During my last month as a senior trial attorney at the Internal Revenue Service (IRS), I trained hundreds of revenue agents nationwide on the basics of obtaining and using electronically stored information. If you are involved in a tax controversy with the IRS, by way of an audit or litigation, you should expect, and plan for, your digital information to be front and center. This article will introduce you to electronically stored information, explain its importance in tax controversy matters, address how the IRS may require that you produce it, and outline the methods of handling electronically stored information and how they might even save you money.
What is Electronically Stored Information?
Electronically stored information (ESI) is any information that is created, manipulated, communicated, or stored in digital form. For example, email, portable document files (PDFs), spreadsheets, and word processing documents are common examples that come to mind when we think about ESI. Less common examples include accounting software files, customer management databases, cookies, history, text messages, chat logs, file settings, social media messages and profiles. If you use computers, smartphones, and websites to create, organize, or store information—as the majority of us do—then you have ESI, and you cannot ignore it in a tax controversy.
ESI is more than the words and images that appear on a digital file. It also is the information that explains exactly how those words and images came to be in a digital file. That information about other data is called metadata. Metadata provides the date that documents and spreadsheets were created, modified, and by whom they were created or modified. Metadata provides the senders, recipients, and time and date stamps of emails. Metadata provides information about who may have created, modified, and deleted accounting entries.
ESI is stored in many places. It can be found on computers, smart phones, flash drives, hard drives, CDs, DVDs, and far more commonly now, in the “cloud,” on servers throughout the world. If you use a backup service, your service provider stores your ESI on its servers. If you use an email service provider, such as G Suite or Microsoft Office 365 Portal, then those providers store your ESI. If you create documents in the cloud, using services like Google Docs, Microsoft OneDrive, or Evernote, then those providers store your ESI.
Why is Electronically Stored Information Important in Tax Controversy?
ESI is increasingly important in tax controversy because the world continues to become more digital. We are shifting from handwritten paper documents to typewritten documents, to emails, to text messages, and more recently, to instant messages. We should expect that these new digital methods of creating and storing information are relevant in tax controversy disputes because ESI is a storyteller. And nearly every tax controversy requires that a fact finder—whether that be an IRS revenue agent, IRS appeals officer, or a Tax Court judge—decide the story as part of applying the tax laws.
The importance of ESI in tax controversy extends far beyond the words and images that appear on the digital files. ESI is easy to organize, search, and share, but the real reason that the IRS wants your ESI is because it wants to see the metadata—the data about the data. Metadata is not easily manipulated, and it may plainly contradict a narrative that a witness may provide. For example, a witness may proclaim that a promissory note was created when the transfer of funds occurred, but the draft document may show that the promissory note was created just days before a meeting with an IRS revenue agent. QuickBooks files, and other accounting software files, will show the date that entries were created, and when the IRS analyzes the data, it will want to know if entries were created or deleted in preparation for the audit. The details that ESI provide make it important to all of us.
Does the IRS have the power to obtain my Electronically Stored Information?
The IRS has broad summons authority to compel the production of information. That authority, provided by section 7602 of the Internal Revenue Code, authorizes the IRS to compel the production of data that may shed light on the positions taken on a tax return. But there are some limitations to the IRS's authority that are specific to ESI. The IRS must request ESI in the format that it wants—and it must exist in that format—before it can compel production, and the Stored Communications Act (SCA) limits the IRS's ability to obtain certain information from third party providers. Both are addressed below.
The IRS can only compel the production of information, including ESI, in the format that it has requested. If the IRS wants ESI in its native format—the files created by original creating applications—then it must say as much in its request. The same is true for taxpayers seeking information from the IRS through a Freedom of Information Act (FOIA) request. See Facebook, Inc. v. United States, No. 16-CV-05884 (N.D. Cal. June 19, 2017) (denying Facebook's motion to compel because it failed to request ESI in native format). IRS requests for information should be carefully reviewed. Taxpayers should only produce information in the format specified in the requests, and taxpayers have no duty to produce information to the IRS in any format other than as it is stored in the ordinary course of business. Taxpayers may have opportunities to object to the IRS's requested format, depending on the stage of the controversy and the issues presented, and the parties are always free to negotiate production methods that are beneficial to everyone involved.
The Stored Communications Act (SCA) was passed by Congress in 1986, well before the invention and prevalence of social media. But today, it offers important protections to taxpayers. The SCA prohibits third party providers from disclosing private communications without the account holder's consent. Congress wanted to provide Fourth Amendment-like protections for information stored online. Taxpayers should consider moving to quash summonses that the IRS issues to third parties when it appears to circumvent the SCA.
How should I handle Electronically Stored Information?
Your tax controversy attorney should be knowledgeable about ESI issues, and address its preservation and production with you. All parties, taxpayers and the IRS alike, have a duty to preserve ESI when litigation is reasonably anticipated. Tax controversy attorneys should provide written advice to clients to help them preserve ESI, commonly referred to as a “litigation hold.” Failure to preserve information may result in serious consequences, including sanctions against parties and attorneys. But the litigation hold is only the beginning of the process.
Once a litigation hold is implemented, tax controversy attorneys and their clients should assess the breadth of data involved—that which may be produced, and received—and consider the need for eDiscovery tools to assist with preservation and production of ESI. There are many different eDiscovery tools available, including dtSearch, Concordance, Clearwell, Relativity, , and more recently, DISCO. Selection of an eDiscovery tool should be made only after understanding the volume and type of data involved because costs vary.
eDiscovery tools offer money saving opportunities for taxpayers. These tools are capable of replacing expensive “eyes on” review—where an attorney reviews each document for relevance and privilege—with predictive coding, which is an efficient, computerized method of reviewing information to determine relevance and privilege. Predictive coding has been explicitly accepted by the Tax Court in one case. In Dynamo Holdings, Ltds v. Commissioner, 143 T.C. No. 9 (2014), the taxpayers sought to use predictive coding to respond to the IRS's discovery requests, and estimated that predictive coding would cost approximately $80,000 rather than $500,000 for “eyes on” review. The Tax Court ruled that the taxpayers could use predictive coding because its discovery rules were to be construed to “secure the just, speedy, and inexpensive determination of every case.” eDiscovery tools also may assist in reviewing information produced by the IRS, or other parties, by providing efficient search and organizational mechanisms for large amounts of data.
If you are involved in a tax controversy, ensure that your tax controversy attorney understands ESI and the important role that it may play, how to respond to requests for ESI, and how to efficiently and effectively manage it.