Cohan Rule
Can't find all your records? No problem.
Back in 1930, George Cohan was one of the first victims of a tax audit (from the then Bureau of Internal Revenue). Mr. Cohan couldn’t produce all of his records, and the Bureau disallowed his deductions. He appealed to the Board of Tax Appeals and lost. He then took his case to court. Cohan vs. Commissioner, 39 F. 2d 540 (2d Cir. 1930). George Cohan had the dubious honor of being one of the first IRS audit victims. Due to a lack of substantiating records, George had many of his show business-related expenses disallowed by an auditor citing IRC §162 -- the cornerstone of deductibility of business expenses. IRC §162, in addition to requiring a taxpayer establish an expenditure was:
- paid or incurred for
- business or profit-oriented purposes, also requires showing
- the amount spent.
Although the law does require contemporaneous records to be maintained (everything alludes to them) for Travel expense and Meals & Entertainment expense, there's always the Cohan Rule in the event of an audit.
Here is what then Circuit Court Judge Learned Hand said in the opinion that has been part of our common law for more than three quarters of a century. (Judge Learned Hand, held that the sums were allowable business expenses. It was unreasonable of the IRS to not allow, at least some of his earnings, not to be based on Cohan's approximations).
Judge Hand's ruling: In the production of his plays Cohan was obliged to be free-handed in entertaining actors, employees, and, as he naively adds dramatic critics. He had also to travel much, at times with his attorney. These expenses amounted to substantial sums, but he kept no account and probably could not have done so. At the trial before the Board he estimated that he had spent eleven thousand dollars in this fashion during the first six months of 1921, twenty-two thousand dollars, between July first, 1921 and June thirtieth, 1922, and as much for his following fiscal year, fifty-five thousand dollars in all. The Board refused to allow him any part of this, on the ground that it was impossible to tell how much he had in fact spent, in the absence of any items or details. The question is how far this refusal is justified, in view of the finding that he had spent much and that the sums were allowable expenses. 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. True, we do not know how many trips Cohan made, nor how large his entertainments were; yet there was obviously some basis for computation, if necessary by drawing upon the Board’s personal estimates of the minimum of such expenses. The amount may be trivial and unsatisfactory, but there was basis for some allowance, and it was wrong to refuse any, even though it were the travelling expenses of a single trip. It is not fatal that the result will inevitably be speculative; many important decisions must be such. We think that the Board was in error as to this and must reconsider the evidence. [emphasis added]
Today, this is called the Cohan Rule: A taxpayer can use estimated when he can show some factual foundation to make a reasonable estimate of the expense. The Cohan Rule does not apply to deductions for travel, meals or entertainment because Congress has imposed specific contemporaneous documentation requirements.
Caveat: Although you, as the petitioner may prevail without records thanks to the Cohan Rule, do note that it is far easier to win at an audit if you have contemporaneous records, and you usually won’t need to go through the expense of a case at Tax Court. Acceptance of the Cohan Rule approximations is always discretionary with a court; a taxpayer is not automatically entitled to make an approximation in a tax matter. The IRS must be shown, by oral or written statements or other supporting evidence, a foundation on which a reasonable approximation can be based.
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