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What is the Cohan rule, and how does it apply?

On Behalf of | Mar 7, 2024 | Employment Tax Law |

Business owners often find themselves completing one task and quickly moving on to another in the day-to-day of staying dynamic and relevant.

Hence, it is not surprising that in pursuit of a successful business, receipts, expenses and business activities that would be deductible are set aside and/or not timely accounted for so as to result in relevant expenses offsetting taxable income.

As a result, many business owners find themselves estimating these expenses when filing their returns.

Will the IRS question this estimate?

They may. The Cohan rule can apply if the Internal Revenue Service (IRS) conducts a tax audit and has questions about these estimates.

What is the Cohan rule?

The courts established the Cohan rule back in 1930. It was the result of a case involving a taxpayer business owner, business expense deductions, and poor record keeping. The court basically held that in some instances it will allow taxpayers to claim deductions based on a reasonable estimate even if they did not keep adequate records as long as they have some factual basis to back up their claims.

Is there anything else I should know about business expenses and the Cohan rule?

There are some exceptions. The court will generally exclude certain entertainment and travel deductions for example, as listed under Section 274(d).

It is also important to note that this law, like all things in the tax world, is evolving. It is not the same as it was when created in 1930. Congress made some changes in the sixties that increased substantiation rules for certain deductions, like automobiles, and the Tax Cuts and Jobs Act (TCJA) from just a few years ago made additional changes — removing entertainment deductions completely. The rule is likely to continue to change.

As such, it is wise for those who are looking to use the Cohan rule as a defense to allegations of wrongdoing during a tax audit to seek legal counsel. An attorney experienced in this niche area of tax law can review your case and discuss how to use this, or other applicable defense strategies, to your advantage.