In an IRS audit, if you don’t have receipts here’s a workaround

As anyone who has been through a tax audit knows, the IRS wants to see receipts. But it is easy to misplace them. Is there any alternative to losing your audit over a lack of what the IRS calls substantiation? In one famous tax case, Cohan v. Commissioner a taxpayer won even though he didn’t have any. George M. Cohan was a Broadway pioneer with hits like “Give My Regards to Broadway” and “Yankee Doodle Boy.” His statue still stands in Times Square, though it is eclipsed by the bright lights and chaos.

Many a taxpayer has been saved by this case and what it represents. The IRS disallowed Cohan’s large travel and entertainment expenses because he didn’t have receipts. He was a flashy guy and tended to pay in cash. And he wasn’t going to take no for an answer. So when the IRS denied all his deductions, he took the IRS to court. Receipts being the stock in trade of the tax system, the trial court upheld the IRS.

Again, Cohan wouldn’t take no for an answer and appealed to the Second Circuit. The Appeals Court held for Cohan and against the IRS. The Cohan rule allows taxpayers to prove by “other credible evidence” that they actually incurred deductible expenses. Cohan testified that he paid in cash, and others also supported Cohan and remembered big and expensive dinners. Of course, this is a tough way to prove expenses.

Not surprisingly, the Cohan Rule often doesn’t impress the IRS. You may have to go to court, and the argument doesn’t always work even there. Still, the IRS or a court may be convinced by oral or written statements or other supporting evidence. If you get over that hurdle and can make a reasonable approximation of the expenses, your tax position may be sustained despite your lack of documentation.

It isn’t just business expenses that can be substantiated in this way. Even charitable contributions have been allowed under the Cohan rule, although not in cases subject to special strict substantiation requirements. The fact that some taxpayers may have trouble maintaining good records to show the IRS may have been helped by the IRS’s own problems maintaining evidence.

Back in 2014, Rep. Steve Stockman of Texas introduced a bill he called the “The Dog Ate My Tax Receipts Act,” to allow us all to try out some excuses. Rep. Stockman said, “Taxpayers should be allowed to offer the same flimsy, obviously made-up excuses the Obama administration uses.” This silly bill was a response to the IRS over the Lois Lerner flap, and the bill never went anywhere. But had it passed, it would have allowed taxpayers who do not provide documents requested by the IRS to claim that “the dog ate my tax receipts,” and numerous other silly-sounding excuses.

The old Cohan case is still a favorite with taxpayers, and it’s not hard to see why. But not everyone’s use of it turns out well. Recently in David Villa and Juanna M. Villa, T.C. 2023-155, (2023), the Tax Court dealt with a contractor who kept poor records, deposited about $60,000 of checks without reporting them, and had his cousin prepare his tax returns. When he could not convince the IRS he was right, the IRS issued a Notice of Deficiency for taxes, penalties and interest.

In Tax Court, Villa argued Cohan and said that he used part of the $60,000 for materials. The court was harsh on some points, but cut Villa some slack on his undocumented cost of goods sold. The court said that if a taxpayer clearly shows that he incurred a deductible expense but is unable to substantiate the exact amount, the Cohan rule permits the court to estimate it, provided there is a reasonable basis for making such an estimate. In making an estimate, the court takes into account the fact that the taxpayer’s lack of proper records created the situation.

In other words, you are likely only to get half a loaf. Still, it isn’t just about deductible business expenses like the big dinners Cohan paid for in cash. Although the Cohan rule by its terms applies to deductible expenses, the Tax Court has adapted it to estimate cost of goods sold as well. See, e.g., Olive v. Commissioner, 139 T.C. 19, 34 (2012), aff’d, 792 F.3d 1146 (9th Cir. 2015); Alterman v. Commissioner, T.C. Memo. 2018-83, at p. 30-31.

Still, there are exceptions where even the Cohan rule is no help to taxpayers. Every tax item has substantiation requirements, but there are even stricter substantiation requirements than normal for some types of costs. Some expenses for transportation, lodging, meals and entertainment, among other things, have tougher rules, and the IRS refuses to apply the Cohan rule. See IRC section 274(d); Sanford v. Commissioner, 50 T.C. 823, 827-29 (1968), aff’d per curiam, 412 F.2d 201 (2d Cir. 1969).

In another recent case, Alvarado v. Commissioner, T.C. Memo 2024-1, the Tax Court faced similar issues in the context of a used car dealer whose records were poor. The IRS had taken the position that many of the used cars sold had no inventory cost whatsoever. Alvarado could not prove what he paid for the cars, so the IRS said zero. But the Tax Court said that was implausible, and that “the law does not require this bizarre result.”

Instead, the Tax Court listened to testimony about the purchase of the used cars. AnIn the end—although Alvarado would have done much better with receipts—the Tax Court was able to increase his costs of goods by about $1 million more than the IRS’s harsh stance. In short, in a pinch—and if you are willing to fight with the IRS even in court—the old Cohan rule can help.

Is this a good planning technique? Hardly. If you don’t want to take your chances in court and likely endure a severe haircut when you do, you are always better off with good substantiation. Checks, receipts, invoices, and more are always helpful. In an old Seinfeld episode called ‘‘The Truth,” the IRS questioned Jerry about a $50 charitable contribution to the people of Krakatoa for volcano relief.

The charity turned out to be fake, courtesy of Kramer. As this episode revealed, worrying about an IRS audit isn’t fun. Trying to prove expenses isn’t either. The best advice? Save those receipts so you never have to argue the Cohan rule.