In a prior article on the documentation and records one must keep for federal tax purposes, I mentioned “the Cohan rule.” I said that, under some circumstances, the Cohan rule can help a taxpayer who has paid a deductible business expense but who cannot substantiate the exact amount.
What Is the Cohan Rule?
The Cohan rule comes from a court case from the 1930’s, titled Cohan v Commissioner.
George M. Cohan was a theatrical manager, producer and a playwright. In the production of his plays Cohan was obliged to entertain actors, employees, and dramatic critics. He also traveled much, at times with his attorney. These expenses amounted to substantial sums, but he kept no account of the expenses. The Court also recognized the he probably could not have kept good account of the expenses. The Board refused to allow him any part of this, on the ground that it was impossible to tell how much he had in fact spent, in the absence of any items or details.
The Court went to say that absolute certainty in such matters is usually impossible and is not necessary. Rather, the Court directed that the Board should make as close an approximation as it could, “bearing heavily if it chooses upon the taxpayer whose inexactitude is of his own making.” The Court went on to say that allowing nothing at all was inconsistent with saying that something was spent. There was obviously some basis for computation, even if it was necessary to draw upon the Board’s personal estimates of the minimum of such expenses. Additionally, the amount allowed may be trivial and unsatisfactory, but in this case there was at least some basis (Mr. Cohan’s testimony) for some allowance, and the Court found that it was wrong to refuse any. So, the Court allowed some expenses without documentation.
The Cohan Rule Is No Longer Available for Travel and Entertainment Expenses
Note that this first application of the rule related to travel and entertainment expenses. However, the Cohan rule is no longer available for travel and entertainment expenses. The rule has been superseded by section 274(d) of the Internal Revenue Code, which now governs the deductibility of entertainment and travel expenses. Since 1962, travel and entertainment expenses have been only partly deductible and must be carefully documented.
How Is the Cohan Rule Being Applied to Other Categories of Business Expenses?
However, the Cohan rule is still being applied to other categories of business expenses.
An example of application of the Cohan rule occurred in a case in which the taxpayer claimed a deduction for $8,237 for “supplies.” Most of the purchases could be verified in their amount and location by credit card statements and cancelled checks. However, there was nothing to support the claim that the expenses from Hone Depot, Walmart, Best Buy, etc., were business and not personal. Given the taxpayer’s extensive intermingling of business and personal expenses, the Court could not allow him all of his claimed expenses. But, the Court did acknowledge that, based on ALL the evidence, the taxpayer did incur some business expenses. So, the Court applied the Cohan rule to estimate a reasonable amount. The Court allowed only 40% of his claimed deductions for the tax year in question.
In another case the taxpayer claimed expenses for contract labor. He told the Court these were cash payments for which he did not have any receipts to substantiate the expenses. The Court said that, without any basis to even estimate these expenses, it could not invoke the Cohan rule. It said that any allowance of the expense would amount to unguided largesse. The Court denied the entire amount claimed.
What You Want to Remember
So, what is the take away from all this? First, one should keep business expenses separate from personal expenses. Have, and use, separate bank accounts and credit card accounts for your business. Clearly document on your receipts the business purpose for the purchase. This is particularly important for items that could also be for personal use. Make those notations at the time of purchase to give them more credibility.
Secondly, to get the benefit of the Cohan rule, you MUST have at least some credible substantiation for the expenses – you cannot just guess. Without some documentation, the Cohan rule doesn’t help you.
In summary, 1) keep business expenses separate from personal expenses; 2) keep contemporaneous, detailed records and receipts for the business expenses; and 3) keep your receipts and records for at least four years from the date your tax return was due or was filed, whichever is later. (There may be reasons for keeping your records longer, in which case you should keep them for the longer period.)
For More Information, Contact Us Today
If you have any questions about your record keeping procedures or about the Cohan rule, contact the Sodowsky Law Firm to schedule a consultation.