The Cohan Rule Explained for IRS Audits
One of the most important rules to know when facing an IRS audit is the Cohan Rule. The IRS allows businesses to invoke this rule when claiming business expense deductions without the relevant receipts to back up their claims.
Claiming allowable business deductions can make a significant difference to the profitability of many businesses. Though keeping thorough records is always the best policy in business, the Cohan Rule can help you when your bookkeeping goes awry.
What Is the Cohan Rule?
Businesses incur many expenses in the course of doing business, including basic overheads like rent, utilities, transport, and entertainment expenses. Because such expenses are a necessary part of doing business, many of them are tax deductible.
Many businesses have a robust system in place for keeping receipts and accounting for them. This could be a manual or electronic system. When companies don't have a clear system, problems with receipts—like losing or failing to secure one—can happen. In this case, the Internal Revenue Service (IRS) may allow you to use the Cohan Rule to claim certain tax deductions even if you don't have all of your receipts.
Most people won't ever need to use the Cohan rule. However, there are various consequences if an IRS audit finds you guilty. This is why it’s essential to be well-informed about tax laws and preferably to work with a small business bookkeeping and accounting professional from day one.
The Origins of the Cohan Rule
George M. Cohan was a Broadway star in the early 1900s. When he found himself at the wrong end of an IRS audit, he had to defend many of the expenses he'd claimed as deductions on his tax return. The IRS ruled that many of the tax deductions weren't admissible as he didn't have receipts to back up his claims. However, when Cohan appealed the case, the court sided with Cohan and ruled that the IRS must accept his estimated expenses without receipts.
This still has tax implications for modern-day businesses that can defend themselves in the case of an IRS audit with the Cohan rule. Many businesses have been able to advocate for themselves by invoking this rule.
What Does the Cohan Rule Say?
The Cohan Rule gives your business some room to move when you don't have all your receipts. However, the ruling also stipulates that your claims must be reasonable and credible when you deduct expenses. For example, you couldn’t claim thousands of dollars on regular office supplies that typically cost just a fraction of that.
The taxpayer (the individual or business being audited) must be able to present sufficient evidence by corroborating their claims and establishing a reasonable and rational basis for their estimated deductions. If they’re able to do this, the Cohan Rule may be able to help in their defense.
Tax professionals who offer IRS tax audit help may be able to help you make a basis for your claim when your claims for business expenses aren't fully backed up with receipts.
Businesses should be aware that even with reasonable claims, the Tax Court can still deny some petitions. The Cohan rule states that the taxpayer must be able to show that:
They have paid or incurred a legitimate deductible expense
They can produce credible evidence that provides a basis for their claims
The Supreme Court also added that claims must establish the possibility of approximating the amount paid and provide a method to do so.
The IRS closed 708,309 tax return audits in 2022. Audits often happen when inconsistencies or red flags are detected. Suspicious or incomplete claims may be part of that and may raise the chances of your businesses being audited by the IRS. Though the Cohan Rule may be able to help you in the unwelcome case of an audit, it’s always best to prevent avoidable stress by implementing a clear bookkeeping system in your business from the start.
Exceptions to the Cohan Rule
The Cohan Rule doesn't apply to some common business expenses. These include:
Entertainment expenses
Travel
Meals
Business-related gifts
This is because tax code IRC 274 (d) demands strict substantiation requirements for these expenses, when you are claiming they are for a business purpose. Be sure of the eligibility of certain business expenses, especially entertainment or meals, before splurging on your employees or clients.
Estimating Deductions Using the Cohan Rule
There are various ways to claim an item as a business deduction when you don't have access to the receipts:
Show canceled checks
Show credit card statements or bank statements
Show invitations or tickets to events you attended
You could also simply estimate your expenses.
Please note: The Cohan Rule may be able to help you claim business expenses, but you probably won't be able to deduct the whole costs of your expenses without receipts. The IRS will determine a minimum standard amount for the item or service you claim and will only allow you to deduct that minimum amount.
When to Invoke the Cohan Rule
You're most likely to need the Cohan rule when facing an IRS audit because you don't need to submit receipts with your tax return. The IRS accepts the numbers you present on your form unless there's a reason to suspect otherwise or if you're randomly chosen for an audit. The IRS audit statute of limitations is three years, so in 2024, you could potentially be audited for tax years going back to 2021.
Working with an experienced professional in tax affairs can help you navigate the audit process and protect your rights. Your accountant can cite the Cohan Rule when necessary, help you find other ways to justify your expenses, and assist you with strategies to minimize your tax obligations during your audit.
Keeping Accurate Records Is Always Best
It's always better to be safe than sorry. That's why keeping adequate records and keeping all of your receipts in organized files is the best policy in any business.
However, when things go wrong, an Enrolled Agent can help you when you're audited. As well as being able to suggest future changes you could implement in your business to help with bookkeeping, they can help you face your IRS audit with confidence.
