What Is the Cohan Rule and How Does It Affect Taxes?

The Cohan Rule is a tax principle allowing taxpayers to estimate certain deductible business expenses when precise records are unavailable. It provides a framework to prevent the complete disallowance of legitimate costs due to inadequate documentation. Understanding its application and limitations is important for individuals and businesses navigating tax obligations.

Defining the Cohan Rule

The Cohan Rule is a judicial doctrine allowing taxpayers to estimate deductible business expenses when exact records are unavailable, provided a reasonable basis for the estimate exists. This rule originated from the 1930 court case Cohan v. Commissioner, involving Broadway producer George M. Cohan. Cohan incurred significant business expenses but had poor record-keeping, leading the IRS to disallow his deductions.

The court ruled in Cohan’s favor, acknowledging he incurred legitimate business expenses despite lacking detailed records. The court stated tax authorities should make a “close approximation” rather than disallowing expenses entirely, even if the taxpayer’s “inexactitude is of his own making.” This established a precedent: if a taxpayer demonstrates expenses were genuinely incurred and provides a logical basis for an estimate, the IRS or tax courts may accept a reasonable approximation.

The Cohan Rule is a last resort, not a substitute for proper record-keeping. It applies only when some evidence, even circumstantial, indicates deductible expenses were paid. The rule permits estimation when exact figures cannot be proven, but still requires credible evidence to establish the expenses and a rational basis for the estimated amount.

When the Cohan Rule Applies

The Cohan Rule applies when a taxpayer establishes a “reasonable basis” for estimated expenses. This requires providing testimony, circumstantial evidence, or other corroborating information to convince tax authorities that expenses were genuinely incurred and the estimated amount is logical. For example, bank statements or credit card records showing payments for business activities, even without individual receipts, could support an estimate.

The rule traditionally applies to minor, recurring business expenses where meticulous record-keeping for every small transaction is impractical. This includes incidental office supplies, small local transportation costs, or other minor business outlays. The core idea is that an expense was clearly incurred, but precise documentation is missing.

Application of the Cohan Rule is discretionary for the tax court or IRS. The burden of proof remains on the taxpayer to demonstrate the estimate’s reasonableness. The court “bears heavily” upon taxpayers with inexact records, meaning the allowed deduction might be less than the actual amount spent.

Expenses Not Covered by the Cohan Rule

While the Cohan Rule offers flexibility, it does not apply to all expenses. Specific categories are subject to strict statutory substantiation requirements under the Internal Revenue Code (IRC) Section 274. For these expenses, detailed records are legally required, and the Cohan Rule cannot override these mandates.

Common expenses not covered include travel, meals, entertainment, business gifts, and “listed property” (certain vehicles, computers, and cell phones). Congress enacted Section 274 to curb potential abuses, requiring taxpayers to maintain specific documentation for the amount, time, place, business purpose, and business relationship for each expense.

For these categories, simply estimating an amount or providing only a reasonable basis is insufficient. Taxpayers must provide adequate records, such as receipts, invoices, logs, and other documentary evidence, detailing the expense. Failure to do so results in the disallowance of the deduction, as the Cohan Rule is superseded by these specific statutory requirements.

Why Good Recordkeeping Matters

While the Cohan Rule serves as a fallback for taxpayers lacking complete documentation, relying on it is a last resort. Maintaining accurate and complete records for all business expenses is always in the taxpayer’s best interest. Proactive recordkeeping minimizes audit disputes with the IRS and prevents the disallowance of legitimate deductions.

Good recordkeeping involves systematically retaining receipts, invoices, bank statements, credit card statements, and detailed logs for mileage or other business activities. Organized financial records support tax deductions and provide a clear picture of a business’s financial health, aiding in monitoring progress and making informed decisions.

The IRS requires businesses to keep records supporting income, expenses, and credits reported on tax returns, generally for at least three years. Adhering to these requirements through diligent recordkeeping is the most effective way to substantiate deductions and avoid invoking the Cohan Rule, which can lead to additional scrutiny and potential penalties.