Practice Management QuickBooks Small Business

IRS Audits and your QuickBooks Data File

Written by Scott Bonacker

The IRS has been training revenue agents on how to use QuickBooks, and they may request your QuickBooks company file as a part of an audit. What does this mean to accounting professionals and their clients? This has been a hotly debated topic – let’s take a look at the facts.

The first I heard that the IRS might be asking for a copy of the QuickBooks data file was in a June 2010 message to one of the tax study groups in Yahoo Groups. A group member reported to the others on one of the topics discussed at an IRS liaison meeting:

QuickBooks rolled out to all of their revenue agents recently.

At first I was concerned, but as I thought about the implications I realized that taxpayers have always been required to retain the records backing up their tax returns, and IRS has always been able to ask to examine those records.

About a year has passed now and there have been more discussions and more releases from IRS on the subject.

Preserving Records

Internal Revenue Code§ 6001 requires a taxpayer to maintain books and records that substantiate income, deductions, and credits, including adequate records to substantiate deductions claimed as trade or business expenses. Along with loss of deductions, negligence penalties may also be assessed if a taxpayer has failed to maintain required copies of historical records to substantiate a tax return

To quote a statement from an IRS liaison officer –

“IRS has found that many taxpayers do not save hard copies of their records or the copies they have are incomplete.”

As a matter of fact, in a quick review of a handful of record retention guidelines that can be easily found with Google on some CPA and other accountant’s websites, it is clear that keeping a copy of the general ledger, whether in printed form or as an electronic data file, is not always included in the lists of things to keep. Bank statements, invoices, paid bills, etc. and all that are mentioned consistently but not always general ledgers and trial balances.

This may be due to an impression that small businesses and in particular small business software were exempt from some of the electronic recordkeeping requirements that big corporations have long been living with. But it is becoming clearer that it was a false impression.

Revenue Procedure 1998-25 states in part:

“(2) A taxpayer with assets of less than $10 million at the end of its taxable year must comply with the record retention requirements of Rev. Rul. 71-20 and the provisions of this revenue procedure if any of the following conditions exists: (a) all or part of the information required by § 6001 is not in the taxpayer’s hardcopy books and records, but is available in machine-sensible records; (b) machine-sensible records were used for computations that cannot be reasonably verified or recomputed without using a computer (e.g., Last-In, First-Out (LIFO) inventories); or (c) the taxpayer is notified by the District Director that machine-sensible records must be retained to meet the requirements of § 6001.”

A too-quick read of those words would focus on the $10 million cutoff and skip over the qualifications. But the IRS website states (see Q7):

“Revenue Procedure 1998-25 does not exempt a taxpayer from providing electronic records, if such records exist.”

IRS Legal Authority for requesting electronic files

In early 1999 an analysis and critique of Revenue Procedure 1998-25 in the Tax Executive magazine pointed out that:

“A taxpayer is required to promptly notify its District Director in the event that records are lost, stolen, destroyed, damaged, or otherwise no longer capable of being processed.”

How many small businesses notify IRS if their computer crashes and they lose their data? Or if they update software and the data file has to be reformatted to work with the new software?

This represents one of the great opportunities for the tax professionals: Helping clients to make sure that they have the records that they are required to keep, and that they keep them as long as they should. This is not to say that it hasn’t always been important, but additional publicity can make the advice more effective. It is certainly getting more notice now because the press releases and other things are specifically mentioning the accounting software applications. And because QuickBooks is predominant that is the one that is getting the most air-time.

The requirements for preserving electronic records potentially include more than just the transactions stored in the accounting software. The history of IRS rules is that Revenue Rule 71-20 addressed the existence of computerized records – punch cards, mag tape, etc. – and Notices 1996-09 and 1996-10 come along and give recognition to the growing practice of scanning and destroying documents and only keeping the images in the paperless environment. The point here is that the regulations on what records to keep have expanded to include not only the accounting transaction files – general ledger and related subledgers – but the scanned documents that are part of some business’ paperless management practices as well.

Locating copies of notices, revenue procedures and revenue rulings dealing with electronic record keeping would add very valuable resources to anyone’s tax library. Many of these relevant documents have been collected and made available on the University of Iowa website.

I should point out that while QuickBooks is frequently mentioned in any discussion of this topic, Peachtree, MAS 90, Dynamics GP, BusinessWorks, and any other brand of software, are equally subject to the same rules and regulations.

Responding to Requests

When a QuickBooks user reports that there is an examination by IRS and a copy of the data file is requested, a common response has been to say variously that a new file can be created and then transactions for the relevant year transferred, or that the transactions can be exported to Excel or that the reports can be printed to paper and given to IRS instead of a copy of the data file.

A better response would be for the taxpayer representative to talk with the requestor about whether that is necessary or whether some other format or a more limited collection would be acceptable.

In a worst case scenario, an insistent request for a copy of the data file that is met either with flat refusal or by handing over something that was altered or newly created in response to an Information Document Request could be interpreted as one of the “Badges of Fraud” that leads to further investigation.

The IRS says, in a FAQ page (note, subsequent to publishing this article, the IRS moved this document):

“If the taxpayer or representative creates or reconstructs a new company file, for example, by re-inputting the transactions for only the year under examination, this new file does not satisfy the requirements or needs of the IRS. The new or modified company file is not a copy of the books and records of original entry. The altered electronic file would not meet the requirements of the Information Document Request or a summons and the taxpayer’s representative could be in violation of Circular 230.”

That being said, there is no information yet that IRS will ask for a copy of a computer data file in all cases. Nonetheless small business taxpayers should be staying in compliance by keeping the required records as described in these new IRS documents so they will be ready if questions do come. The policies and procedures that IRS is applying to small business audits and electronic records are developing as you read this, but it would be risky at this point to parse the requirements too finely, and not take the words in their plain meaning.

See our Resource PDF file for a complete list of useful resource links on this topic.


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About the author

Scott Bonacker

Scott has 30 years of experience in Public Accounting. After graduation from college he worked in the Public Accounting Department of MFA Incorporated auditing farmers exchanges and grain elevators for three years before returning to Springfield, Missouri where he worked in a regional CPA firm. In 1987 Scott opened his own accounting practice, and joined McCullough and Associates L.L.C. in 1997. Scott has worked with QuickBooks accounting software since 1992, and is a QuickBooks ProAdvisor.

47 Comments

  • When performing an audit, the IRS typically specifies certain years to examine. Since the IRS is not entitled to records other than those requested for the years being considered in audit, how does one provide an electronic copy of the records held only in Quickbooks, for only the years being requested. Provision of any other unspecified records provides an opportunity for the IRS to open a whole new audit without proper notification to the taxpayer. I currently have such a situation and have no objection to providing a CD if I can do a backup of the years in question only without providing records the IRS is not entitled to. Thus far I have not figured out how to do a partial backup, for example years 2008 and 2009. Any help will be appreciated.

    • I have represented many clients before the IRS and i have never been asked for the QBs file. I am located in San Francisco so the agents should have the capabilities. The IDRs i receive request substanation so i give them a print out of the QBs account and the invoices and checks to support the deductions. If I were to receive a request for the file i would fight it for the reason that it would contain data outside of the audit period. If i had to give it over i would password the prior years data and if that did not work I would use data transfer because i have used the software and it does work.

      • Thank you Marc, one thing that is needed is anecdotal reports.

        In an AICPA Tax Update last week it was reported that there haven’t been any new pronouncements or clarifications. The recommendation remains that if a file is requested, talk to the examining agent about it.

  • Paul, in the QuickBooks Market place is a utility by Karl Irwin that extracts a date range and or makes a new file to go forward with. Data Transfer I think, but search for his name and you will find it.

  • Paul, the first item in the “Resource PDF” is an article written by Kip Dellinger for the California CPA magazine. The article offers some suggestions on how to proceed.

    Unfortunately, as far as I know current technology does not provide for compartmentalizing a QuickBooks general ledger without creating a brand new file.

  • Probably the vast majority of smaller QuickBooks users are going to give the IRS exactly what they ask for (a copy of the entire file) because they view the hassle of paying someone to make a ‘audit year only’ copy of the file as being excessive on their part. I do believe that any copy of the file given to the IRS should have a ‘closing date’ set for the file as a whole, that is ‘closed as of the date’ the file is given. This precludes the IRS from accidentially or intentionally making any changes to the file (we all know how easy it is to ‘increment’ a change in a transaction if almost anything has changed in the way of default information for a transaction if the transaction is reopened.

    If an Agent (or IRS as a whole) wants to request a password to unprotect the closed data, they certainly should have to ‘justify’ why they need such access since their job is to ‘examine’ data rather than manipulate it.

    William “Bill” Murphy – Oklahoma City

  • Scott
    Great article. This is something that I’ve been following as well as I fear that we are all in for a “wild ride” with this one.

    My confusion stems with your quote from the IRS FAQ page regarding:
    creates or reconstructs a new company file, for example, by re-inputting the transactions for only the year under examination, this new file does not satisfy the requirements or needs of the IRS. The new or modified company file is not a copy of the books and records of original entry. The altered electronic file would not meet the requirements of the Information Document Request or a summons and the taxpayer’s representative could be in violation of Circular 230.”

    It seems as though it may be contradicted by Q13: Can a taxpayer or representative condense or “clean up” the electronic accounting software data file before submission? which seems to indicate that condensing data prior to the audit year in question is ok.

    Would this mean, for instance a taxpayer is being audited for tax year 2008 in 2011, they could condense their file up to and including 12/31/2007 and the file would be acceptable?

    Would it then be acceptable to use one of the services or tools available to strip out date from 1/1/2009 to present?

    I’m “guessing” that they want to have the Audit trail report available so that they can see who changed what and when – but of course this is open to interpretation.

    What’s your take on this?

    Nancy

    P.S. In addition to setting a closing date, I think setting up an External Accountant user would be a good idea.

  • Let me clarify what I was suggesting. A User would make a complete copy of the current file, and then would ‘lock down’ that copy by creating a Closing Date and Password as of the very last date of transactions in that copy of the file. You could then in effect eliminate all passwords to the file (except the closing password) because the closing password would permit them to ‘view everything’ but prevent them from ‘making changes to anything’.

    Of course this procedures does not ‘do anything’ about them being able to view everything in the file (just modify unintentionally or intentionally any data), but the ‘jest’ of the article from which this discussion was originated was that if you attempted to do anything that in effect kept them from having free rage to view every aspect of a file, it could be construed as an attempt to hide information which could then be deamed as either ‘noncompliance’ or grounds for expansion of the audit into either earlier or later periods.

    William “Bill” Murphy – Oklahoma City

  • Perhaps if this approach is going to be the norm by the IRS, all Users should ‘archive’ a copy of their data as of the end of the tax year. That archived copy would then be their ‘official’ file for that year end (in much the way that older accounting software and manual books were ‘set-aside’) after being closed at year end. Obviously this will require a little ‘extra planning’ as part of ending the year, but seems like another possible alternative. Of course, I would also suggest that the ‘archived file’ be ‘closed’ with a closing date and password as of the final day of the year again to prevent unintentional or intentional manipulation of the data.

    Couple that with Nancy’s approach to using the ‘condense’ functionality for all prior years, as a part of making the year-end archive copy, and that seems to be about as close as having a ‘single-year only’ set of data without going the extra steps (of having a professional modify the file or lop-it-off front-n-back).

    William “Bill” Murphy – Oklahoma City

    • That’s probably pretty close to what happens in most cases – the client makes all the entries they can, reconciles the bank account(s) and then gives a copy of the file to the accountant who possibly makes further adjustments and ends up with informatoin for a tax return.

      Those further adjustments are then given to the client for re-keying or importing or whatever and the production data file file goes on.

      The copy that the tax preparer kept (or maybe should have kept) is the archive copy then. Or the client has that copy and should keep it.

      Unlike Dynamics GP for example, QuickBooks accounting data files are easily transportable.

  • Thank you for your comments Nancy, good questions.

    Pretty much any technique I know of, whether exporting transactions to Excel and then using IIF Creator from Big Red Consulting to prepare an import into a new file or using the transaction transfer utility from Karl Irvin, is equivalent to re-inputting the transactions. It doesn’t matter if it is by human hands or by action of software tools.

    One of the key data elements that is removed or left out in that process is the audit trail – the meta data – that is useful in determing what happened. Also there is the transaction number that QuickBooks keeps for internal use which indicates the sequence of entry irrespective of the assigned transaction date.

    The closing date idea probably isn’t bad, and the additional user as well, but it’s not like the IRS is going to look at the file and then give it back so that the taxpayer can continue with business. Once the file is copied, it is out of production and exists only for it’s historical content. The audit trail can tell what was done and when, if anything, for any party who has an interest in looking.

    As to whether condensing might be OK – I don’t know. Probably depends on factors unkown outside of a specific situation. It does have the benefit of leaving the meta data intact for the transactions that are not condensed.

    As someone I respect has mentioned elsewhere, the examining agents have rules of conduct just as much as the tax preparers – if not more stringent – and might not be inclined to go glancing about in areas not opened otherwise.

    In any case, don’t act like there is anything to hide – unless there is of course in which case an attorney and not a CPA should handle it – and wait for the rest of the story to be told.

  • Great discussion, folks.

    I would like to mention that Nancy Smyth has a couple of blog articles on the subject in her wonderful blog, at http://blog.sunburstsoftwaresolutions.com/2011/02/28/your-quickbooks-company-data-file-the-irs-and-you/ for example.

    From a database technical standpoint (since I’m not a CPA or tax lawyer), as I look at it, if you are using any of the utility programs that are available outside of QuickBooks to compress a file or remove old data, you are creating a new file and you may have problems. If you are using one of the third party services – I’m not sure, as I don’t know what methods they are using. I suspect it is a new file without the original audit trail, but I don’t know. I would use caution here. The only compression technique that I’m aware of that would let you keep the original file, and compress old information as they allow, is the “condense” features in QuickBooks itself, I believe. And, as we all know, that is not a very good condensation technique.

  • Hey Scott –

    Until now, it seems that we have been discussing ‘copies’ of data for the IRS from “Desktop QuickBooks versions”, but what about data stored ‘in the cloud as with QuickBooks On-line. Is a User required to create a ‘download copy’ of their data? Is such a copy considered their actual data since it is now in an entirely different format? What about ‘transitional issues’ in how the data could appear different from On-line to Desktop format……….how would a user even do that if they don’t have the desktop version……the download process to desktop requires you to have a specific desktop version? Or are QB Online users ‘reguired’ to give an IRS agent ‘access’ to their OnLine account?

    Scott – do you have any information regarding IRS requests as it relates to ‘in the cloud’ QB data?

    William “Bill” Murphy – Oklahoma City

  • I have seen discussion about the QuickBooks Online Edition, but mainly about how there is not a backup function that is equivalent to the desktop version.

    There is an export function I see –

    https://qboe.custhelp.com/app/answers/detail/a_id/1077/kw/export%20to%20desktop/r_id/103898

    – but I haven’t worked with the online edition, and can only say that ‘export’ doesn’t sound the same as ‘backup’ so probably the metadata doesn’t survive the trip.

    Other than that, there aren’t any anecdotal reports that I know of involving the online edition. Not that it hasn’t come up anywhere of course, just that I haven’t seen it.

    You mention differences in how the data would appear between the online and desktop editions. It would be interesting to know a little more about how different applications operate wouldn’t it.

    For example, Dynamics GP does not permit deleting or editing transactions but QuickBooks does. I have Peachtree but haven’t tested the boundaries in it.

    It may be that the ability of QuickBooks Desktop to delete and edit historical transactions is what makes it particularly interesting.

    I know that many times in the past I have told potential users that if they can accurately (and completely) keep track of the ins and outs, we can always and easily correct the account coding/classifications once the data is in the check register. In that kind of situation I’ve not been particularly concerned with what the audit trail may show except that it can make the data file grow faster.

  • About a month ago, an attorney in Seattle, WA named Seaton Daly wrote an article in his blog that does a good job of addressing a major problem:

    “Unlike large corporations who have elaborate accounting systems that can give the IRS exactly what they seek, small businesses rely on more basic rudimentary software programming (i.e. QuickBooks, Peachtree, etc.) that is unlikely to have the necessary filter controls in place. Lack of technical controls aside, small businesses are also unlikely to have a comprehensive data governance program in place, and when those two factors are meshed together, the fears expressed by CPA trade associations become increasingly more valid. However, are those factors a sufficient enough position to say that small businesses should be treated differently than larger corporations when it comes to business records requests under an IRS audit?”

    http://emergingbusinessadvocate.wordpress.com/2011/05/26/under-audit-irs-wants-all-electronic-records-from-small-business-owners/

    A part of the answer to his rhetorical-question-with-realworld-consequences would have to be found by studying the recordkeeping requirements of Revenue Procedure 98-25, Section 3.

  • The July issue of Journal of Accountancy included an article on this issue –

    http://www.journalofaccountancy.com/Issues/2011/Jul/AccountingSoftwareAudit.htm

    The article includes two links to IRS letters –

    http://www.aicpa.org/InterestAreas/Tax/Resources/IRSPracticeProcedure/DownloadableDocuments/IRS_Letter.pdf

    http://www.aicpa.org/InterestAreas/Tax/Resources/IRSPracticeProcedure/DownloadableDocuments/software_letter.pdf

    The second one “software_letter.pdf” includes the following –

    “Similar to paper records, it is important an exact copy of the original electronic data file be provided to the examiner and not an altered version. Only an exact copy of the original file includes the unaltered metadata which allows examiners to properly consider the integrity and veracity of the electronic files through use of such means as reports generated by the software program that may help to identify deleted or altered entries. For example, the original data file may provide the date a transaction was originally created, dates of subsequent changes, what changes were made, and the username of the person who entered or changed that transaction. This type of information is directly relevant to the evaluation of the taxpayer’s internal controls.

    We agree the best and most satisfactory way to resolve the concerns expressed in your letter may be improvements to the file backup process by the various software manufacturers, but this may not happen in the short run. In the alternative, many of your concerns may be alleviated by the following suggestions:

    • Suggest to your members that their clients’ electronic data files be backed up annually at the end of each tax year. This action will allow the business to provide a backup file created immediately after the close of the audit year(s). In the event of an audit, this backup process will lessen the amount of data provided to the IRS.

    • While condensed data is not acceptable for the tax year(s) under audit, client electronic data files may be condensed for dates prior to the year(s) under audit. This is acceptable as long as the condensed data does not include transactions created or changed for time periods under audit, or for transactions from prior years that have an effect on the years under audit. However, if the scope of an audit is expanded, the IRS may request another backup file that was created prior to the date the company file was condensed or request a copy of the archive file that was created during the condensing process. If the client does not have a complete understanding of the software’s condensing feature, please contact the software provider for additional guidance before using.”

  • There is new information in a “Memorandum for Examination Area Directors” issued on September 1, 2011.

    The memo says, in part: “IRS has the authority to summons a taxpayer to produce electronic records under IRC Section 7602(a)(2), if such electronic records are maintained by the taxpayer. A decision to issue a summons should be made on a case by case basis and after a discussion with the group manager.”

    Get the whole thing here:

    http://www.irs.gov/pub/foia/ig/sbse/sbse-04-0911-086.pdf

  • IRS has also updated the Question and Answer page on this topic to include many of the issues raised by practitioners and professional organizations during discussions of the policies.

    http://www.irs.gov/businesses/small/article/0,,id=238525,00.html

    The notation at the bottom of that web page says:
    Page Last Reviewed or Updated: September 08, 2011

  • In the text of the article above I referred to Q6 on an IRS web page. That web page has been updated since the article was written, and the September 8 2011 revision of the page has renumbered that item to Q7 where it says:

    “Note that, although Revenue Procedure 98-25 exempts certain taxpayers from the requirements of the Revenue Procedure, this does not create an exemption for any taxpayer from having to produce electronic books and records if they otherwise exist when a business chooses to use an electronic accounting software program to maintain their books and records.”

    IRS does update it’s website periodically as circumstances develope and feedback is received, and as explanations are added to make the information more clear.

  • Ed Zollars has written an article about a new Chief Counsel Memorandum outlining IRS authority to request copies of QuickBooks data files in an examination.

    “The IRS Chief Counsel’s office in CCA 201146017 has provided a legal analysis of the rights of the agency to demand electronic data files from small business clients. The IRS project, focused primarily on providing agents with access to Quickbooks and training on using the program, has generated some concern among small business advisers.
    In conducting the analysis of what the IRS may force a taxpayer to produce under the threat of summons, the memo lays out three tests the IRS has to demonstrate regarding the information:

    1) Whether this data is within the scope of “books, papers, records and other data” as it appears in IRC §7602(a),

    2)Whether the specific information in question “may be relevant” to the examination in question under the standard provided in IRC §7602(a), and

    3)Whether the IRS already possesses the information being requested.”

    Read the rest of Ed’s article here:

    http://ascpa.wordpress.com/2011/11/20/irs-outlines-legal-basis-for-demanding-small-business-client-data-files-in-examination/

    The Chief Counsel Advice can be found here: (also linked in Ed’s article)

    http://www.irs.gov/pub/irs-wd/1146017.pdf

    There isn’t enough room here to summarize the article, but it is well written and worth reading.

  • On 12-19-2011, IRS revised it’s web page “Use of Electronic Accounting Software Records; Frequently Asked Questions and Answers”.

    See the revised page at:

    http://www.irs.gov/businesses/small/article/0,,id=238525,00.html

    It was previously revised 9-8-2011 and 4-18-2011 (unless I missed one or two in between those) so it pays to check back every once in a while.

  • An article by Brian Lopez, CFE discusses how Forensic Data Analysis can be performed on electronic records, but it requires 100% of the data and not just a sampling.

    “What is Forensic Data Analysis?

    In short, forensic data analysis is the process of taking disparate types of data collected and accumulated in the normal course of business, and running queries and comparisons on that information to help uncover fraud indicators. The key word here is disparate.

    Forensic data analysis compares and analyzes different—or disparate—types of information in ways that aren’t performed normally. For example, a business will collect and maintain accounts payable and payment information, such as a check register or disbursements ledger. Additionally, this business may have a building access system that contains a log of when employees access building entry points. If we were to take these two disparate sets of data—the disbursements ledger and the building access log—and compare them against each other, we would be performing forensic data analysis.”

    Read the rest:

    http://www.calcpa.org/content/26523.aspx

    Scott

  • Missouri Department of Revenue is also requesting data files.

    A document request from the field compliance bureau dated February 8, 2012 includes a Quickbooks backup file and Quickbooks custom transaction detail report in the list of documents requested.

    And the paragraph after the list of documents begins with this sentence: “If any of the records listed above are maintained in an electronci format, please provide them in electronic format.”

    Would expect similar wording from all state revenue departments.

  • IRS has again updated the FAQ page “Use of Electronic Accounting Software Records; Frequently Asked Questions and Answers”

    http://www.irs.gov/businesses/small/article/0,,id=238525,00.html

    Each update makes the page more informative – The current version of the FAQ includes a new Q13.

    Note that this update was 1-20-2012, and the previous update was 12-19-2011. As things develope, the FAQ page can be updated as frequently as necessary.

  • Can the IRS demand that i change versions of my QB. I currently have QB enterprise and they are telling me i have to convert it to QB pro. Ive asked around and this task is “nearly impossible” to accuratley complete, and quite expensive. what are my options?

    • Mike, I’m not a CPA, so I can’t give you an official recommendation on this. However, since converting Enterprise files to Pro is not a feature supported by Intuit, and it can only be done with significant expense and trouble, I can’t see how they can make you do that. Unless they are willing to pay (and I wouldn’t even do it then). This represents a lack of understanding of the product on their part.

  • IRS has reorganized their website, and here are two new links:

    Use of Electronic Accounting Software Records; Frequently Asked Questions and Answers, as revised 9-20-2012

    http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Use-of-Electronic-Accounting-Software-Records;-Frequently-Asked-Questions-and-Answers

    IRS Accepts Taxpayer Accounting Records in Electronic Format for Small Business/Self-employed Examinations

    http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/IRS-Accepts-Taxpayer-Accounting-Records-in-Electronic-Format-for-Small-Business-Self-employed-Examinations

    I need to locate a few more of these, and will add comments here when I do.

  • Another important article about examinations and QuickBooks files can be found here:

    http://www.calcpa.org/news/2015/01/09/an%20open%20quickbooks

    In a recent tax study group, the author of the article strongly emphasized a point made in the closing of the article:

    In this respect, attempting to recast, “clean up,” or to lock out access to prior year data may be misinterpreted by a revenue agent as an effort to “hide” something when its only real purpose is to protect against prying eyes.

    Scott

    • There is a file, the QBO software is itself online and it uses a data file that is also online. One way to provide access to that file is to set up a login for whomever is requesting it.

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