Tax research: Compliance questions

This article starts an introductory series on tax research questions.

Before starting any tax research effort, we first need to know when and why tax research becomes necessary. Whether and how to do tax research begins with identifying the type of question asked.

Each type leads to a different kind of research depending on the end goal. The questions posed by tax professionals tend to fall into one of three types: compliance, planning, and policy.

This article focuses on the first and most common type, compliance questions.

Compliance questions, or how to treat a transaction

Compliance questions ask about the correct treatment of a transaction:

• Is this deposit income?

• Is the expenditure deductible?

• Does this transfer qualify for a step up in basis?

Compliance questions generally arise after a transaction has already occurred, or just before it inevitably occurs. There is usually a single correct answer because the transaction is (or will soon be) closed with little or no input from the preparer.

How to ask a good compliance question

A good question about tax compliance does three things. First, it clearly focuses on the specific transaction, with just the essential details:

• “A inherited a rental property from B. A then sold it to C, six months later, but in the same tax year.”

• “On January 2, X refunded a sale to Y made on December 28.” Without any confounding detail, any tax professional can immediately recognize the transaction and begin narrowing down the possible treatment scenarios.

Second, it provides relevant additional details, but only once the transaction has been clearly identified:

• “B did not have an appraisal done on the property upon inheritance, but one was completed as part of the sale to C.”

• “X agreed to the refund and issued a credit memo dated December 29, but the store was closed until after New Year’s Day. X is a cash-basis taxpayer.”

Third, a well-stated compliance question anticipates a certain tax outcome, framed in a way that allows for a simple “Yes” or “No” response:

• “Does A have a stepped-up basis in the property, and if so, can she rely on the appraisal from the sale to C when calculating her stepped-up basis?”

• “Can X report the refund in the year promised?”

A note on the dreaded “It depends” reply. Every decent accountant knows that questions framed to allow for a simple “Yes” or “No” response also have a third possible reply: “It depends.” Do not dread this reply! It is the best possible reply for your learning, and here is why: It shows you missed a relevant detail in your question. If the reply depends on an unknown aspect of the transaction, you now know what to look for in your notes or to ask the taxpayer.

Compliance questions that include these three parts—a specific transaction, relevant details, and an anticipation of a certain tax repayment framed for a simple “Yes” or “No” response—make your research and getting responses from colleagues much more likely and helpful. Consider these complete questions:

• “A inherited a rental property from B. A then sold it to C, six months later, but in the same tax year. B did not have an appraisal done on the property upon inheritance, but one was completed as part of the sale to C. Does A have a stepped-up basis in the property, and if so, can she rely on the appraisal from the sale to C when calculating her stepped-up basis?”

• “On January 2, X refunded a sale to Y made on December 28. X agreed to the refund and issued a credit memo dated December 29, but the store was closed until after New Year’s Day. X is a cash-basis taxpayer. Can X report the refund in the year promised?”

Note how they provide sufficient details to generate a “Yes,” “No,” or “It depends” reply with just a few lines of text.

Which details matter for a good compliance question?

Identifying relevant details for tax compliance relies on experience and thoroughness. Ideally, we’d ask the right questions, get complete answers, and take perfect notes. However, in reality, we sometimes overlook important questions, taxpayers may omit key details, and our notes might not capture everything.

At first, you will not know everything to ask. It takes time and experience. But you can help yourself by doing pre-research. Find the relevant Code section, Regulation, and a few recent court opinions. Note the examples in the Regulation and the facts analyzed in the court cases. If the IRS took time to provide an example, and a court judge restated a detail about a case in writing, you can assume it matters generally and possibly for your specific case.

Effective communication with taxpayers is crucial. Make your questions as easy to answer as possible, ideally in a “Yes” or “No” format, but with an opportunity to share additional details or background. If responses are short or vague, try to explain the tax consequence of having additional information. People will usually volunteer almost any detail if they think it will save them from paying more tax.

If you are asking several, detailed questions about a relatively complex transaction, ask the taxpayer to discuss it on a video call. Use a recorder to record and annotate the call. I recommend Grain. Grain works with Zoom and Google Meet to record the call. You also have a digital notepad active during the call to take time-stamped notes. With a full recording of the conversation, you don’t have to worry about forgetting to jot down an important detail in your notes. And, if the taxpayer disagrees with your interpretation of the facts, you can always replay the relevant part of the recording to refresh her memory.

And don’t be afraid to ask the taxpayer a follow-up question or two. Tax research, especially for complex transactions or ones with potentially large tax consequences, is an iterative process between research and asking the taxpayer for details. But remember, each interruption slows down progress and frustrates the taxpayer, so it’s a tradeoff between accuracy and efficiency.