During tax filing season, tax preparers often face a common dilemma: how to report items when taxpayers don't have enough documentation to support them. Taxpayers are legally required to keep proper records for their reported items, but this obligation is often overlooked. As a result, CPAs are often left with no choice but to estimate values when preparing tax returns. Fortunately, this practice is generally acceptable, as taxpayers and preparers are allowed to rely on estimates when specific documentation requirements are absent.
One of the landmark cases that established the use of estimates in federal tax matters is Cohan v. Comm’r. You may have heard of it as the "Cohan rule," which is often used by preparers to justify estimation. In this case, the court permitted the use of estimates for deductions even when the taxpayer lacked documentation for claimed expenses. You might think that with the rise of debit and credit cards, digital currencies, and other electronic payment methods, the importance of the Cohan rule would diminish. After all, these forms of payment usually generate some level of documentation. However, records and documents can still be lost, destroyed, or difficult for taxpayers to access. Moreover, cash transactions are still prevalent in the U.S. economy, making the Cohan rule relevant.
It's worth noting that the significance of the Cohan rule extends beyond inadequately documented business deductions. Courts have relied on it to permit estimates in various other situations. Therefore, it's crucial for CPAs to have a clear understanding of the Cohan rule, including its requirements, proper application in different circumstances, and its limitations. This understanding will help CPAs navigate the challenges they face during tax season and provide the best possible service to their clients.
Approximation in Federal Tax Matters
There are various situations in tax matters where approximations become necessary due to the absence, incompleteness, or loss of relevant documentary evidence. One common scenario is when taxpayers are unable to provide exact documentation for a business deduction. It's important to note that while the tax code offers potential deductions, claiming them is ultimately subject to "legislative grace." Taxpayers must identify a rule that allows the deduction and demonstrate that they meet all the rule's requirements. In the case of business deductions, taxpayers must provide sufficient evidence (such as documents or testimonies) to show that the expense was actually incurred. Without such evidence, deductions are generally not allowed. The Cohan rule, which we'll discuss further, cannot assist taxpayers who fail to meet this evidentiary burden.
Beyond business deductions, approximations are also frequently required for other tax items. For example, taxpayers may need to determine the basis or value of their property or make allocations between business and personal use. In all these cases, it is the taxpayer's responsibility to prove the existence and amount of the item. Failing to do so could potentially result in the complete denial of the claimed tax benefit. However, courts have long recognized the potential injustice of disallowing an item entirely solely because the taxpayer lacks proof of the exact amount, providing some relief for taxpayers.
Cohan Let's now examine the famous case of Cohan v. Comm'r. The taxpayer involved was George M. Cohan, a renowned composer of the World War I era and Broadway legend. Cohan deducted substantial expenses related to his entertainment business activities on his tax returns ($55,000 in total for two years). Notably, these expenses were primarily travel and entertainment expenses, which today would face limitations or complete disallowance under IRC section 274, regardless of documentation. During the IRS audit, Cohan was unable to substantiate these expenses with documentation, leading to the disallowance of the deductions. The Board of Tax Appeals (BTA) upheld the IRS decision. However, on appeal, the Second Circuit overturned the disallowance. The appellate court acknowledged the existence of business-related expenses based on Cohan's testimony.
It concluded that since the BTA had been convinced of the expenses' existence, it should have estimated the appropriate amount. The court emphasized that absolute certainty in such matters is usually impossible and unnecessary, and that the BTA should make a reasonable approximation, placing some responsibility on the taxpayer for their lack of precision. The case was remanded to the BTA to make the estimation, which was apparently satisfactory to both parties involved.
Estimating Deductions Using Cohan Taxpayers have relied on the Cohan rule for many years, mainly to support estimates of allowable business deductions. The typical situation where the Cohan rule comes into play is when a taxpayer acknowledges spending money related to their business but lacks the documentation to prove it.
Taxpayers facing this challenge encounter two main obstacles. First, they must demonstrate the existence of the claimed expense. Second, they must establish the amount of the deduction they seek. The Cohan rule specifically addresses the second requirement. It applies when a taxpayer can convince a court (even if not the IRS) that they incurred an expense but cannot adequately document the exact amount. In such cases, courts that rely on the Cohan rule generally allow a deduction based on the taxpayer's limited documentation or unsupported testimony, although often in a reduced amount compared to the original claim.
It is crucial for tax preparers to understand that the Cohan rule has limitations. Firstly, it is discretionary and does not bind a court. Cohan and its subsequent cases provide courts with the option to estimate deductions when some evidence is presented. However, a court's failure or refusal to estimate based on Cohan is not grounds for an appeal. Similarly, the IRS is not obliged to estimate or accept a taxpayer's estimate under the Cohan rule. The IRS can disallow deductions if the taxpayer fails to properly document or substantiate them outside the scope of IRC section 274.
Secondly, the Cohan rule does not permit taxpayers to guess or fabricate expenses and deductions, nor does it excuse poor recordkeeping. It only allows a court (not the taxpayer) to determine a "reasonable" deduction. Thirdly, the rule applies solely to help a court determine the amount of the taxpayer's allowable deduction, not the existence of the underlying expense. The taxpayer's initial burden is to prove the actual incurrence of expenses, providing the court with a basis for estimation or allocation. Without this assurance from the record, a court cannot estimate a reasonable allowance, resulting in the loss of the desired tax benefit.
Lastly, the Cohan rule does not apply when specific recordkeeping requirements are imposed by law or regulations, such as those outlined in IRC Section 274 (pertaining to substantiation requirements for travel, meals, and gifts) and IRC section 170 (relating to charitable contribution deductions). In such cases, the Cohan rule is not applicable.
Overall, understanding the limitations and scope of the Cohan rule is essential for tax preparers and taxpayers alike when addressing estimation and documentation challenges in tax matters.
Limitations on Cohan
It is also important for CPAs to remember that the taxpayer may not rely on the Cohan rule where statutory or regulatory provisions specifically establish substantiation requirements. In these cases, the documentation itself is a requirement for the taxpayer’s entitlement to the item. The absence of the required documentation is generally a complete bar to any benefit under the applicable statute or regulation, and no estimates are permitted. Two of the most common examples of such provisions are highlighted below.
Business travel and entertainment expenses. IRC Section 274 is a prime example of a statute that specifically imposes substantiation requirements for certain business-related expenses, including travel, meals, and entertainment. While a comprehensive discussion of Section 274 is beyond the scope of this article, it's important to note that Section 274(d) sets forth specific documentation standards that override the Cohan rule. Congress perceived that business travel and entertainment expenses had been an area of abuse over the years and attempted to curb this abuse by enacting section 274. IRC section 274(d) requires taxpayers to substantiate certain deductions with adequate records or sufficient evidence to document the amount of the expense or item, the time and place of the travel or the date and description of the gift, the business purpose of the expense or item, and the business relationship to the taxpayer of the person receiving the benefit. Temporary Treasury Regulations section 1.274-5T(a) specifically states that section 274(d) supersedes the Cohan rule.
The regulations further expand on the statutory requirements, explicitly stating that approximations or estimates are not permitted. It is important to note that the regulations do not allow for a re-creation of the expense log without sufficient supporting evidence. Substantial documentation includes “an account book, diary, log, statement of expense, trip sheet, or similar record must be prepared or maintained in such manner that each recording of an element of an expenditure or use is made at or near the time of the expenditure or use” [Temporary Treasury Regulations section 1.274-5T(c)(2)(ii)].
Taxpayers routinely litigate disputed section 274 business expenses in Tax Court, and the court has firmly refused to extend the Cohan rule in this context [e.g., Sanford v. Comm’r, 50 T.C. 823, 827-828 (1968), aff’d, 412 F.2d 201 (2d Cir. 1969); Noz v. Comm’r, T.C. Memo 2012-272; Rogers v. Comm’r, T.C. Memo 2019-90]. For example, this past year a taxpayer’s travel expense deductions were disallowed because her records did not permit the court to distinguish personal and business expenses (Franklin v. Comm’r, T.C. Memo 2020-127). The court was not persuaded to use the travel records the taxpayer created only after IRS notification of examination, holding “while a contemporaneous log is not required to substantiate the deduction, a taxpayer’s subsequent reconstruction of his or her expenses does require corroborative evidence with a high degree of probative value to support such a reconstruction, in order to elevate that reconstruction to the same level of credibility as a contemporaneous record” (Franklin, at 13-14). The case demonstrates the court’s reluctance to use testimony as an exclusive corroboration to substantiate an expense under IRC section 274.
Charitable contributions. Stringent documentation requirements are imposed on charitable contributions under IRC Section 170. The statute outlines specific documentation criteria that vary depending on the type and amount of property contributed. Failure to comply with these requirements generally results in the disallowance of any deduction for the contribution. For example, contributions of $250 or more require a contemporaneous written acknowledgment from the receiving charitable organization that meets specific requirements [IRC Section 170(f)(8)(A)]. The regulations provide detailed guidelines for establishing verifiable contributions, including receipts or written communication from the donee organization, additional forms like Form 8283 for noncash gifts over $500, and qualified appraisals for gifts over $5,000 [IRC Section 170(f)(17), Treasury Regulations Section 1.170A-13(f)(1)]. Cash donations require retention of a cancelled check, receipt, or other reliable evidence, while noncash property donations necessitate a receipt showing the donee's name and a description of the gifted property [Treasury Regulations Section 1.170A-13(a)(1), (b)(1)].
The courts and the IRS view the documentation requirements of Section 274 as strictly mandatory, leaving no room for estimation under the Cohan rule. The regulations clearly demonstrate the intent to prevent such estimations. In contrast, the Tax Court had previously shown some leniency in the area of charitable donations, allowing estimates or allocations implicitly or explicitly justified by the Cohan rule. However, statutory amendments enacted in 2006 eliminated this flexibility, making strict compliance with Section 170's documentation requirements the only way to claim a permissible deduction.
In summary, CPAs must be aware that the Cohan rule is not applicable when statutory or regulatory provisions establish specific substantiation requirements. Documentation becomes an indispensable requirement, and the failure to meet these requirements precludes taxpayers from receiving any benefits outlined in the applicable law or regulation. Properly adhering to the substantiation requirements outlined in the Treasury Regulations is crucial for taxpayers seeking to claim business travel and entertainment expenses or charitable contribution deductions, as the Cohan rule is not allowed in these circumstances.
No Substitute for Good Record-keeping
The Cohan rule can be a valuable tool for taxpayers in various circumstances, but it is crucial for CPAs to understand its proper application and limitations. Preparers should keep in mind that, where not overridden by statutory documentation requirements, the Cohan rule necessitates taxpayers convincing the IRS or a court, if the matter goes to litigation, that they genuinely incurred an expense. There are three key elements to consider in the application of the Cohan rule.
Firstly, taxpayers must prove the existence of the expense through credible evidence. Failure to establish the existence of the expense will automatically preclude any estimation of its amount. It is essential to provide reliable and convincing evidence to support the claim.
Secondly, having demonstrated the actual incurrence of the expense, taxpayers must also establish that the item, or at least a portion of it, is deductible. This requires demonstrating that the expense is properly allocable to a business activity or meets the specific requirements outlined in the tax code for deductibility.
Lastly, taxpayers must provide a basis upon which the IRS or a court can estimate the amount of the item. It is important to note that courts will not engage in guesswork, nor will they accept or endorse the taxpayer's mere guess. The taxpayer must provide reasonable grounds for estimation or allocation to justify the claimed deduction.
The cases mentioned earlier provide clear evidence that taxpayers must establish reasonable grounds for estimation or allocation if they wish to succeed in using the Cohan rule.
In conclusion, tax professionals should view the Cohan rule as a last resort defense rather than a substitute for proper recordkeeping. While the Cohan rule can offer some relief in certain circumstances, it is far more prudent for taxpayers to maintain adequate records to substantiate their expenses. Good recordkeeping practices ensure compliance with statutory requirements, reduce the reliance on estimation, and provide a stronger foundation for the taxpayer's claims.
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