When planning for the next tax year, taxpayers should keep accurate records and receipts of any expenses they plan to deduct. However, if no records exist, the Cohan Rule may benefit the taxpayer in such that it states expenses may be reasonably and credibly estimated. The taxpayer in the next situation benefited from the Cohan Rule in combination with appropriate testimony.
The Situation:
A sole-proprietor of a restaurant was able to devote a small portion of the day to the business, as he had other full-time employment. His employees included a part-time chef, a dishwasher, and a minimum of one waitress, all who were paid in cash. At the time, his current girlfriend was responsible for maintaining the books, along with a little manual work around the restaurant. When they broke up, she took the business records with her.
On his tax return, the restauranteur reported $21,280 on a Schedule C, with no cost goods sold. He claimed a deduction of $9, 258 in supplies, and $5,620 in contract labor, though he reported no wages. Both deductions were denied by the IRS, citing lack of substantial proof.
In court, the taxpayer could not provide substantiation for the amounts deducted, due to his ex-girlfriend having the appropriate paperwork. His supplies deduction consisted of food and other items that would have been calculated in his cost of goods sold. He admitted that the deduction he claimed regarding contract labor was the amounts he paid to his dishwasher, cook, and waitress.
Additionally, he was denied a deduction for $2,880 in advertising fees for similar reasons of providing sufficient documentation. In court, the taxpayer presented a copy of a full-page ad taken in the local Spanish-language newspaper. The ad suggested readers should die at his establishment and contained a photo of the taxpayer, his chef, and his ex-girlfriend. According to the taxpayer, the ad ran monthly for a portion of the year at a rate of $100/month.
IRC Section 6001 states that taxpayers must retain documentation and records to prove claimed deductions. The case of Cohan, 2nd Cir. 1930, allows the court to estimate the amount of expenses if a taxpayer can prove it was incurred, even if there are no records to document the exact amount. The taxpayer is responsible for providing a foundation for estimation. The lack of record-keeping weighs against the taxpayer’s proof.
In this situation, the IRS agreed that the taxpayer did in fact run a restaurant business for the tax year and allowed other expense deductions. Labor costs are part of doing business, so the taxpayer should have incurred the expenses for his cook, waitress and dishwasher, as well as cost of goods sold in relation to the food served at the restaurant. Because he didn’t have appropriate records, the court estimated the expenses using the Cohan rule, weighed heavily against the taxpayer’s inability to maintain records.
The court changed his $9,258 supplies deduction to $6,000 for cost of goods sold, and his $5,260 contract labor deduction to $4,000 for wages. The advertising expense was reduced from $2,880 to $500, considering his testimony that he was charged $100 a month for a portion of the year.
