A taxpayer may deduct all ordinary and necessary expenses paid or incurred during the taxable year in carrying on a trade or business.[1] In contrast, a taxpayer may not deduct personal, living, or family expenses unless the Code expressly provides otherwise.[2] The determination of whether an expense satisfies the requirements of IRC § 162 is a question of fact for the Tax Court.[3]

Proving Entitlement

A taxpayer must prove his entitlement to all deductions and credits.[4] Taxpayers, therefore, must maintain sufficient records to establish the amount of the deduction to enable the IRS to determine the taxpayer’s correct tax liability.[5]

The Cohan Rule

If the taxpayer is able to establish that he paid or incurred a deductible expense but is unable to substantiate the precise amount, the Tax Court may approximate the deductible amount, but only if the taxpayer presents sufficient evidence to establish a rational basis for making the estimate (the so-called “Cohan” rule).[6] Even then, the taxpayer might catch the Tax Court on a bad hair day and find it unwilling to apply the Cohan rule. Under Cohan rule, the taxpayer must be able to demonstrate that (1) the taxpayer has paid or incurred a deductible expense, and (2) the taxpayer produces credible evidence providing a basis for the Tax Court to do so.[7] The Supreme Court has added the gloss that the record must at least establish the possibility of approximating the amount,[8] and it must provide a method for doing so.[9]

Expenses Subject to IRC § 274

It must be noted that as helpful as the Cohan rule might be, it has zero application to expenses incurred for entertainment, travel, meals, allegedly business-related gifts, etc., because IRC § 274(d) requires strict substantiation for such expenses.[10] Thus, even where such expenses may otherwise be deductible, if the taxpayer doesn’t have appropriate records or other evidence, the Tax Court will not estimate the value of the porterhouse the taxpayer bought for its new client to seal the deal on that mobile home park the taxpayer’s been itching to build.

No deductions are allowed with respect to travel, entertainment, or listed property (as defined in IRC § 280F(d)(4)), unless the taxpayer substantiates by adequate records or by sufficient evidence corroborating the taxpayer’s own statements (1) the amount of expense or item, (2) the time and place of the travel, entertainment, or expense, (3) the business purpose of the entertainment or expense, and (4) the business relationship to the taxpayer of the person or persons entertained.[11]

Substantial Substantive Substantiation

To substantiate by adequate records, the taxpayer must provide (1) an account book, log, or similar record prepared at or near the time of the expenditure and (2) documentary evidence, which together are sufficient to establish each element of an expenditure.[12] Documentary evidence includes receipts, paid bills, or similar evidence.[13] Such corroborative evidence must have a high degree of probative value to elevate the taxpayer’s claim to the level of credibility of a contemporaneous record.[14]

To substantiate by “other sufficient evidence” corroborating the taxpayer’s own statement, the taxpayer must establish each element by his or her own statement and through the presentation of documentary or other direct evidence.[15] To establish the business purpose of an expenditure, however, a taxpayer may corroborate his or her own statement with circumstantial evidence.[16] The latter standard may seem less stringent, but in practice, proof of either type of evidentiary category is exacting.[17]

Footnotes:

[1] IRC § 162(a); Treas. Reg. 1.162-1(a).

[2] IRC § 262(a).

[3] Cloud v. Commissioner, 97 T.C. 613, 618 (1991) (citing Commissioner v. Heininger, 320 U.S. 467, 473-475 (1943)).

[4] INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934).

[5] IRC § 6001; Treas. Reg. § 1.6001-1(a); see also Higbee v. Commissioner, 116 T.C. 438, 440 (2001).

[6] See Cohan v. Commissioner, 39 F.2d 540, 543-544 (2d Cir. 1930); Vanicek v. Commissioner, 85 T.C. 731, 742-743 (1985).

[7] Id.

[8] Humes v. United States, 276 U.S. 487 (1928), aff’g Mitchell v. United States, 63 Ct. Cl. 613 (1927).

[9] Robinette v. Helvering, 318 U.S. 184 (1943), aff’g 129 F.2d 832 (3d Cir. 1942).

[10] See Sanford v. Commissioner, 50 T.C. 823, 827 (1968), aff’d per curiam, 412 F.2d 201 (2d Cir. 1969); Treas. Reg. § 1.274-5T(a).

[11] IRC § 274(d); see also Treas. Reg. § 1.274-5T(b)(6)(i); see also Balyan v. Commissioner, T.C. Memo. 2017-140, *7.

[12] Treas. Reg. § 1.274-5T(c)(2)(i).

[13] Treas. Reg. § 1.274-5(c)(2)(iii).

[14] Treas. Reg. § 1.274-5T(c)(1).

[15] Treas. Reg. § 1.274-5T(c)(3)(i).

[16] Id.

[17] Williams v. Commissioner, T.C. Memo. 2020-48.

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