Individuals or businesses 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 cannot verify or substantiate certain expenses.  A business attorney has prepared this article at The McGuire Law Firm to provide additional information related to the Cohan Rule and IRS tax audits.  You should use this article only for informational purposes and discuss your facts and circumstances with your tax attorney and other advisors.

Understanding the Cohan Rule

For the Cohan Rule to come into play, a taxpayer must provide evidence that his or her estimate is based upon facts rather than mere speculation. Taxpayers must maintain adequate books and records to establish the amounts of deductions claimed. If a taxpayer fails to do so, he or she cannot rely on unsupported estimates to prove entitlement to a particular deduction. However, the IRS allows taxpayers to use reasonable assumptions to support their claims, and there are exceptions where even an unverified claim may be allowed.

In addition to keeping accurate records, taxpayers must demonstrate that they incurred the expenses being deducted. Businesses are generally required to document their costs related to running a business. If a taxpayer fails in either of those regards, he or she risks losing any claim for a deduction.

Maintaining Tax Records

The Internal Revenue Code requires that a taxpayer maintain certain records for the IRS to allow an expense or deductions.  When the IRS is auditing a taxpayer, generally, the taxpayer must show a receipt, invoice, canceled check, or like the item for the IRS to allow the expense that is under audit.  The IRS may disallow the expense or item if the taxpayer cannot provide the necessary documentation.  Under the Cohn rule, the IRS or a court may allow taxpayers reasonable deductions.  The critical issue is, what is reasonable?

Establishing The Cohan Rule

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, taxpayers can argue that an expense deduction is allowed without proper documentation.

Applying the Cohan Rule

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 under Internal Revenue Code Section 274(d).  IRC 274(d) applies to travel expenses, entertainment expenses, gifts, and other listed property, and taxpayers must comply with very strict verification rules for the IRS to allow a deduction.

Cohan’s rule states that if you write off a business expense, you must prove the amount was incurred. For example, if you claim $1,200 worth of office supplies, you cannot simply say that you bought $1,200 worth. Instead, you must provide proof such as canceled checks, invoicing, calendar entries, etc. This rule applies to both employees and contractors.

Common Cohan Rule Questions

One question 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 to information, documents, interviews, meetings and maintains records under the Internal Revenue Code.