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A Financial Status Analysis is an analysis of the taxpayers cash flows to estimate whether there are sufficient funds to cover the taxpayers expenses. The analysis serves two purposes:

The intent of the analysis is to determine whether there is a significant risk of a material misstatement of taxable income.
Materiality is the significance or importance of an item in determining the correct tax liability and requires the examiner’s
judgment regarding the return as a whole and the separate items that comprise the return. Among the factors which must be
considered when determining whether the imbalance is material are:

The Financial Status Analysis should include consideration of all sources and expenditures of funds identified on the tax
returns, information included as part of the case building, and internal sources of information such as Accurint, Currency
and Banking Retrieval System (CBRS), Information Document Retrieval System (IDRS), Corporate Files on Line (CFOL), and/or
Midwest Automated Compliance System (MACS). See Exhibit 4.10.4-2. for internal sources of information. Reasonable estimates for other expenses known to exist, but for which the exact costs
are not known should be included in the analysis. Personal living expenses (PLE) must be estimated using Bureau of Labor Statistics
information (or comparable statistic from a reliable source), except where the actual amount of the expense is disclosed on
the tax return.

The analysis should also be updated during the examination as additional information becomes available; i.e., nontaxable sources
of funds or disallowed expenses. Refer to See Exhibit 4.10.4-4., Example of Financial Status Analysis for Individual Business Return.

The “T-Account”
provides a quick and easy format for documenting and determining whether there is an indication of a potential understatement
of taxable income. Enter sources of cash funds on the left side of the T-Account and expenditures of cash funds on the right
side. Total sources are compared with total expenditures.

The completion of a Financial Status Analysis does not trigger the provisions of IRC section 7602(e), which states that “the Secretary shall not use financial status or
economic reality examination techniques to determine the existence of unreported income of any taxpayer unless the Secretary
has a reasonable indication that there is a likelihood of such unreported income”
. A Financial Status Analysis is an analytical tool used to identify and estimate the materiality of cash flow imbalances. Financial Status Audit Techniques are the formal indirect methods used to make the actual determination of tax liability and are subject to the limitations
of IRC 7602(e) . See IRM 4.10.4.6

Steps for completing a Financial Status Analysis:

Income or losses reported on Schedule E may not represent an actual flow of funds.

Common errors include failure to include loan payments as an application of funds, treating the Cost of Goods Sold as an application
of funds rather than current period costs (i.e.; purchases, labor costs, materials and supplies, and other costs associated
with inventory), and accepting unreasonably low estimates of personal living expenses.

An examiner may consider observing a taxpayers residence when completing a Financial Status Analysis. However, observing
a taxpayers home should not be intrusive and generally should not include talking with the taxpayers neighbors. Inspections
of the inside of a taxpayers home should be limited due to privacy issues and the intrusive nature. Note: the purpose of
inspecting the interior of a taxpayers home includes determining the validity of a deduction for an office or business located
in the residence.

Example:
An examiner believes, based on the address on the tax return, that the taxpayers home is located in a recently developed
subdivision where the homes are selling for more the $300,000. The preliminary Financial Status Analysis indicates that the
taxpayer could not support the purchase or maintenance of such a home based on the reported income. The examiner drives by
the home and discovers that the taxpayer lives in a modest 40 year old home across the street from the new subdivision.

The Financial Status Analysis, as originally prepared based upon the tax return data and information in the case file and
subsequently modified, will be made part of the examination workpapers.

Financial Status “Audits”
are cases where the Financial Status Analysis indicates that the taxpayers sources of funds are not sufficient to support
the taxpayers expenditures, and the use of a formal indirect method can be justified. Note: the decision to use a formal
indirect method should not be made until after completion of the minimum income probes.

The taxpayer should be interviewed. From the taxpayers perspective, an interview with an Internal Revenue examiner may be
overwhelming. Therefore, initial interviews should be professional and not overbearing.

Internal Revenue Code section 7521(c) states that an examiner cannot require a taxpayer to accompany an authorized representative
to an examination interview in the absence of an administrative summons. However, the taxpayers voluntary presence can be
requested through the representative as a means to expedite the examination process. Should an examiner find that a representative
has unreasonably delayed or hindered an examination, an examiner can bypass the representative and deal directly with the
taxpayer. See Exhibit 4.10.4-5., Bypassing Powers of Attorney

Question the taxpayer/representative concerning possible nontaxable sources of funds, gifts, loans, known errors/omissions
on the return, and unreported sources of income. These questions should be addressed at the initial interview early in the
examination. The information will be needed to reconcile the Financial Status Analysis, analyze the bank accounts, and reconcile
the income reported on the tax return to the books and records. Also, the information will be critical should it later become
necessary to use a formal indirect method to make the actual determination of tax liability.

Affirmatively obtain the beginning and ending balances for cash-on-hand from the taxpayer or representative for the year(s)
under examination. See IRM 4.10.4.6.8.3 for complete discussion and See Exhibit 4.10.4-1. for interview questions. Generally, cash-on-hand is currency associated with normal business practices and the need to complete
cash transactions with customers. If additional years are examined, be sure to determine and document the beginning and ending
cash-on-hand for those years. This information will be needed to complete the reconciliation of income as reported on the
tax return to the taxpayers books and records and will be critical should it later become necessary to use a formal indirect
method to make the actual determination of tax liability.

Affirmatively determine the beginning and ending balances of accumulated funds for the year(s) under examination. Generally,
accumulated funds is currency not associated with normal business practices. The funds may have been taxed in prior years,
originate from nontaxable sources, or may represent taxable income in the year under audit. See IRM 4.10.4.6.8.3 for complete
discussion and See Exhibit 4.10.4-1. for interview questions.

Ask the taxpayer for assistance to resolve a Financial Status Analysis indicating a material imbalance.

Ask the taxpayer to explain the accounting system, including:

Question the taxpayer regarding business policies and practices for:

Affirmatively determine the extent of the taxpayers use of the Internet for e-commerce purposes. See See Exhibit 4.10.4-7. for a list of interview questions.

IRC section 7521(b)(2) requires examiners to suspend interviews when taxpayers state that they wish to consult with a representative
or otherwise seek advice. The taxpayer’s right of consultation will be strictly observed and interviews will be suspended
and rescheduled accordingly. This provision does not apply to interviews initiated by administrative summons and will not
be used to repeatedly delay or hinder the examination process.

For Tax Compliance Officers and Tax Auditors: Completion of Forms 4700–A, Form 4700 Supplement, and Form 4700–B, Business
Supplement, will assist the auditor in fulfilling the minimum income probe requirements. Notations on the leadsheet are not
sufficient documentation.

Refer to IRM 4.10.7.3.2, Oral Testimony, for complete discussion and documentation requirements.

Conduct a tour of the business site. Generally, the principal location and any other locations acquired during the period
under examination should be visited, as well as reviewing Internet websites (see IRM 4.10.4.3.6.2). The purpose of a tour
is to:

A tour of the business site is not required for Office Audit cases. However, if appropriate (and with manager approval), a
tour of the business site may be conducted.

The results of a tour and any observations and/or comments should be documented in the examination workpapers.

See IRM 4.10.3.3, Tours of Business Sites, for complete discussion.

Evaluate the internal controls to gain an understanding of the taxpayer’s business operations and control features. The evaluation
will help examiners set the scope and depth of the examination of income and determine the appropriate audit techniques.

Examiners should:

The evaluation should not be limited to a consideration of the segregation of duties. See IRM 4.10.3.4 for complete discussion.
Examiners should:

While there is no exhaustive definition of weak internal accounting controls which will impact the scope and depth of the
examination of income, examples include:

Weak internal controls alone do not necessarily establish a reasonable likelihood of unreported income under IRC 7602(e) that justifies the use of a formal
indirect method to make the actual determination of tax liability. Examiners must also demonstrate that there are irregularities
in the taxpayers books and records. See IRM 4.10.4.3.3.5.

Example:
The fact that a taxpayer does not maintain separate business and personal bank accounts does not, per se, warrant the use
of a formal indirect method to make the actual determination of tax liability. The examiner must first determine whether the
books and records are reliable, whether the income per the books and records can be reconciled to the return, and whether
the taxpayer segregated or identified the sources of funds to properly account for taxable income. The test of whether an
examiner can use a formal indirect method to determine the tax liability is whether there is a reasonable indication that
there is a likelihood of unreported income.

The workpapers will document:

Reconcile the income reported on the tax return to the taxpayer’s books and records. Ask the taxpayer how income was computed
and duplicate the taxpayers steps. Refer to IRM 4.10.3.5.6, Step 6: Reconciling the Taxpayers Books and Records to the Tax
Return, for complete discussion.

Test the information obtained in the initial interview, observed during the tour of the business site, and from the evaluation
of the internal controls to determine if transactions were properly recorded.

Test Gross Business Receipts. For additional techniques, see IRM 4.10.3.9.

Test whether income from e-commerce activities has been accounted for in the books and records and reported on the tax return.
See IRM 4.10.4.3.6.4.

If the income per the books and records cannot be reconciled with the income reported on the tax return, ask the taxpayer
to provide an explanation for the difference; i.e., how the accounts per books were accumulated for the tax return.

Irregularities in a taxpayers books and records, or inconsistencies in reporting transactions may be an indication of unreported
income justifying the use of a formal indirect method to determine the actual understatement of taxable income.
Example:
A taxpayers books and records are reconciled to the income tax return. No discrepancy is noted when reconciling income to
the bank statements and sales journals, or verifying purchases by inspecting cancelled checks and invoices. The examiner also
attempted to tie purchases to specific jobs and the income received from those jobs. For a few purchases, there was no corresponding
job or income reported.

The lack of books and records, or the underlying source documents will justify expansion of an income probe beyond the minimum
income probes.
Example:
The taxpayer owns and operates a cash-intensive food service business. The taxpayers books and records tie to the tax return.
As part of the audit, the examiner should test gross receipts by tying the original source documents (cash register receipts
and/or invoices) to the books. However, the taxpayer does not have the original documents.

The fact that a taxpayers books and records were not prepared contemporaneously to the business activity does not, per se,
permit an examiner to use a formal indirect method to make the actual determination of tax liability. The test of whether
a formal indirect method can be used is whether there is a reasonable indication that there is a likelihood of unreported
income.
Example:
A taxpayer advises an examiner during an audit that the books were prepared after the end of the tax year based on bank statements
and cancelled checks.

Perform an analysis of the taxpayers business and personal bank accounts (including investment accounts); i.e., statements,
deposit slips, and canceled checks, etc. The examiner should use judgment to determine the depth of the analysis and use of
automation. The Service is not prohibited from asking for these records, as well as wire transfers, on the initial information
document request (IDR) or at any time during the examination for an individual business return. See IRM 4.10.4.3.3(1).

This analysis is used to

The steps of the Bank Account Analysis are:

Compare the total deposits with the reported Gross Income. Include all accounts, whether designated as personal or business.

If the analysis results in the identification of excess deposits over reported Gross Income, the excess represents potential
unreported income.

If the business expenditures paid by check are less than the deducted business expenses on the return, then the taxpayer may
be overstating expenses, paying expenses by cash (unreported income), or paying expenses from an undisclosed source of funds.

If the analysis indicates significant commingling of funds, then the internal controls are weak and the books and records
may be unreliable. (See IRM 4.10.4.3.3.4.)

A potentially material misstatement of taxable income identified through a bank account analysis establishes a reasonable
likelihood of additional unreported taxable income justifying the use of a formal indirect method to make the actual determination
of tax liability.

The initial reconciliation of income per the books and records to the tax return provides the examiner with an understanding
of how the taxpayer determined gross receipts. The books and records can also be used to evaluate the accuracy and reasonableness
of the reported amount of income through the use of ratios.

Horizontal Analysis – This analysis identifies changes over time and may result in the identification of LUQ items not readily identified from
a review of a single return alone. The tax return under audit should be compared to the prior and subsequent year returns.

Example:
In many industries, Cost of Goods Sold bears a direct relationship to Sales. An analysis of the prior and current year business
ratios indicates consistency between years. The analysis for the current and subsequent year indicates a change in business
practices that should be explained by the taxpayer.

Vertical Analysis – This analysis identifies differences between the taxpayers business and the industry standards for a given year and is
an indicator of the reasonableness of gross receipts and net profit reported on the tax return. Ask the taxpayer what the
gross profit should be and test the gross profit percentage by tracing specific transactions from the purchase of a product
for resale to the sale of the item. Industry statistics can be found at http://www.bizstats.com.

Example:
An analysis of the taxpayers business activity can be based on the following ratio.

Examiners are not limited to the ratio demonstrated above. Any ratio or standard available for the taxpayers industry can
be used for the analysis. See IRM 4.10.3.9.1, Gross Profit Ratio Test.

Example:
The taxpayer is the sole proprietor of a bar. The examiner reviews the taxpayers books and records, and tests the gross
receipts as a percentage of purchases. The taxpayer states that the markup percentage is approximately 150%, which the examiner
knows is consistent with industry practices. However, the examiner determines that the actual markup percentage is 100%. Based
on the taxpayers oral testimony and the industry practice, it appears that the taxpayer may not be reporting all of the gross
receipts.

Example:
The taxpayer sells pianos. The examiner selected a sample of four actual purchases and subsequent sales by the taxpayer;
the average markup for the four piano sales was 51.7%. Overall, for the business as reported on Schedule C, the markup is
27%. Based on the comparison, it appears that the taxpayer may not be reporting all of the gross receipts.

Prepare an analysis of the balance sheet and tax return information. The purpose of the analysis is to assist in the identification
of issues to be examined.

Significant changes to any accounts should be noted and resolved during the examination.

Use CFOL information or secure copies of subsequent and prior year returns from the taxpayer to complete the comparative analysis
when the examination is initiated.

Tie balance sheet accounts, such as Cash, to their respective source documents (Cash Receipt/Disbursement journals and bank
reconciliations).

Tie balance sheet accounts such as Accounts Receivable and Accounts Payable to the receivable/payable subsidiary ledger ending
balance.

Compare the adjusted trial balance to the balance sheet to ensure they match. Account grouping sheets should be requested
for this analysis. This is an essential step in the examination of a double-entry set of books.

Review the adjusting journal entries from the unadjusted trial balance to the adjusted trial balance for misclassifications,
unusual debits to income accounts or possible manipulations of reported income. The adjusted trial balance should be tied
to the general ledger to ensure there are no missing adjusting journal entries.

The general ledger should be scanned for large, unusual or questionable items in the journal entries or adjusting journal
entries, such as debit entries to income accounts or credit entries to asset accounts (i.e. Accounts Receivable that do not
flow from the Cash Receipts journal).

See IRM 4.10.3.8, Balance Sheet Analysis: Introduction, for additional instructions.

Perform a reconciliation of Schedule M–1, Reconciliation of Income/Loss Per Books with Income Per Return, or equivalent schedule.

Perform a reconciliation of Schedule M–2, Analysis of Unappropriated Retained Earnings per Books, or equivalent schedule.
The disposition, or changes to, retained earnings can indicate whether monies have been distributed to a shareholder and where
those funds originated. Refer to IRM 4.10.3.6.2, Schedule M-2, for complete discussion.

Perform a reconciliation of Schedule M-3, Net Income (Loss) Reconciliation for Corporations with Total Assets of $10 Million
or More.

Corporate and stockholder returns, as well as partnership and the associated partner returns, are considered related because
the returns are for entities over which the taxpayer (stockholder or partner) has control and which can be manipulated to
divert funds or camouflage transactions. Evaluate copies of the tax returns of significant shareholders or partners (greater
than 20% direct or indirect ownership) for:

See Exhibit 4.10.4-8., Tax Treatment of Diverted Income, if funds diverted from a corporation to a stockholder are identified.

Completion of the Required Filing Checks (see IRM 4.10.5) is not a violation of IRC 7602(e) .

Copies of related shareholder/partner returns should be obtained using CFOL or MACS first. If the CFOL and MACS information
is insufficient, the return should be requested from either the campus or the taxpayer for inspection. See IRM 4.10.5.2.2,
CFOL and MACS.

For cases in which entities related through a flow-through relationship are suspected, but cannot be otherwise identified,
examiners should request research using the yK1 Link Analysis Tool. This Tool provides a graphic representation of flow-through
relationships created by partnerships, trusts, and S corporations. The Tool uses Schedule K-1 data to depict ownership relationships
and income/loss flows between payers and payees. More information is available at http://sbse.web.irs.gov/Exam/Apps/yK1/yK1.htm.

Examiners should determine if the income from the related business entity was included on the shareholder/partners individual
return. If the income was reported and there are no other issues, the return should not be opened for examination. If the
income from the related business entity was not reported on the return, the examiner should open the shareholder/partners
individual return for audit. For example, the business did not issue Form W-2 to corporate officers. See IRM 4.10.5.4, Related
Returns, for additional discussion.

Independent of the potential underreported income from the business entity, the return should be opened for audit if the examiner
notes that a Financial Status Analysis based solely on the return indicates insufficient funds to support the identified expenses,
or a large, unusual, or questionable item is identified.

Effectively, examiners should determine whether the related return warrants examination from a classification perspective;
i.e., trace the transactions between the individual and related business entity, complete a Financial Status Analysis based
on the return as filed and internal sources of information ( See Exhibit 4.10.4-2.), and review the return for other potential issues.

Should the related individual return be opened for audit, it is subject to the minimum income probes and examiners are expected
to determine whether the taxpayer has reported the correct amount of taxable income. The depth of the examination of income
and the techniques used are dependent on the facts and circumstances of the case.

Example:
A closely held corporation was examined. The 100% shareholders personal expenses were deducted as a business expense on
the corporate return. The shareholders personal return was examined to make the adjustment for the unreported dividend. A
reasonable likelihood of unreported income on the shareholders return exists because the shareholder has manipulated the
corporate entity and camouflaged nondeductible personal expenses as deductible business expenses. The minimum income probes
should be completed for this related 100% shareholder.

This interview, wherever possible, should be held with the partnerships general partner (managing member if an LLC) or Tax
Matters Partner (TMP) if a TEFRA entity, or the corporate officer most familiar with the day-to-day operations of the business.
From the taxpayers perspective, an interview with an Internal Revenue examiner may be overwhelming. Therefore, initial interviews
should be professional and not overbearing.

IRC section 7521(c) states that examiners cannot require a taxpayer to accompany an authorized representative to an examination
interview in the absence of an administrative summons. However, the taxpayer’s voluntary presence can be requested through
the representative. Should an examiner find that a representative has unreasonably delayed or hindered an examination, an
examiner can bypass the representative and deal directly with the taxpayer. See Exhibit 4.10.4-5., Bypassing Powers of Attorney.

Question the TMP, corporate officer, or representative concerning possible loans, gifts, or other nontaxable funds, known
errors/omissions on the return, unreported sources of income and ask for any information necessary to resolve issues identified
during the pre-audit analysis. If loan proceeds are identified, request the loan application documents to validate that financial
reporting is consistent with the tax return. Discrepancies should be resolved with the taxpayers assistance.

Question the TMP, corporate officer or representative about Cash on Hand and Accumulated Funds. See IRM 4.10.4.3.3.2, IRM
4.10.4.6.8.3, and See Exhibit 4.10.4-1. for additional discussion.

Question the TMP, corporate officer or representative about e-commerce activities. See IRM 4.10.4.3.6.3 and See Exhibit 4.10.4-7. for additional discussion.

Question the TMP, corporate officer or representative about internal controls, including the segregation of duties, which
can be verified during the audit. The flow of money should be established to determine any potential control weaknesses which
could result in diversion of funds.

Additional interview questions can be found at IRM 4.10.4.3.3.2(3)(a). Although intended for individual business returns,
the questions are equally applicable to other business entities.

IRC section 7521(b) (2) requires examiners to suspend interviews when taxpayers state that they wish to consult with a representative
or otherwise seek advice. The taxpayer’s right of consultation will be strictly honored and interviews will be suspended and
rescheduled accordingly. This provision does not apply to interviews initiated by administrative summons and will not be used
to repeatedly delay or hinder the examination process.

Conduct a tour of the business site. Generally, the principal location and any other locations acquired during the period
under examination should be visited, as well as reviewing Internet websites (see IRM 4.10.4.3.6.2). The purpose of a tour
is to:

The results of a tour and any observations and/or comments should be documented in the examination workpapers.

See IRM 4.10.3.3 for complete discussion.

This requirement applies to Field examinations only.

Internal controls are the taxpayers policies and procedures to identify, measure and safeguard business operations and avoid
material misstatements of financial information. Evaluate the internal controls to gain an understanding of the taxpayer’s
business operations and control features. See IRM 4.10.3.4, Evaluation of Taxpayers Internal Controls. If the taxpayer maintains
electronic books and records, refer to IRM 4.10.4.3.6.5.

While there is no exhaustive definition of weak internal accounting controls, which will impact the scope of the examination
of income, examples include:

If it is determined that the internal controls are weak, identify when and how income could be diverted.

Example:
A taxpayers business consists of small home repairs and construction projects. The taxpayer files a corporate tax return
and is the 100% shareholder. The books and records tie to the corporations income tax return and the invoices tie into the
gross receipts shown on the return. The corporate return reflects a net profit of $5,000. The corporation did not pay the
taxpayer a salary, but the taxpayers spouse earned $30,000 in wages from an unrelated business (as reported on the shareholders
Form 1040 tax return). Although the cash flow analysis suggests sufficient funds to support the corporations expenses, most
of the gross receipts are cash and the internal controls are weak because the shareholders spouse maintains the books.

The workpapers will document:

Test the information obtained in the initial interview, observed during the tour of the business site, and from the evaluation
of the internal controls to gain a complete understanding of the taxpayer’s business operations and control features.

Reconcile the bank records. See IRM 4.10.3.7, Bank Record Reconciliations. The depth of bank record inspection will depend
on the reliability of internal controls and the judgment of the examiner. Refer to IRM 4.10.3.5, Examination of the Taxpayers
Books and Records, for complete discussion. Consider the results of the analysis of the primary shareholders’ or partners’
individual returns. The initial IDR may include a request for the business bank records, including the statements, deposit
slips and cancelled checks.

See IRM 4.10.3.9, Testing Gross Receipts or Sales, for a complete discussion and listing of audit techniques.

See IRM 4.10.4.3.6.4 for identifying Gross Business Receipts from e-commerce activities.

The taxpayers books and records can be used to evaluate the accuracy and reasonableness of the reported income through the
use of ratios.

Horizontal Analysis – This analysis identifies changes over time and may result in the identification of LUQ items not readily identified from
a review of a single tax return. The tax return under audit should be compared to the prior and subsequent year returns. See
IRM 4.10.4.3.3.7 for complete discussion and examples.

Vertical Analysis – This analysis identifies differences between the taxpayers business and industry standards for a given year and is an
indicator of the reasonableness of Gross Business Receipts and net profit reported on the tax return. Industry standards can
be found at http://www.bizstats.com. See IRM 4.10.4.3.3.7 for complete discussion and examples.

Determining whether a taxpayer uses the Internet can be done during any phase of the examination. However, if it can be identified,
the web site should be reviewed during the pre-contact stage.

.

If a web site is discovered, viewing it can provide insight into the taxpayers activities. Reviewing a taxpayers web site
is a complement to touring the physical business site; i.e., to gather information helpful to understanding the business activities.

To see how the web site looked in the year under audit, search the Internet Archive at http://www.archive.org. The search feature is call the “Wayback Machine.”
You will be provided with a historical copy of all available archived copies of the web site.

Use http://www.linkpopularity.com to identify websites with hyperlinks that are linked to the taxpayers web site. Linkpopularity.com is a metasearch web site
that uses the reverse link feature in Google, MSN and Yahoo to find websites that have hyperlinks pointing to a web site.

Evidence of an unreported e-business activity can be found by reconciling credit card payments as a taxpayer may consolidate
all credit card or payment vouchers when submitting them to the e-payment provider.

When reviewing a web site, consider the following questions..

Further inquiry will be needed to determine how the web site is supported; i.e., whether the web site is hosted by a third
party or maintained on the taxpayers own web servers, the location of the web servers, what equipment or computers are used,
who has access to the servers, what records are maintained, and when the web site was placed in service.

To document the case file, save the web site or make hard copies of the web site pages. Documenting the web site content before
the taxpayer limits access may be important to the development of, or providing evidence for, an unreported income issue.
To save a single web page with active hyperlinks using Microsoft Internet Explorer:

The taxpayer should be interviewed regarding Internet use for e-commerce activities. For individual business returns, the
taxpayer should be asked about both personal and business use. Payments made over the Internet need to be considered as part
of the minimum income probes.

See Exhibit 4.10.4-7. is a list of interview questions specific to Internet and web site use.

For more questions and explanations, see: http://www.e-commerce.web.irs.gov/ebg.htm (Income Probes > Sample Question and Answer).

This section provides an overview of common sources of taxable income generated by e-commerce activities and associated audit
techniques.

The Uniform Electronic Transaction Act (UETA) defines electronic records as a record created, generated, sent, communicated,
received, or stored by electronic means. The UETA is suggested legislation that the National Conference of Commissioners on
Uniform State Laws, in 1999, drafted and recommended be adopted by all states. More information about the UETA can be found
at http://www.nccusl.org .

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 taxpayers Automatic Data processing (ADP) system are records within
the meaning of IRC section 6001 and regulation section 1.6001-1, and are required to be retained so long as the contents may
become material in the administration of any internal revenue law.

Rev. Proc. 98-25, 1998-1 C.B. 689, specifies the basic requirements that the IRS considers essential when a taxpayer maintains
records within an ADP.

Rev. Proc. 98-25 provides an exemption for small business taxpayers with assets of less than $10 million at the end of its
taxable year in complying with the record retention requirements of Rev. Rul. 71-20 and Rev. Proc 98-25. For purposes of meeting
that exemption, a controlled group of corporations (as defined in IRC section 1563) is considered to be one corporation and
all assets of all members of the group are aggregated. Also, a small business taxpayer will not meet the exemption provided
in Rev. Proc 98-25 if any of the following three conditions exist:

An “ADP system”
consists of an accounting and/or financial system (and subsystems) that processes all or part of a taxpayers transactions,
records, or data by other than manual methods. It includes, but is not limited to, a mainframe computer, stand-alone or networked
microcomputer system, Data Base Management System (DBMS), and a system that uses or incorporates Electronic Data Interchange
(EDI) technology or an electronic storage system. Key requirements include:

Understanding the reliability of electronic books and records is critical to evaluating internal controls, reconciling the
books and records to the tax return, and obtaining records. The following attributes of electronic records need to be considered
when evaluating the reliability of electronic books and records:

Rev. Proc. 97-22, 1997-1 C.B. 652, provides guidance to taxpayers that maintain books and records by using an electronic storage
system that either images their hardcopy (paper) books and records or transfers their computerized books and records to an
electronic storage media, such as an optical disk, which allows books and records to be viewed or reproduced without the use
of the original program. Key requirements include

A taxpayer is not in compliance with the recordkeeping requirements under IRC section 6001 (and associated regulations) if
the taxpayers electronic storage system fails to meet the requirements of Rev. Proc. 97-22, and a Notice of Inadequate Records
pursuant to Regulation 1.6001-1(d) should be issued. See IRM 4.10.8.16 for complete discussion of Notices of Inadequate Records.

Traditional banks and other financial institutions that previously maintained account information such as signature cards,
loan applications, and account activity in hard copy may now do so electronically. Currently, there are online banks that
only do business on the Internet. Taxpayers can now maintain accounts with banks across the country or even overseas, rather
than with banks in close proximity to the their physical location.

The Internet has resulted in new third party record keepers whose information may be of help in resolving tax issues. These
new third party record keepers may be able to supply information regarding web site ownership, related websites owned by the
taxpayer, location of the business, contact information, and the taxpayers bank accounts. Examples include: