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The Cohan Rule

Individuals or business who have been audited by the Internal Revenue Service may be familiar with the Cohan rule.  The Cohan rule is based upon a court case that may allow a taxpayer an allowance for certain business deductions even if the taxpayer is unable to verify or substantiate certain expenses.  This article has been prepared by a tax attorney at the The McGuire Law Firm to provide additional information related to the Cohan Rule and IRS tax audits.  It is recommended you use this article for informational purposes only and discuss your facts and circumstances specifically with your tax attorney and other advisors.

The Internal Revenue Code requires that a taxpayer maintain certain records for the IRS to allow an expense or deductions.  When a taxpayer is being audited by the IRS, generally the taxpayer must show a receipt, invoice, cancelled check or like item for the IRS to allow the expense that is under audit.  If the taxpayer is unable to provide the necessary documentation, the IRS may disallow the expense or item.  Under the Cohn rule, the IRS or a court may allow a taxpayer reasonable amount of the deductions.  The key issue is, what is reasonable?

The Cohan rule was established through a Court of Appeals case in the Second Circuit in 1930.  Although, the court stated the taxpayer did not have adequate substantiation to verify expenses, the court held the board (IRS) should make an approximation.  In short, the court felt that it was reasonable for the taxpayer to have some reasonable business expenses, and should not be disallowed all deductions due to lack of records.  Thus, under the Cohan rule, a taxpayer can make an argument for an expense deduction to be allowed without proper documentation.

It is important to remember that the Cohan rule does not apply to all expenses.  For example, the Cohan rule does not apply to items whereby Internal Revenue Code Section 274(d) applies.  IRC 274(d) applies to travel expenses, entertainment expenses, gifts and other listed property, and taxpayer must comply with very strict verification rules for the IRS to allow a deduction.

One question that is often asked is, who has the burden of proof in a tax audit?  Generally, the taxpayer will have the burden of proof that they are entitled to the deduction and the additional tax proposed by the IRS is incorrect.  However, under Internal Revenue Code Section 7491(a), the burden of proof can switch to the IRS when the taxpayer produces credible evidence relating to factual issues, complies with requirements and verifies deductions, cooperates with reasonable requests by the IRS relating information, documents, interviews, meetings and maintains records under the Internal Revenue Code.

If you are being audited by the IRS, you may consider representation by a tax attorney.  You can speak with a tax attorney by contacting The McGuire Law Firm.

IRS Audit Tip On Mileage Deduction

If you take mileage as a deduction on your income tax return, the IRS audit tip below may help you.  Many individuals will claim mileage as a non-reimbursed employee expense on Form 2106, or if self-employed, on a Schedule C, or the deduction may even be stated on another business income tax return.  Most individuals know that to substantiate the mileage deduction they need to keep a mileage log stating where they drove, the total mileage and other information such as the business purpose for the travel.  What many individuals may not be aware of is that the IRS may also request them to verify the total mileage driven on their vehicle with third party records.  This issue is discussed below in greater detail.

Recently, I was involved with an individual income tax audit with a client over multiple periods of 1040 Schedule C (self-employed) filings.  The individual drove a decent amount in their business and had taken the mileage deduction on multiple vehicles that were used for business purposes.  The individual had maintained mileage logs for each vehicle and properly claimed the deduction on their schedule C.  During the audit, the IRS examiner requested that the individual obtain maintenance records to substantiate the total miles driven in each vehicle during the year.  This request was not to produce a mileage log of business miles driven, but records from oil changes and other maintenance records to show and verify the total number of miles, personal, business and commuting, over the course of the year.  For example, the examiner wanted to see the report from Grease Monkey stating the total mileage on the vehicle and be able to track and substantiate the mileage driven to see if the business miles claimed appeared reasonable and within the total mileage driven on the vehicle.

After the above incident, it is apparent the IRS is not only requiring a mileage log, but some form of 3rd party document to verify that the miles claimed are in line with the actual miles driven.  This being said, in addition to maintaining a mileage log, it is apparent that taxpayers taking the mileage deduction would be best served by maintaining all reports and maintenance records to verify their mileage.  Remember this the next time you take your car to the shop for an oil change or any repair!  It is probably best to even make a copy of the maintenance records and maintain the document with your mileage log and other tax related documents.  Tell your mechanic to keep the receipt clean!

John McGuire is a tax attorney and business attorney at The McGuire Law Firm.  Mr. McGuire’s practice focuses on tax issues before the IRS, tax planning, business transactions and tax implications to his individual and business clients.

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