Apr 19, 2010

What If You Don't Have Proper Tax Records?

Because you're human, you may not have kept all the records required to back up your tax deductions. Don't despair, all is not lost--you may be able to fall back on the so-called Cohan rule. This rule (named after the Broadway entertainer George M. Cohan involved in a tax case in the 1930s) is the taxpayer's best friend.

The Cohan rule recognizes that all business people must spend at least some money to stay in business, and so must have had at least some deductible expenses, even if they don't have adequate records to back them up. If you're audited and lack adequate records for a claimed deduction, the IRS can use the Cohan rule to make an estimate of how much you must have spent, and allow you to deduct that amount. However, you must provide at least some credible evidence on which to base this estimate, such as receipts, canceled checks, notes in your appointment book, or other records. Moreover, the IRS will only allow you to deduct the least amount you must have spent, based on the records you provide. In addition, the Cohan rule cannot be used for travel, meal, entertainment, or gift expenses; or for listed property.

If an auditor claims you lack sufficient records to back up a deduction, you should always bring up the Cohan rule and argue that you should still get the deduction based on the records you do have. At best, you'll probably get only part of your claimed deductions. If the IRS auditor disallows your deductions entirely or doesn't give you as much as you think you deserve, you can appeal in court and bring up the Cohan rule again there. You might have more success with a judge. However, you can't compel an IRS auditor or a court to apply the Cohan rule in your favor. Whether to apply the rule and how large a deduction to give you, is within their discretion.

For more information, see Deduct It! Lower Your Small Business Taxes, by Stephen Fishman.