For several businesses in the Baton Rouge area, one of the many implications of the recent flooding is the loss of business records that are subject to retention requirements under various state and federal laws. In light of the destruction of many such records in the flood, a question arises as to the applicability of these retention requirements and the steps a business should take to maintain compliance with the law.
Under federal laws, businesses generally remain subject to their record-keeping obligations, but the IRS and the Department of Labor have provided some guidance in the past on how businesses who have lost records in a natural disaster can comply with the law.
With respect to records required to substantiate business losses and other tax deductions, the Internal Revenue Code addresses the loss of records due to circumstances beyond the taxpayer’s control. Specifically, Treasury Regulation § 1.274-5T provides that “[w]here the taxpayer establishes that the failure to produce adequate records is due to the loss of such records through circumstances beyond the taxpayer’s control, such as destruction by fire, flood, earthquake, or other casualty, the taxpayer shall have a right to substantiate a deduction by reasonable reconstruction of his expenditures or use.”
When claiming this exception, the taxpayer must be diligent about the reconstruction of records. Corroborating records or testimony regarding the specific expenses incurred is required, and a deduction will be denied if a business makes no attempt to recreate its destroyed records. Similarly, if the reconstruction is uncorroborated or perceived as unreliable, the deduction can be denied for lack of substantiation.
According to the Disaster Resource Guide published by the IRS, a business seeking to create a “reasonable reconstruction” of its lost business records should obtain copies of invoices from its suppliers, copies of bank statements, and copies of the last year’s federal, state and local tax returns, including payroll tax returns and business licenses, as these will reflect gross sales for a given time period.
In addition to reconstructing destroyed records, the Tax Court has indicated that it is necessary to document the extent of the destruction at the facility where the records were stored and the extent of the records that were lost. For instance, where the taxpayer did not provide evidence as to flood water damage at his record-keeping facility, the Tax Court denied the deduction, observing that it was not obligated to accept a taxpayer’s “unverified and self-serving testimony.” Darling v. C.I.R., 89 T.C.M. (CCH) 1334 (Tax 2005).
There is somewhat less guidance with respect to a business’s obligations to maintain records related to employees and employee benefit plans under applicable federal laws such as ERISA or COBRA. Generally speaking, these laws do not anticipate how to apply the record-keeping rules when a natural disaster occurs and records and businesses are destroyed.
Although there is no statutory guidance on the record-keeping requirements under these laws after a natural disaster, the Department of Labor has previously considered this issue in advisory opinions and in rules published in the Code of Federal Regulations. According to the DOL, the loss or destruction of records required to be maintained under ERISA does not discharge the business from its statutory duty to retain such records. 29 CFR Part 2520.
The DOL has also indicated that there is a general duty to reconstruct the records required to be retained under ERISA. That said, whether lost or destroyed records can, or should be, reconstructed and whether the persons responsible for the retention of records are, or should be, personally liable for the cost incurred in connection with the reconstruction of records is “necessarily dependent on the facts and circumstances of each case.” DOL Advisory Opinion 84-19A (April 26, 1984).
For instance, if reconstruction cannot be accomplished without excessive or unreasonable cost, a company would not be under a duty to reconstruct or attempt to reconstruct the lost or destroyed records. Further, if a company has access to other documents from which the lost or destroyed records could reconstructed and such other documents would be available to the company for the remainder of the requisite retention period, reconstruction of the destroyed records would not be required, provided that the company “make such agreements and arrangements necessary” to ensure that such other documents would remain available. DOL Advisory Opinion 84-19A (April 26, 1984).
In sum, if you or your business lost records in the flood which were subject to retention requirements, the best course of action is to undertake reasonable efforts that demonstrate good faith compliance with the law. Such steps include documenting the destruction done to the building in which your records were stored, the types of records that were kept prior to the flood, and the measures taken to remediate the problem. To the extent reasonable, make a good faith effort to reconstruct the lost records. Ultimately, if a business can show that it took the most reasonable and appropriate steps to comply with its record-keeping requirements, it may be able to persuade the IRS or other governmental authority to waive applicable sanctions.
For more helpful information on record reconstruction, the Disaster Resource Guide published by the IRS contains specific steps that individuals and businesses can take to reconstruct their records.