Today I have a very special guest I would like you to meet: George M. Cohan. George has been a regular fixture of my practice from nearly the first day. But he has one serious problem; he hates keeping business records.
There is a very good reason why Cohan doesn’t keep good records of his business expenses. He is a very famous Broadway actor. He also likes to enjoy his fame.
Well, the IRS came knocking and since most of his receipts were missing the expenses were disallowed. Cohan might be lax when it comes to keeping business records, but he can fight like a pit bull in the hot sun after a pair of double espressos. Our good friend was headed to court.
The IRS felt they had it in the bag. Unfortunately, the IRS had an education coming. The 2nd Circuit US Court of Appeals settled the case in our good friend’s favor. The court said when receipts are absent it would be impossible to get a perfectly accurate number. However, the court continued, allowing nothing is inconsistent when it is obvious there were expenses.
This court ruling happened March 3, 1930 and my office has never been the same.
Close Enough for Government Work
Paid tax preparers sign tax returns under threat of perjury that the return they are signing is true and accurate to the best of their knowledge. Too many tax professionals forget this as they quickly scribble their signature for the eighteen thousandth time this tax season.
The shoot from the hip response from most tax professionals is if you don’t have the receipt you don’t get the deduction. Sometimes, as we shall shortly see, this is true. Many times it is not.
Even when a client has records it may be necessary to make adjustments to reflect the facts and circumstances. A handful of returns grace my desk every year I wish never showed up in the office because I need to apply more art than science to the return. There is no other option.
Before we talk about adjusting deductions we need to set a few ground rules. The Cohan Rule doesn’t apply to every area of the tax return. The court ruled an approximation of business expenses, based on credible evidence other than actual documentation, was enough to sustain a deduction.
The Cohan Rule can be applied to most deductions or business expenses with the exception of travel, meals, entertainment and listed property (Section 274). Airfare and hotels need a receipt or the deduction is lost. Mileage records need to be contiguous. This means you need to record the information in your logbook near the time of the event and certainly before the tax return is filed. Meals under $75 don’t need a receipt, but you need to record the expense in your logbooks along with the business purpose of the meal and who you were talking with. Receipts for entertainment are required to qualify for the deduction.
What about that listed property thingy? Listed property consists of computers (and related peripherals) not used exclusively at a regular business establishment or qualified home office; vehicles susceptible to personal use; and property used for entertainment, recreation or amusement (i.e. video recorder). Cell phones are not considered listed property. No deduction/depreciation is allowed on listed property unless you can substantiate the expense (have a receipt). [IRC Sec. 274(d)(4)]
The Tax Court has provided plenty of help over the years in determining which instances we can use the Cohan Rule. There are also areas of inconsistency. A few years back the IRS started requiring charitable deduction receipts must be in your hand prior to filing the return. However, the Court has applied the Cohan Rule in some cases involving small charitable donations while disallowing the deduction if the amount donated involved $250 or more in any one donation.
To make it even more interesting, the Tax Court used the Cohan Rule when determining gambling losses in a 1991 case. Who would have thought?
Time to Get Creative
Now that the basics are out we can apply the Cohan Rule for more obvious cases to more creative uses of the rule.
A fire or theft could cost you your substantiation of deductions and the Cohan Rule would apply. A computer systems failure is a modern version of “the house burnt down” excuse.
Recreating deductions might not always be as hard as first thought. Bank statements are not technically receipts or allowable substantiation, but the IRS uses them all the time. Check stubs and statements from a vendor after the fact can get you reasonably accurate numbers the IRS should accept.
Certain tax forms like a 1099 can also do the trick as the IRS will already have that information. You can request a transcript from the IRS to see what they have on file as a good starting point to reconstruct a substantial or complete loss of documentation.
Now things get harder. You think you have all your receipts but they don’t make sense. I’ll use an example from a real client. Names and certain facts are changed to protect the guilt.
The client in question has a retail store. He expanded to a second store this last year. His paperwork was a mess. Some records were there, a lot was missing. When I added what appeared to be income it amounted to a massive increase over the prior year even adjusting for the new location.
After a dozen or so rounds with the client we were able to get a reasonably clean revenue number for the business. Reminder, the number I used was reasonably accurate. There was no way to guarantee it was absolutely accurate. As I sign the return, it was “true and accurate to the best of my knowledge”.
Now came the hard part. Major expenses were missing. Anything unsubstantiated under Section 274 was automatically lost per the Code. What we had, we used. No more, no less.
The other expenses were also obviously off and to make matters worse the client paid for many items, including inventory, with cash. (Please god, be kind to an accountant. Don’t use cash for business expenses with the exception of a few minor items from petty cash.)
Some receipts were illegible and the bookkeeping was incomplete and a mess. We had to reconstruct. I’ll save you the boring details and give you the important information. I used a model based on prior year data and expected ratios for the business at hand to determine reasonable numbers. It sounds easy, but it took a lot of time as I kept working the numbers until it all looked acceptable. In this case we had at least a few numbers to establish a baseline.
Whenever I rely on the Cohan Rule on a tax return I attach a statement clearly outlining what we did and how we arrived at the numbers we did. Whenever I have attached such a statement to a return the IRS has never, I said never, audited any of those returns. Maybe I am lucky or maybe the IRS figures if I went to that much trouble to get it right they would come to a similar conclusion.
The same applies in an audit. I take a lot of IRS audits from off the street. These people usually have a mess on their hands and missing receipts. When I bring up the Cohan Rule auditors have always been receptive once I outline how I will determine a reasonable number. I think they like my methodology because I am intense instead of guessing. I really devise a method to arrive at relatively clean numbers in pretty much any case. Auditors are usually impressed and if they aren’t their supervisor is. A few cases went to appeals over the years, but none to Tax Court and we always had end results within a nickel’s throw of where I said we would land.
Having your books and substantiation of deductions in order is the best policy. If disaster strikes you can rest assured there are alternatives for fixing most of the problem. Any additional tax liability should be small unless major Section 274 issues are involved.
Even bad bookkeeping has a solution. If a client brings in books that defy logic I must, as a tax professional, dig deeper. Sometimes the client has more material to clear up the issues. Sometimes I have to make adjustments. I disclose any adjustments to the IRS as an attachment to the return.
I sign my name attesting to the accuracy of a return to the IRS. I take that attestation seriously. When you sign your tax return you are making the same attestation I am. You can’t just file a return because that is what your books read or what a tax document or statement says. Statements can be wrong; books can be wrong.
Adjust obvious errors where allowed to reflect a more accurate return. Keep a record of the changes and the method used to reach the final numbers. I recommend attaching a statement to the return as well.
From now on you can sleep better knowing a lost receipt isn’t the end of the world. Make a note of it and take the deduction. The IRS (and the Tax Court) have your back on this one.
Micro Business and Side Gig Tax Guide | The Wealthy Accountant
Tuesday 6th of November 2018
[…] You can even estimate some expenses! If receipts are lost or destroyed you can use reasonable numbers for expenses, except for meals & entertainment, travel, auto expenses and listed property. Advertising, supplies and postage can be estimated if records are unavailable. Be sure to review the rules with the link at the beginning of this paragraph to avoid problems. […]
When Claiming Fake Deductions is Legal | The Wealthy Accountant
Monday 8th of January 2018
[…] summer I wrote about the Cohan Rule. Now with tax season racing straight for us at warp speed, it’s a good time to review an extreme […]
Friday 11th of August 2017
Didn't know about the Cohan Rule - thank you for that - learnt something new today! Also, I guess I should start jotting down the client's name I had a lunch meeting with within Quickbooks. I used to jot them down on the back of the receipt but those fade over time...