In the past, taxpayers have often relied on the “Cohan rule” from an age-old case to bail them out of a tax jam. It often comes up when a business is unable to substantiate all of its out-of-pocket expenditures. Now a restaurant owner in a brand-new case, Pak, TC Memo 2024-86, 9/11/24, has gone back to the well again.
Basic premise: The plaintiff in the landmark federal court decision was none other than legendary vaudeville and Broadway star George M. Cohan, the “Yankee Doodle Dandy” born on the Fourth of July. Cohan claimed deductions for various travel and entertainment expenses, but said he was too busy with his hectic career to take the time to document all the expenses.
After a drawn-out battle in lower courts, Judge Learned Hand approved an approximation of expenses because Cohan clearly had incurred some costs, although he could not substantiate the exact amount. In the oft-cited summary, Hand said “… to allow nothing at all appears to us inconsistent with saying that something was spent.” (Cohan, 39 F2d 540, CA-2, 1930).
Thus, the Cohan rule was born. When taxpayers who don’t possess sufficient records are pushed to the brink, they may pull this tax-saver out of their back pocket.
Facts of the new case: The taxpayer operated a Japanese hibachi and sushi restaurant in a leased space in an Alabama shopping mall. The parties agree that it was a “high-end” restaurant with hibachi grills, a 25-foot-long sushi bar, and a 16-foot-long martini bar.
Prior to the restaurant opening in 2008, the taxpayer had to make numerous improvements to the location in the undeveloped mall. He hired a construction firm to do most of the work. The improvements were permanent and would be retained by the mall owner in the event the lease ended.
The taxpayer contends that he paid $1.1 million for the build-out and $400,000 for the purchase and installation of the hibachi tables that was separate from work by the construction firm. In addition, he claims he paid $100,000 for other fixtures and equipment, including the sushi bar, martini bar, tables, chairs, and kitchen equipment.
Unfortunately, the taxpayer didn’t have records to substantiate these expenditures at the time of trial, which took place 12 years after the build-out. However, on federal tax returns for the tax years in question, the taxpayer claimed depreciation deductions based on his assertions. The returns were prepared by a professional.
The IRS issued a notice of deficiency to the taxpayer. Subsequently, he hired a CPA to try to clean up the mess. The CPA entered additional depreciation deductions on amended returns by extrapolating from the basis used in 2008 for property placed in service in that year. But he didn’t independently investigate any records supporting the basis figures reported on the 2008 return.
The Tax Court determined that the taxpayer was entitled to at least some depreciation deductions for improvements and other business expenses that a high-end Japanese restaurant in a shopping mall would incur. It was satisfied that the claims were reasonable and that the tax returns were prepared by reputable professionals.
The court also found the taxpayer’s testimony to be credible. Accordingly, under the Cohan rule, it approved deductions for half the amounts claimed by the taxpayer.
Just dessert: Be forewarned that using the Cohan rule is a last resort. Keeping detailed records can avoid tax hassles in the first place.
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Tags: Income Tax, IRS, Taxes
