Can't Find All Of Your Records?
© 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
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 canand can't dosee 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.
(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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