The Cohan Rule lets the IRS and courts use sources other than normal records to estimate expenses and amounts, if this evidence is both credible and sufficiently detailed to verify the deduction and to make a reasonable estimate of the amount.
The cases below are still valid today.
Case 1: In a 2009 case, an S corp claimed an R&D tax credit. The IRS issued refund credits to the owner—but later, under audit, denied them because the claimant could not produce supporting documents—in particular, records of the number of hours employees worked on the R&D.
Held: The appeals court said the IRS must accept, as support for the tax credit, nondocumentary evidence including employee testimony of rough estimates of time worked and non-contemporaneous documents. [U.S. v. Arthur McFerrin et ux., No. 08-20377 (5th Cir. 2009)]
Case 2: J, a loan officer for a mortgage broker, had a deal with a loan processor who generated most of the business. Because the processor did not have a license, J’s name was on the loans, and all commission checks from the broker for loans generated by the team were in J’s name. J said he deducted expenses from each check, then kept 10% of the remainder and paid the processor the remaining 90%.
The mortgage broker sent J a 1099, and J sent one to the processor showing nonemployee compensation equal to about 90% of the amount on J’s 1099. J then deducted that amount on Sched. C as a wage expense. The IRS disallowed most of the wages expense because he did not have sufficient records to document the payments. The case went to court.
Held: Mostly for the taxpayer. When the taxpayer produced few records other than his bank statements—which lacked key details such as the recipient and business purpose for every payment—the court estimated his deductions under the Cohan rule, which permits estimated expenses based on records and other evidence. The taxpayer said he sometimes deposited checks and transferred 90% to the loan processor’s account at the same bank. The transfers were on his bank statements. Other times he cashed the checks, gave 90% to the processor and deposited his 10%. The smaller cash deposits on his bank statements seemed to support this.
The court found the taxpayer’s testimony credible and allowed most of the deductions. The small portion for which he could not show support was denied. [Jenkins v. Comm.,
T.C. Memo. 2010-251]
Limits of the Cohan rule: You cannot use it for expenses requiring strict record-keeping, such as travel, meals, business gifts and “listed property” (e.g., cars, computers, cell phones); there should be no questions that some expense was truly incurred, and you must show some evidence that allows a “reasonable approximation,” such as a bank statement, testimony or even just a calendar.
Keep in mind: Even if the skeptical IRS accepts approximations, the courts are even more skeptical; the Cohan Rule is useless in an audit.
