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By Michael S. Anderson of Anderson Tax Law logo for Arizona tax attorney Michael S. Anderson P.C.
  • IRS AUDIT – Overcoming poor recordkeeping – the “Cohan Rule”

    The IRS audit  or the creation of tax returns by the IRS are uncomfortable propositions no matter your circumstance.  The Cohan Rule may help.

    Why so scary? An audit is just an attempt by the government to grade your homework right? A simple review of the documents you used to create your income and deduction disclosures. No big deal.

    For many, the above is true. Of course, they are the ones that sat in the front of the class.

    For most of us, a review of documents used to create income and deduction disclosures is scary. Why? Bad recordkeeping.

    Now, I am just trying to be funny by over-generalizing. In reality, many of those who sat in the back of the class , are good record-keepers and vice versa. No matter our personalities, we should all be aware of the following:

    1. The IRS can ask for documents and other proof to substantiate income and deductions claims on the tax return.
    2. The IRS can review bank statements and lifestyle clues for signs of unreported income.
    3. The IRS can expand an audit from one year to multiple years
    4. The lack of substantiation can turn a civil audit into a criminal referral.
    5. An attorney is needed to deal with the sensitive areas of the audit to try and prevent audit expansion and criminal referral.

    The Good News:

    Despite the above, “holes” in your record keeping i.e. missing receipts, checks etc. can be filled in legally.

    Thanks to an old case called Cohan v. Commissioner, 39 F 2nd 540 (2nd Cir. 1930), the IRS will allow proof of expenses, even if receipts and checks are missing.

    The catch is that the taxpayer must have a “reasonable basis” for the claim made on the return.

    What is “reasonable basis” then? An example.

    Imagine a realtor that drove many miles over hill and dale, night and day in her attempt to sell homes. She maintained a calendar of her workday all year, but didn’t keep a mileage log.

    When audited she reconstructs the mileage log using the calendar. She submits the new mileage log along with an affidavit in which she swears that she drove that many miles.

    What if the audit has already completed and the realtor did not recreate her mileage log. She knows the new bill is too high but doesn’t know what to do.

    If the audit has been completed and the bill is too high, the audit may be reopened and the IRS can review the created mileage log. This process is called “”audit reconsideration“.

    The Cohan rule still stands for the proposition that direct records aren’t necessary to verify an IRS expense deduction if a “reasonable basis” estimate can be reconstructed. If you have unfiled returns or are being audited and are concerned about missing documents, you are welcome to call me to discuss.