BUSINESS
EXPENSES
Cohan Rule
Cohan,
8 AFTR 10552 (2nd Cir. 1930); Barton,
TC Memo 2005-97
All
is not lost for taxpayers who fail to maintain
adequate business records, provided they can
support that business expenses were, in fact,
incurred. However, as a taxpayer recently
discovered, certain expenses must meet strict
substantiation requirements. But first,
some brief history.
For
tax years 1921 – 1923, George M. Cohan, a
famous Broadway theatrical producer, had all of
his unsubstantiated business deductions
disallowed by the IRS. At trial, however,
the Second Circuit Court of Appeals reversed the
lower court’s holding and allowed an
approximation of the expenses based on credible
evidence that the expenses were incurred.
In so holding, the Court stated:
“Absolute certainty
in such matters is usually impossible and is not
necessary; the Board should make as close an
approximation as it can, bearing heavily if it
chooses upon the taxpayer whose inexactitude is
of his own making. But to allow nothing at
all appears to us inconsistent with saying that
something was spent.”
This holding gave rise to
what today is known as the Cohan Rule (or Cohan
Doctrine), which allows a taxpayer who can
establish that he incurred a deductible business
expense but cannot support the exact amount to
claim a deduction for a reasonable estimation of
the expense.
But
not all expenses are eligible for the Cohan Rule,
as taxpayers James Barton recently found
out. Barton, a salesman, deducted $14,741
of unreimbursed business auto expenses and $2,422
of unreimbursed business meals and entertainment
expenses on his 2000 return. The deductions
ere based on incomplete mileage logs and year-end
credit card summary statements that did not
distinguish between business and personal
expenses. Upon audit, the IRS disallowed
most of the deductions due to lack of
documentation.
Before
the Tax Court, Barton acknowledged that he
reconstructed many of the records supporting the
deductions, years after they were incurred.
In so doing, there were many discrepancies
between the records he created and the deductions
claimed.
Analyzing
the applicable tax laws, the Court first
dismissed use of the Cohan Rule as a basis for
deducting estimated amounts. Here, the
Court noted that Section 274, enacted after the
Cohan decision, includes strict substantiation
rules for business expenses claimed for travel,
meals, entertainment and listed property, which
includes automobiles. To deduct expenses
for these items, taxpayers must substantiate the
amount, time and business purpose of the expense,
supported with adequate records. To be
adequate, a record generally must be written and
must be prepared at or near the time of the
expense. These rules override the Cohan
Rule.
Because
Barton had reconstructed his records years after
he said the expenses were incurred and they did
not reconcile with the amounts claimed, he failed
to adequately support the deductions. And
because of the nature of the expenses, the Court
could not invoke the Cohan Rule to allow
deductions for reasonably estimated
amounts. Thus, the Court ruled in favor of
the IRS and disallowed Barton’s deductions.
Editor’s
Note: The Cohan Rule can be a powerful ally
for taxpayers who can support the existence, but
not the exact amount, of business
deductions. However, it’s important to
remember that certain business expenses, notably
those for travel, meals, entertainment and
automobiles, are not eligible for the Cohan
Rule. Therefore, it’s imperative that
taxpayers maintain proper records supporting
these deductions and before claiming these
deductions on a return, tax prepares should
remind taxpayers of the strict substantiation
rules.
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