The Cohan rule originated from a case from 1930, but it is still applicable and used to this date.
The Cohan rule allowed to claim deductions even if the taxpayer had no documentation for these expenses (in general and in practice, the Court allows lower expenses that the ones claimed by the taxpayer). Cohan was a composer back from the World War I times and had significant entertainment expenses (around $50k for two years) and there was no documentation, even if the IRS did not allowed those deductions at first, it required the appellate Court (Second circuit) to allow some of those business expenses.
If you are wondering if the Cohan rule is still used today, then, the short answer is yes (we even had used in some of our IRS audits). One of the most recent case was Alvarado against the IRS. Mr. Alvarado has a car dealer business and purchased the vehicles at car auctions, but keep no records on the cost of those vehicles and the inventory amounts. When the IRS audited him, the IRS did not allowed any specific cost to the items sold (crazy, right? are used cars free these days? ). As a result, the taxpayer Mr. Alvarado had no other option that go to Tax Court, where the Court estimated the cost of goods sold around 55% (not 40% as the IRS claimed).
From the CPA Journal article, “… First, the taxpayer must demonstrate the existence or fact of the claimed expense. Second, the taxpayer must demonstrate the amount of the claimed deduction. The Cohan rule is only helpful with respect to the latter requirement. It only applies when a taxpayer can demonstrate (to a court’s satisfaction, if not the IRS’s) that he incurred an expense but is unable to adequately document the amount thereof. In this circumstance, courts relying on Cohan have generally allowed the taxpayer a deduction in an amount the court deems reasonable based on the taxpayer’s limited documentation or their unsubstantiated testimony, albeit often less than the taxpayer originally claimed.”
There is no substitute for good bookkeeping or accounting records, so use the Cohan rule as last resort when no records, no potential redoing the accounting based on bank records and credit cards, or any other option is available. Note that potentially the estimates will have to be accepted by the IRS during the audit (or by the settlement officer or Court).
We have successfully used this rule when the activity did not change significantly and we were able to estimate similar expense categories and percentage values based on revenues for previous years when no documentation was available (In on of our cases, the previous accountant that keep the receipts had a flooding in her basement and no prior records were available).
As mentioned before, this is just a last hope tool so there are some deductible expenses and the tax bill is reduced, which has been recognized by the IRS as indicated in the jurisprudence above.
Casetext – Cohan case – 1930
Casetext – Car salesman Alvarado – 2024
Link CPA Journal – “Cohan Rule” Estimates – A Useful Tool if Properly Used
