Lesson From The Tax Court: The Structure Of Substantiation Requirements

Say you have 20 boxes of 5 different sizes.  Each size comes in 2 different colors  You can organize them in two ways.  You could create 5 groups of sizes, subdivided into 2 colors each.  Or you could create 2 groups of color, subdivided into 5 sizes each.  Or you could, like many of our clients, smash the boxes, throw then in a closet, and hope you never need them again.

Organizing boxes of deductions involves similar choices. The Tax Court keeps telling us that taxpayers bear the burden to prove their entitlement to deductions.  Taxpayers repeatedly fail to learn the lesson. Viola Chancellor v. Commissioner, T.C. Memo. 2021-50 (May 4, 2021) (Judge Urda), teaches a nice lesson on how one might organize various deductions according to the applicable substantiation requirement.  Judge Urda’s opinion addresses deductions taken on Schedule C by dividing them into two groups depending on their substantiation requirements.  Organizing deductions by their substantiation requirements is useful because taxpayers can use the Cohan rule to fill some substantiation requirements, but not others.  Spotting when and how to use the Cohan rule can be useful for tax preparation and planning, especially when your client’s dog ate the receipts — an increasingly tenuous claim in light of electronic receipts.  So I think it’s a lesson worth learning.  Details below the fold.

Law: The Two Requirements For Substantiating Deductions
Congress allows taxpayers a cornucopia of deductions when computing taxable income.  Some deductions come above the adjusted gross income (AGI) line.  They are used to reduce gross income (GI) to AGI.  They tend to be business-related deductions.  Other deductions come below the AGI line, reducing AGI to taxable income.  Those tend to be personal-related deductions, with the major exception being for both non-rental §212 deductions and unreimbursed employee expenses.

Whether a deduction goes above or below the line is one way to group deductions.  However, it may not be the most useful way to understand what it takes to successfully claim an entitlement to a given deduction.  For that, I think it useful to think about the requirements to prove, or substantiate, a deduction.  Taxpayers often think that as long as they keep receipts, they have substantiated the deduction.  Nope.  Substantiation requires two items of proof, not one.

First, you do need to prove up the amount of the deduction.  For that you need receipts (or comparable evidence) of the specific expenditures.  Call that that specific receipts requirement. .... and then say it three times out loud, fast.

Second is the often overlooked need to connect those amounts to the legal basis for the deduction.  Taxpayers need to prove to the court how the expenses relate to whatever Code section allows the deduction.  Call that the nexus requirement.  We saw a good lesson on that in Lesson From The Tax Court: Receipts Are Not Enough, TaxProf Blog (Sept. 21, 2020).

Thinking about deductions this way can be helpful because of the Cohan rule.  Let’s look at that.

Law:  Cohan Rule
The reason I like thinking about deductions in terms what it takes to claim them is because it helps me understand the scope and limits of the Cohan rule.  When taxpayers have problems with the specific receipts requirement, the Tax Court will sometimes help out.  That is, sometimes taxpayers can meet the nexus requirement (they can show they actually incurred expenses that meet the legal requirements for the deduction claimed).  But they cannot prove the specific amounts.  In those situations the Tax Court will guesstimate for them, so long as the taxpayer gives the Tax Court some reasonable basis to make the guess.  That’s the Cohan rule, named after the case that most famously did this, in a fun opinion by Learned Hand.  See Cohan v. Commissioner, 39 F.2d 540, 543 (2d Cir. 1930) (“In the production of his plays Cohan was obliged to be free-handed in entertaining actors, employees, and, as he naively adds, dramatic critics.”).  I go into details in Lesson From The Tax Court: Substantiation and the Cohan Rule, TaxProf Blog (Oct. 30, 2017).

Courts typically use the Cohan rule in situations involving  §162 deductions.  But they have used the rule in other situations too, situations far removed from the entertainment expenses at issue in the actual Cohan case.  The above-cited Lesson From The Tax Court involved theft loss deductions.  You can see Cohan in play in cases involving: §41 research tax credits (Suder v. Commissioner, T.C. Memo. 2014-201; determination of basis in assets (Wheeler v. Commissioner, T.C. Memo. 2014-204 (collecting cases)); and COGS (Huzella v. Commissioner, T.C. Memo. 2017-210 ).

While the Cohan rule can sometimes rescue taxpayer from the specific receipt requirement, I am not aware of it saving taxpayers from the nexus requirement.  As the Tax Court repeatedly tells us, it will not use the Cohan rule unless and until the taxpayer shows they actually incurred some expenditure connected to the legal requirements for the deduction sought.  That’s the nexus requirement.  The reason for the awkward language “connected to the legal requirements for the deduction sought” is seen in the case Judge Urda uses to describe this requirement, Norgaard v. Commissioner, 939 F.2d 874 (9th Cir. 1991).

In Norgaard, the taxpayers reported on their tax returns only those gambling winnings reported to the IRS on Form W-2G.  They then claimed an equal amount of losses.  At trial, the Tax Court rejected their proof of losses.  The taxpayers then asked for the Tax Court to apply the Cohan rule and at least give them some amount of gambling loss deductions!  And there was no doubt they showed evidence of losses.  However, in addition to failing to prove up their losses to the Court’s satisfaction, the taxpayers also admitted they had additional gambling winnings over and above the W-2G amounts they had reported (now there's a lesson as well).  They were unable to establish the amount of those unreported winnings.

Both the Tax Court and the 9th Circuit held that the taxpayers could not invoke the Cohan rule because they had failed the nexus requirement.  They did not connect the expenditures to the legal requirements for the deduction sought.  Specifically, they had “failed to lay a proper foundation for the application of the Cohan rule” because without accurate amounts for winnings “there was no way for the tax court to determine whether the claimed losses [equaled] or exceeded the unqualified, unreported winnings.”  Id. at 880.  No nexus, no Cohan rescue.

Law: Interplay of Statutory Requirements and Cohan
Because the Cohan rule is judge-made, it can be affected by statutes.  Sometimes a statute trumps the Cohan rule.  Sometimes a statute just creates a heightened nexus requirements and not a heightened specific receipts requirement.  That may allow room for Cohan.  Finally, sometimes a statute actually adopt a Cohan approach to the specific receipts requirement.  Let’s take a look.

Section 274(d) is the statute than most often trumps Cohan.  Many expenses allowable under §162 also contain a significant personal component.  Section 274(d) jacks up both the specific receipts requirement and the nexus requirement for certain expenses that have a dual business/personal character to them.  Those expenses include (1) expenses for travel away from home (including meals), and (2) expenses related to “listed property,” a term which is elsewhere defined as including “any property of a type generally used for purposes of entertainment, recreation, or amusement.”  §274(d)(4)(A)(ii).  Before 2018 the list included entertainment expenses “directly connected” to a trade or business but now those are simply disallowed.  §274(a)(1).

For expenses subject to §274(d) substantiation rules, taxpayers cannot use the Cohan rule to avoid specific receipts requirement.  They must keep receipts or other “documentary evidence” of the amount.  You can find the details in Temp. Treas. Reg. 1.274-5T(b), (c).  Moreover, §274(d), as interpreted by the regulations, also gives detailed instructions for the nexus requirement. Taxpayers must keep contemporaneous records (e.g. diary, log, statement, trip sheets, or a similar records) that show the time, place, and business purpose of the expense.

Home office deductions are subject to similar heightened substantiation requirements and for the same reason: Congress is concerned about taxpayers turning otherwise non-deductible personal expenses into deductible trade or business expenses.  Thus, §280A(a) disallows all deductions “with respect to the use of” a taxpayer’s residence.  Section §280A(c) permits deduction only where the taxpayer can prove that a certain portion of the home was used “exclusively and on a regular basis” for one of three narrowly defined business purposes.  See generally Commissioner v. Soliman, 506 U.S. 168 (1993) (creating restrictive test for determining whether a taxpayer’s home was a “principal place of business”).

Unlike §274(d), however, §280A does not create a heightened specific receipts requirement.  There is room for the Cohan doctrine.  Section 280A’s thrust is to tighten the nexus requirement, not the specific receipts requirement.

Sometimes Congress is concerned about taxpayers abusing a deduction that is explicitly allowed for certain personal expenses.  Section 170(a) for example, authorizes deductions for charitable donations.  You find the substantiation requirements in §170(f)(8) and (f)(11) and Treas. Regs. 1.170-16, and 1.170-17.  Those provision impose increasingly strict substantiation requirements corresponding to the size of the claimed donation.  For more on that, check out Lesson From The Tax Court: The Substantial Substantiation Rules of §170, TaxProf Blog (Sept. 24, 2018).

A closer look at those substantiation requirements shows how, as with §280A, the Cohan rule might still apply.  It won’t apply to cash donations because Treas. Reg. 1.170-16(a)(2) creates a heightened specific receipts requirement.  And it won’t apply to donations of cars because §170(f)(12) creates very strict specific receipts requirements for those.  However, for other donations of property, the taxpayer need only provide “a description of the property in sufficient detail under the circumstances (taking into account the value of the property) for a person who is not generally familiar with the type of property to ascertain that the described property is the contributed property.”  Treas. Reg. 1.170-16(a)(1)(iii).  Substitute “the Tax Court” for “a person who is not generally familiar with the type of property” and you have the predicate for the Cohan doctrine. Again, however, the taxpayer must still meet the nexus requirement.  For example, if the taxpayer, without reasonable cause, fails to attach a required appraisal for a contribution of $5,000, that will fail the nexus requirement.  The taxpayer will not have properly connected the amount claimed to the legal requirements for the deduction sought.  See e.g. Duane Pankratz v. Commissioner, T. C. Memo. 2021-26 (Mar. 3, 2021).

Finally, Congress has sometimes codified the idea behind the Cohan rule.  For example, when a taxpayer wants to claim a deduction for payments of state sales tax, the taxpayer can still get a deduction even if the taxpayer fails the specific receipts requirement.   Yeah, I used to keep all my receipts (tracking them on a home personal finance software called Managing Your Money which, sadly, is long gone).  What a pain!  Now, Congress allows taxpayers to elect into the sales tax tables authorized by §164(b)(5)(H).  Once invoked, the deduction becomes computational, and the taxpayer is relieved of the burden to show specific receipts. See Figures v. Commissioner, T.C. Memo. 2012-296.  The Tax Court even permits a taxpayer who did not initially make the election to use the tables during proceedings before the Court.  See Beaubrun v. Commissioner, T.C. Memo. 2015-217.

Facts and Holdings
On her timely filed 2015 return, Ms. Chancellor reported about $40,000 of income and about $33,000 in deductions.  She grouped most of her Schedule A deductions ($14,000) into the charitable donations ($6,500) and sales taxes ($4,500) boxes.  She grouped her Schedule C deductions of almost $19,000 for her notary/paralegal business into six boxes of expenses: (a) meal and entertainment ($1,500); (b) car and truck ($13,600); (c) utilities for home office ($920); (d) legal (700), (e) advertising ($80), and (f) “other” expenses ($2,300), consisting of a computer purchase, internet fees, and post office box rental.  On audit, the IRS disallowed her Schedule A deductions for charitable contributions and for taxes.  The IRS disallowed all the Schedule C deductions.

In Tax Court, Ms. Chancellor could not meet the specific receipt requirement for her Schedule C deductions because, she explained, her business records for 2015 had been stolen.  She asked for the Cohan rule for all of them.  She did not claim her non-business records for 2015 had been stolen.  Still, she was unable to meet the specific receipt requirement for either her cash donations to charities or her claimed sales tax amounts.

At one level, then, this is a garden variety substantiation case.  Judge Urda upheld the IRS’s denial of all these deductions, except for the sales tax deduction on Schedule A.  For the latter, Judge Urda let Ms. Chancellor use the sales tax tables.  So she was rescued there by the statutory Cohan rule in §164.  But for all the other deductions Ms. Chancellor failed either or both of the two substantiation requirements.  She had no specific receipts and/or could not establish the required nexus.  She had not even tried to reasonably reconstruct the records she claimed had been stolen.

The lesson for me here is not so much the substantive outcome but is how Judge Urda organizes his discussion.  While my take is slightly different, the key insight comes in looking at how he addresses the Schedule C deductions.

Lesson: Substantiation as an Organizational Tool
Ms. Chancellor claimed that all her deductions taken Schedule C were allowed by §162.  Judge Urda points out that §274 imposes heightened substantiation requirements for some such deductions.  So he divides his analysis of her Schedule C deductions into two boxes:  “1.  Expenses Subject to Section 274(d) Requirements” Op. at 11, and “2. Expenses Not Subject to Section 274(d) Requirements.”  Op. at 14.  Then he sub-divides each box by the particular deductions claimed.  Under Box 1 he puts (a) meal and entertainment expenses (remember, this was the 2015 tax year) and (b) car and truck expenses.  Under Box 2 he addresses the claimed deductions for: (a) utilities; (b) legal fees; (c) advertising; (d) “other.”  In that last category were some deductions claimed for computers, which, as listed property, were subject to §274(d) substantiation requirements.  Judge Urda explains in a footnote that he addresses them in this box because that is how Ms. Chancellor grouped them.

This is a great way to think about grouping deductions.  I would suggest perhaps a slightly broader organization:  box one goes those deductions subject to any heightened substantiation requirement, not just those subject to the §274(d) heightened requirements.  That would leave the second box to be all deductions potentially subject to the Cohan rule.  And you can do that for Schedule A deductions as well as Schedule C deductions.

Here, for example, the utility expenses would go in the heightened substantiation box because Ms. Chancellor was claiming a home office and so subject to §280A.  Similarly, the computer expenses would be analyzed within the heightened substantiation box because of §274(d).  Notice also that while the charitable donation deduction would go in the heightened substantiation box, the sales taxes would not.

To be sure, taxpayers must meet the specific receipts and nexus requirements for all claimed deductions.  However, thinking about deductions in terms of what it takes to prove them, and then looking at what records the client has available may help identify where the real work needs to be done to gather or evaluate evidence.  Here, for example, Ms. Chancellor needed to reconstruct her records but given the heightened returns receipt requirements for car and truck expenses, that would be a useless effort.  It would have only been useful for those deductions where she could invoke Cohan, being her claimed home office, advertising, legal and post office expenses.  I'm not saying it would be easy even here, but Cohan helps satisfy the specific receipts requirement.  So if Ms. Chancellor could reconstruct records, or otherwise establish the nexus, she would have had a chance.

In sum, I like Judge Urda's way of grouping deductions by substantiation requirements.  I may even steal it to use in teaching, and make a chart of common deductions organized by which ones have heightened specific receipt requirements and which do not.

Bryan Camp is the George H. Mahon Professorship at Texas Tech University School of Law.  He invites readers to return to TaxProf Blog each Monday for another boxy Lesson From The Tax Court.