On May 10, 2021, the Tax Court issued a Memorandum Opinion in the case of Adler v. Commissioner (T.C. Memo. 2021-56). The primary issue presented in Adler was whether the petitioner was entitled to deduct business expenses for 2016 and 2017 (the years in issue).
The petitioner was a consultant for an entertainment company in Los Angeles. He incurred business-related expenses, including travel expenses, and he reported these expenses on his Schedule C in 2017. The trouble was that the entertainment company was in the habit of reimbursing the petitioner for his expenses, and the CFO testified that this was the company’s practice.
The petitioner was not able to substantiate his travel expenses, and the Tax Court could not apply the Cohan Rule, as travel expenses fall under the IRC § 274 carveout of Cohan v. Commissioner, 39 F.2d 540, 543-544 (2d Cir. 1930). See Boyd v. Commissioner, 122 T.C. 305, 320 (2004); Treas. Reg. § 1.274-5T(a).
Deductions, Substantiation, and Cohan
IRC § 162(a) allows a taxpayer to deduct all ordinary and necessary expenses paid or incurred in carrying on a trade or business. An ordinary expense is one that commonly or frequently occurs in the taxpayer’s business, Deputy v. du Pont, 308 U.S. 488, 495 (1940), and a necessary expense is one that is appropriate and helpful in carrying on the taxpayer’s business, Welch v. Helvering, 290 U.S. at 113. A taxpayer may not deduct a personal, living, or family expense unless the Code expressly provides otherwise. IRC § 262(a).
Deductions are a matter of legislative grace, and a taxpayer must prove his or her entitlement to a deduction. INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934). Whether an expenditure is ordinary or necessary is a question of fact. Commissioner v. Heininger, 320 U.S. 467, 475 (1943).
IRC § 6001 and the regulations promulgated thereunder require taxpayers to maintain records sufficient to permit verification of income and expenses. See Treas. Reg. § 1.6001-1(a), (e). When a taxpayer is unable to substantiate his expenses, the Tax Court may (sometimes) estimate the amount of a deductible expense if a taxpayer establishes that an expense is deductible but is unable to substantiate the precise amount. See Cohan, 39 F.2d at 543-44; Vanicek v. Commissioner, 85 T.C. 731, 742-743 (1985).
This principle is often referred to as the Cohan rule. See, e.g., Estate of Reinke v. Commissioner, 46 F.3d 760, 764 (8th Cir. 1995), aff’g T.C. Memo. 1993-197. Certain expenses, such as travel, specified in IRC § 274 are subject to strict substantiation rules. No deductions under IRC § 162 shall be allowed for “listed property,” as defined in IRC § 280F(d)(4), unless the taxpayer substantiates the expenses through adequate records or through sufficient evidence corroborating the taxpayer’s own statement. IRC § 274(d)(4). Unfortunately for the petitioner, “listed property” includes passenger automobiles and other property used for transportation. IRC § 280F(d)(4)(A)(i)-(ii).
Notably, IRC § 274(d) overrides the Cohan Rule. Boyd, 122 T.C. at 320; Treas. Reg. § 1.274-5T(a) (flush language) (noting that IRC § 274 supersedes the Cohan rule). Therefore, the Tax Court is precluded from estimating any expenses that are covered by IRC § 274(d).
Expenses may be claimed on Schedule C if they are ordinary and necessary to a taxpayer’s business. Expenses may not be claimed on Schedule C if they are reimbursed. The Tax Court is not the venue in which to double dip your proverbial tax chip. Also, substantiation.Add to favorites