© by Fred W. Daily

Facing an IRS audit without all your business records, don't despair the past sixty-eight-year-old "Cohan Rule" has saved the bacon of many small business audit victims.

The Cohan Rule comes from a federal court decision, which is one of the oldest and best tax cases of all. Its legal citation is Cohan vs. Commissioner, 39 F. 2d 540 (2d Cir. 1930). This court case, against the IRS, was brought in by a famous New York theatrical figure of the early 20th century, George M. Cohan. If you have been to the Big Apple, you may have seen George's statue in the middle of Times Square. If not, you have undoubtedly heard one of his signature tunes, "Give My Regards to Broadway," or "Yankee Doodle Dandy."

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 (1) paid or incurred for (2) business or profit-oriented purposes, also requires showing (3) the amount spent.

The IRS took the position with Mr. Cohan that even if he could convince an auditor that the business expense qualified for a deduction (satisfy number 1 and 2 above), that he also must be able to fully document the amount spent (number 3). George replied that he was always on the run, and had little time to document many of his expenses. George challenged the IRS stringent record keeping requirements in court. His lawyers argued that the IRS was wrong because even though records were missing, George had presented other credible evidence of the amount of the expenses on which approximations of the true amounts could be made.

George had explained the necessity of the (undocumented) expenses and offered his recollections and approximations of the amounts incurred. The items ran from cab rides and tips to large hotel and restaurant expenses for George and his entourage. The Federal Appeals Court, in an opinion by the aptly named Judge Learned Hand, held that the sums were allowable business expenses. It was unreasonable of the IRS not to allow, at least some of his earnings, not to be based on Cohan's approximations.

Today, the Cohan Rule is the antidote to the auditor who says, "no deduction without documentation." However, 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. And, as a practical matter, when raising Cohan, expect a compromise, rather than a full allowance of the approximated expenses. My advice: Never hesitate to bring up the Cohan Rule at any stage of an audit, appeal or court proceeding. It can't hurt.

For a complete explanation of what you can—and can't do—see my book Tax Savvy for Small Business published by Nolo Press.

By: Frederick W. Daily, Tax Attorney,
John Raymond, Bankruptcy Attorney, and
Allan H. Rosenthal, paralegal.
All of the three have offices in San Francisco.

© 1997

(This article was originally written for tax practitioners who represent clients before the IRS. But the information presented here is valuable for all taxpayers.)

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