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A Useful Tool if Properly Used
IN BRIEF
If a taxpayer lacks documentation to support items on a tax return, preparers may use estimates, following an approach long known as the "Cohan rule." Although the rule remains useful for tax preparers, it is limited, and its application varies by the taxpayer's circumstances. This article provides an overview of approximation in tax matters and notes where it has been limited by statute, regulations, and court decisions.
During filing season, tax preparers will inevitably confront the question of how to report items for which a taxpayer lacks sufficient (or even any) documentation. Taxpayers are, of course, statutorily required to maintain adequate records to support the items reported on their returns (see IRC section 6001). But this obligation is more often honored in the breach. Consequently, CPAs are often forced to prepare returns based on estimates. This is not necessarily improper, in the absence of specific statutory documentation requirements, taxpayers and preparers are generally allowed to rely on estimates (e.g., Statement on Standards for Tax Services 4, Use of Estimates).
One of the first cases to allow estimates in federal tax matters was Cohan v. Comm'r [39 F.2d 540 (2d Cir. 1930)]. Preparers are often-perhaps vaguely-familiar with the "Cohan rule," and often rely on this rule to justify estimation. As discussed below, the court in Cohan permitted estimates of deductions even though the taxpayer had no documentation of his claimed expenses. One might reasonably expect that Cohan is of decreasing importance in light of the ever-increasing use of debit and credit cards, digital currencies, and other forms of electronic payment, the use of which typically creates documentation of some sort. Indeed, it might be a rare taxpayer who, like the taxpayer in Cohan, is wholly unable to document the existence and the amount of a disputed item. But records and documents are still occasionally lost, destroyed, purged, or otherwise difficult for the taxpayer to find or access. Moreover, there are still numerous cash transactions in the U.S. economy, in these circumstances, the Cohan rule continues to be important. Finally, even outside its original context (i.e., inadequately documented business deductions), Cohan continues to be important because courts have relied on it to permit estimates in a variety of...