The Cohan Rule Is Still Alive and (Sort of) Well At Least Some of the Time

Written by William Delaney, EA, ATA of Westwood, MA

George M. Cohan was a well-known entertainer in the 1920s and 1930s. He traveled across the U.S. and in many foreign countries. He did not maintain good business records; sometimes he maintained no business records at all. In a well publicized decision issued in 1930, the 2nd poorly documented travel related expenses based upon credible testimony and the obvious fact that if he earned income while appearing at physical location X he must have incurred some expense in traveling to and residing temporarily at physical location X. Thus we have the Cohan Rule. See Cohan v. Commissioner, 39 F. 2nd 1930).

Many years later, the IRS decided to limit the application and impact of the Cohan Rule and it issued temporary regulation 1.274-5T (effective for taxable years beginning on or after 1/1/1986). This “temporary” regulation is still the applicable guideline.

Under the regulation, “...no deduction or credit shall be allowed with respect to---(travel, entertainment, gifts, listed property [editor’s insert])...unless the taxpayer substantiates each element of the expenditure or use...in the manner provided in paragraph (c) [i.e. the substantiation requirements – editor’s insert]...This limitation supersedes the doctrine found in Cohan v. Commissioner...”

Recently, a taxpayer was able to invoke the Cohan Rule to obtain limited relief from an IRS determination that he should not be allowed any expense deductions against his income due to lack of substantiation. It’s a classic example of what not to do and how not to do it.

Taxpayer, Lee A. Baker, was self-employed as an over-the-road truck driver owner/operator. Although Mr. Baker obtained an extension of time for filing his 2009 income tax return, he never filed it and the IRS, in 2012, prepared a substitute return and issued a notice of deficiency. They had all of his income information, via 1099 forms. They had no information regarding deductions so he was allowed none except for the
standard deduction and personal exemption. Self-employment tax was computed on the gross receipts as reported to the IRS.

One complicating factor for the taxpayer was that he had filed for bankruptcy in 2011. He lost his home and all of his business related records (to the extent that they ever existed) as a result of the bankruptcy proceedings. His trucking business ceased operations after February 2010.

In Court, the taxpayer claimed (without any substantiation) that he incurred approximately $63,638 of business-related expenses for truck fuel, maintenance, insurance, taxes and fees, etc. Taxpayer also estimated that he drove approximately 65,000 miles that year using his 1995 Mack Truck. The Court “...found the petitioner to be a credible witness. However, all of his figures were based on rough estimates that were made years after the fact without documentation. Applying the Cohan rule, we bear heavily against the taxpayer whose inexactitude is of his own making.(emphasis added)”

What saved the taxpayer from application of a high standard of proof as required under the temporary regulation (see above) was a ruling by the Court that listed property, which is one of the items subject to a high standard of proof [see Reg. 1.274-5T(a)(4)], “...does not include ‘property substantially all of the use of which is in a trade or business of providing to unrelated persons services consisting of the transportation of persons or property for compensation or hire.’” This moved the 1995 Mack Truck out of the listed property category and “Accordingly, these expenses are not subject to the heightened substantiation requirements of section 274(d)(4).” Claimed (though unsubstantiated) travel expenses of $6,500 were not a part of this exception to the general rule and, as a result, were disallowed in full.

The end result was that the Court allowed $18,000 business related expense and -0- in travel related expense. The decision did not detail how the Court arrived at this calculation. The lesson to take from this decision is that an ounce of prevention is better than a pound of cure (we bear heavily against the taxpayer whose inexactitude is of his own making). Lee A. Baker v. Comm., TC Memo 2014-122.