Cohan v. Commissioner of Internal Revenue
39 F.2d 540 (1930)
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Rule of Law:
When a taxpayer can prove they incurred deductible business expenses but cannot substantiate the exact amount with records, the court must make a close approximation of the expenses rather than disallowing the deduction entirely.
Facts:
- George M. Cohan was a theatrical manager and producer.
- In the course of his business, Cohan was required to spend substantial sums on travel and entertainment.
- His entertainment expenses were for actors, employees, and dramatic critics.
- His travel expenses were extensive, sometimes including his attorney.
- Cohan kept no accounts, receipts, or detailed records of these specific expenditures.
- At trial, Cohan estimated his total travel and entertainment expenses over several years amounted to $55,000.
Procedural Posture:
- The Commissioner of Internal Revenue disallowed Cohan's deductions for travel and entertainment expenses due to a lack of records.
- Cohan petitioned the Board of Tax Appeals (the trial court for tax matters at the time) to review the Commissioner's determination of tax deficiency.
- The Board of Tax Appeals affirmed the Commissioner's decision, refusing to allow any part of the claimed deductions for travel and entertainment expenses because they were unsubstantiated.
- Cohan, as petitioner, appealed the Board's decision to the United States Circuit Court of Appeals for the Second Circuit.
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Issue:
Is a taxpayer entitled to a deduction for legitimate business expenses when they can prove such expenses were incurred but cannot substantiate the exact amount with detailed records or receipts?
Opinions:
Majority - L. Hand
Yes, a taxpayer is entitled to a deduction for legitimate business expenses even without exact records. It is an error to allow no deduction at all when the court is convinced that something was spent and that the expenses were allowable. The court reasoned that absolute certainty in substantiating expenses is often impossible and should not be required. While the taxpayer's lack of records is of their own making, which allows the court to 'bear heavily' against them in its estimation, it is inconsistent to find that expenses were incurred and then allow nothing. The Board of Tax Appeals had a basis for computation, even if it meant drawing on its own estimates of the minimum of such expenses. The court concluded that disallowing the entire deduction was an error and the Board must reconsider and make some allowance, even if the result is inevitably speculative.
Analysis:
This decision established the landmark 'Cohan Rule,' which allows for the estimation of deductible expenses when a taxpayer lacks complete records but can prove that expenses were incurred. This created a judicial backstop against the complete disallowance of legitimate deductions due to imperfect record-keeping. While the rule's application to travel and entertainment expenses was later significantly restricted by Congress with the enactment of Internal Revenue Code § 274(d), which imposes strict substantiation requirements, the Cohan Rule remains applicable to other categories of business expenses not covered by that statute. The case represents a pragmatic balance between the taxpayer's burden of proof and the realities of business.
