Tax Court Corner: Significance of the ‘Cohan Rule’
Typically, when a taxpayer is audited by the IRS, the burden of proof falls on the taxpayer. In order to prove income and expenses, the US Tax Court has ruled that the taxpayer must keep “contemporaneous” records, per Reg. § 1.6001-1. But what if the taxpayer has some sort of accident, an act of God, or something else happens where they can’t produce contemporaneous records?
Cohan v. Commissioner is a very interesting case. In 1918, George M. Cohan was a theatrical manager and producer doing business in partnership with a gentleman by the name of Harris. Cohan had originally been an actor, like his parents. After 1899, the parents with their two children, Cohan and his sister, divided their earnings – one-quarter to each of the children and one-half to the parents. Cohan was in charge of the collection and distribution, collecting for all and distributing to the others.
In 1899, they hired a manager and, after his death, employed another manager who married Cohan’s sister in 1905, and they both left the business. Cohan and his parents then employed Harris as their manager and made a change in the distributions. Cohan had begun to write plays, on which he was receiving royalties, which he withdrew from the net earnings. The parents began to take out $500 a week, and the remaining four divided what was left by designating half to Harris, a quarter to Cohan, and the rest to the parents. Before 1914, Cohan and his father had left the stage and spent their time directing their plays until the father’s death on July 31, 1917. After his father’s death, Cohan divided his portion of the proceeds from the partnership with his mother.
The IRS fixed Cohan’s income as the whole of what he received from the firm of Cohan & Harris, while it lasted, and later as the whole of his own profits. Cohan declared that his mother was always his partner and that he was entitled to deduct from his receipts the sums that he paid to her. If the father was a partner at the time of his death, that partnership ended and Cohan, the survivor, had to account to the legatees or next of kin. The court did not know if there was a will but presumed there wasn’t. If there was a will, the mother and siblings would have been entitled to a portion of the proceeds from the partnership.
In the production of his plays, Cohan was obliged to entertain actors, employees, and dramatic critics. He also had to travel a lot, often with his attorney. These expenses amounted to substantial sums, but he had no accounting of these expenses.
At the trial, in 1930, Cohan estimated that he had spent $11,000 during the first six months of 1921; $21,000 between July 1, 1921, and June 13, 1922; and around the same amount for the following fiscal year – $55,000 in all. The IRS had refused to allow him to claim any part of this based on the grounds that it was impossible to tell how much he had spent, in the absence of any accounting records.
But the 2nd US Circuit Court of Appeals questioned how far the refusal of the deductions were justified because it was obvious that Cohan had spent large amounts. In the absence of substantiation, the court made reasonable approximations of other deductions. Thus, the “Cohan rule” was born.
In Vanicek v. Commissioner, the petitioner did not have substantiation for deductions for utility bills they paid while the husband was a resident watchman for the local forest preserve district. He and his wife were allowed to live in the residence rent-free, but they were required to maintain the residence. The court ruled that without substantiation of the utility expenses, the Cohan rule could not be applied because the taxpayer did not offer any evidence that the expenses could be “reasonably apportioned.”
When applying the Cohan rule, you cannot take into account expenses for travel away from home, entertainment expenses, business gifts, listed property, or local travel expenses. These amounts have specific substantiation requirements that cannot be approximated.
The Cohan rule is not a blank check. In fact, the Tax Court has discretion on what it will estimate and what it will not. To make this type of estimate, there must be sufficient evidence to satisfy the court that at least the amount allowed in the estimate was actually incurred for the stated purpose.
For instance, a taxpayer’s attempt to claim an expense deduction under the Cohan rule was denied when the taxpayer offered the court only his unsupported testimony and a one-page handwritten check log listing purported deductions for charitable contributions, healthcare costs, and other expenses. The deductions were disallowed because they were claimed without any substantiation, such as a third-party statement, checks, bank statements, or receipts, to show that the expenses were actually incurred. There was no reasonable evidentiary basis for estimating the deductible amount.
On the other hand, the Tax Court applied the Cohan rule to estimate labor expenses for an asphalt paving company where no records or evidence corroborated the amounts submitted on a joint return. Nonetheless, credible testimony was provided which made it clear that some offset for labor costs was appropriate. The Tax Court decreased both the wages per day and the number of days, estimated by the taxpayers, to compute the deduction for labor expenses.
As you can see, the Tax Court does not use the Cohan rule recklessly, but you can apply it in certain situations where an amount had to be paid, and it must be substantiated either by testimony or some other form. In short, to use the Cohan rule, you have to have some sort of basis for using it.
Craig W. Smalley, MST, EA, has been in practice since 1994. He has been admitted to practice before the IRS as an enrolled agent and has a master's in taxation. He is well-versed in US tax law and US Tax Court cases. He specializes in taxation, entity structuring and restructuring, corporations, partnerships, and individual taxation, as well as...