 18-year-old pronouncement. It might be time for IRS to do some updating. The closest IRS gets to mentioning the cloud is to say that farming record retention out to a third-party does not relieve the taxpayer from complying with Rev. Proc. 97-22. Here is a brief list of the rules:

  1. All the rules for paper records apply to electronic records unless specifically exempted.
  2. The electronic system must:
    1. Provide an index
    2. Be able to reproduce legible records
    3. Preserve the records
    4. Provide reasonable controls to make sure the records and index are reliable
    5. Reasonable controls to prevent and detect unauthorized creation, deletion, and changes
    6. Include a quality control and inspection system
    7. Evidence of regular evaluations of the system to make sure it is operating as designed
  3. Be able to cross-reference the images to the books, for example the QuickBooks file.
  4. Be able to provide IRS:
    1. A complete copy of the electronic records
    2. An index to the records
    3. A description of the procedures for accessing the records
  5. There can be no contractual requirements that prohibit IRS access to all the records.
  6. The electronic records have to be kept “so long as their contents may become material in the administration of the Internal Revenue laws ….”

Selected practical guidance

Legible

Legible means just what you think it means, you have to be able to easily read everything. Not all scanners are good at this, especially if you are converting a color document into a black and white document. For a small business, at the start you might want to look at every image before destroying the original. Later on in the process, you should sample the scans, especially the ones you find are difficult to read if not handled precisely. For a larger business, sample the images even at the beginning but always look at the first few images for a new type of document.

Indexing

The Rev. Proc. says an index similar to what would be used with a paper filing system is acceptable. For a small business, an alphabetical index separated by tax year would work. The more volume to the records, the more detail in the index. For example, splitting expenses by vendor might be required if there are tens of thousands of documents.

Backups

Keep backups! IRS is not going to buy the equivalent of the “dog ate my homework.” Backup to USB drives, DVDs, or the cloud. Perhaps backup to all three. Just make sure to keep the documents secure and have a plan for protecting them from accidental or intentional erasure or manipulation. Consider keeping hard copies of documents that will just not scan legibly or that involve large amounts. Large being a relative term depending on the business.

What if I choose not to follow the rules?

I think you can guess the outcome – IRS can assess penalties, both monetarily and possibly criminally. If the scanned documents are not compliant with the Rev. Proc. then IRS can deny deductions and make other changes which the taxpayer will find difficult to refute since IRS has already determined the imaged documents are inadequate.