When my son took an informal job as a “ranch hand” this past May, he was delighted to receive unrecorded cash payments. He thinks it means he does not have to report them as income. He will discover differently next filing season when we prepare his taxes. But he is not alone in thinking that unrecorded cash payments are like eating someone else's dessert: the calories don't count.
The attractive obscurity of unrecorded and unreported payments for workers, however, presents a problem for those who employ them. Employers would like to deduct those labor costs under §162. In Engen Robert Nurumbi v. Commissioner, T.C. Memo. 2021-79 (June 30, 2021) (Judge Pugh), we learn that the Tax Court will not even use the Cohan rule to rescue a taxpayer who seeks to deduct unrecorded cash payments made to workers. Mr. Nurumbi’s unrecorded cash payments to his workers may have helped them hide their income, but it also bit him on the butt when he tried to deduct the payments. As part of this short and blunt lesson, I address the question of whether the Cohan rule might actually be mandatory. Details below the fold.
Law: Deductions With The Cohan Twist
Section 162 is the workhorse of deduction statutes, allowing taxpayer to deduct all the ordinary and necessary expenses for the carrying on of their trade or business. But taxpayers have the burden to prove their entitlement to the deduction. As we learned recently, taxpayers must not only prove up the fact of an expenditure, they must also establish how that expenditure is properly linked to their trade or business so as to entitle them to the claimed deduction. I call that the nexus requirement. See Lesson From the Tax Court: The Structure Of Substantiation Requirements, TaxProf Bog (May 31, 2021)
When taxpayers are unable to document the exact amounts of expenditures made for carrying on their business, but meets the nexus requirement, the Tax Court may rescue them using the Cohan rule. That is, when a taxpayer proves the fact of deductible expenditures, but fails to prove the exact amounts spent, the Court, as a rule, will estimate some amount allowable as a deduction, although the amount may be trivial and unsatisfactory from the taxpayer’s point of view. The Tax Court started that practice in response to the Second Circuit’s opinion in Cohan v. Commissioner, 39 F.2d 540, 543-544 (2d Cir. 1930). It has since used the Cohan rule to save all kinds of taxpayers who mostly certainly spent some amounts that would qualify for deductions but, for various reasons of ineptitude, could not substantiate the exact amounts spent.
But the Tax Court does not always apply the Cohan rule, even when the facts of the case appear to permit it to do so. The Court gets concerned when it does not believe it has a good basis for estimating the expenditures. Without such basis, the Court says that any estimation would amount to unguided largess. I also read the Court as being concerned with appearing to “reward” undeserving taxpayers. You can see my critique of this thinking in Lesson From The Tax Court: Substantiation and the Cohan Rule, TaxProf Blog (Oct. 30, 2017) where I thought the Court should have applied Cohan rule. See if you think this case is similar.
Mr. Nurumbi was an Uber driver in 2015, the tax year at issue. That was a good year to be an Uber driver, before Uber made a series of price cuts in January 2016. It was so good, in fact, that Mr. Nurumbi did more that drive his own car for Uber. He bought various vehicles, financing many of them, and convinced others to drive them. However, he made them all use his Uber account. So from Uber’s point of view, it was just paying him. The payments were made as weekly deposits into a Bank of American (BoA) account held by Mr. Nurumbi’s LLC (which the parties and the Court all treat as a disregarded entity). During 2015 Uber reported total payments to Mr. Nurumbi of over $542,000 on Form 1099-K. But not all of that $542k actually went into the BoA account. The withheld fees totaled $143,600 over the year.
When Uber deposited the weekly proceeds into the BoA account, Mr. Nurumbi would withdraw some amounts as cash, and would move other amounts into a second bank account at BBVA, also held by his LLC. He paid some of his drivers with the cash. He paid others by electronic transfer from the BBVA account. During 2015, Mr. Nurumbi transferred just over $157,800 from the BBVA account to pay his drivers.
Mr. Nurumbi eventually filed his 2015 tax return, reporting only wage income of $19,000 and claiming the EITC. On audit, the IRS tagged him for the entire $542,000 from Uber. In Tax Court it apparently allowed a §162 deduction for the Uber fees and the BBVA electronic transfers to other drivers. It re-characterized the reported $19,000 in wages as part of the Uber payments. That left about $240,000 in gross income to be taxed.
Mr. Nurumbi petitioned the Tax Court for review. I am guessing that he believed his other deductions brought down his income to the $19,000 he had reported as wages. Those included vehicle expenses as well as the other driver payments, made using cash. As to the vehicle expenses, Mr. Nurumbi totally failed to comply with the §274(d) substantiation requirements. As to the driver payments...well...he did not keep records. Most critically, he did not file 1099’s on the drivers he paid in cash. After all, it was all under-the-table money. Shhhh.
In Tax Court, Mr. Nurumbi asked the Court to allow him at least some additional deduction for the cash he had paid his drivers. He asked for the Cohan rule. He asked for mercy.
The Tax Court showed no mercy.
Lesson: Those Who Live by Unreported Cash, Die by Unreported Cash
Judge Pugh explains her understanding of the Cohan rule: “the Court may estimate the amount of the expense if the taxpayer is able to demonstrate that he has paid or incurred a deductible expense but cannot substantiate the precise amount, as long as he produces credible evidence providing a basis for the Court to do so.” Op. at 14.
Judge Pugh then refuses to apply the Cohan rule, even though she finds that “petitioner testified credibly that he....paid his drivers in cash [out of the Uber deposits].” Why does she refuse? Well, because Mr. Nurumbi “gave us no basis on which to estimate how much he paid, and we are unable to hazard a guess as to what additional amounts might be properly deducted or excluded from his gross receipts. Without such a basis, any additional allowance would amount to unguided largesse.” Op. at 18.
I am not sure why Judge Pugh thought she lacked a basis to estimate some amount of cash payments, no matter how trivial. For example, the opinion notes that Mr. Nurumbi did produce the weekly statements he received from Uber. And he did produce his BBVA bank statements showing electronic transfers. It would seem that one could thus identify the drivers who received electronic transfers. That would seem a reasonable basis on which to estimate some amount paid to cash-basis drivers. It was uncontroverted that Mr. Nurumbi had more than one cash-paid driver. So why not permit an additional deduction in the amount paid to the lowest-paid of the drivers paid from the BBVA account? Mr. Nurumbi also produced 1099-MISC worksheets for drivers, although he never submitted 1099’s. That also would seem a sufficient basis to permit some estimate—a very conservative one—deduction for an amount equal to one of those worksheets.
The opinion does not discuss any of this. Query whether if Mr. Nurumbi had actually submitted 1099-MISC to the IRS for all his drivers, the IRS and/or Court would have allowed a deduction for all such amounts reported. The impact of this ruling is that Mr. Nurumbi must live with the predictable consequences of his decision to keep those cash payments under-the-table and unreported. The Tax Court will not exercise its discretion to apply Cohan.
But query this: is the Cohan Rule really discretionary, or might it be mandatory?
Comment: Is The Cohan Rule Mandatory?
When one goes back and reads the Cohan cases, one comes away with the firm impression that the Tax Court is required to make a guesstimate once it is convinced that the taxpayer made some sort of deductible expenditure. Let's take a look.
In Cohan, the Tax Court (then called the Board of Tax Appeals) had held Mr. Cohan to his burden of proof, writing:
“The next issue is based on the claims of petitioner for deductions for advertising, entertainment and traveling expenses. We can not doubt, upon the record, that petitioner was required to and did spend large sums of money in traveling and entertaining during the period January 1, 1921, to June 30, 1923. There are, however, two obstacles to the allowance of the claims which the record has failed to overcome. One is that the amounts claimed are bare estimates unsupported by any vouchers or bookkeeping entries of any kind. The other is that we do not know what part of the amounts expended were for personal expenses.” 11 B.T.A. at 761.
On appeal, however, the Second Circuit said that reasoning was erroneous and that the Tax Court was required to make an estimate because "to allow nothing at all appears to us inconsistent with saying that something was spent. True, we do not know how many trips Cohan made, nor how large his entertainments were; yet there was obviously some basis for computation, if necessary by drawing upon the Board's personal estimates of the minimum of such expenses. The amount may be trivial and unsatisfactory, but there was basis for some allowance, and it was wrong to refuse any, even though it were the traveling expenses of a single trip. It is not fatal that the result will inevitably be speculative; many important decisions must be such. We think that the Board was in error as to this and must reconsider the evidence.”
Judge Pugh’s reason for refusing to estimate—because Mr. Nurumbi provided no “basis” for an estimate—seems to be the exact same reason the Tax Court refused to allow any deduction to Mr. Cohan in that long-ago case. Yet that same reason was rejected and reversed by the Second Circuit. Both she and the Cohan court were convinced that the taxpayers had incurred a deductible expense. The problem was in finding a basis for an estimate. In Cohan case, the Tax Court could find no basis to separate out personal from business expenses. In Mr. Nurumbi’s case, the Court could similarly find no basis to separate the cash withdrawn for deductible business payments from cash withdrawn for nondeductible personal expenses. In both cases the taxpayer offered only "bare estimates unsupported by any vouchers or bookkeeping entries of any kind."
However, both taxpayers undoubtedly established that “something was spent” and spent in a way that would permit deduction if the amount were known. Both taxpayers established a nexus. Once a taxpayer does that, the Second Circuit appears to say that the Tax Court must make an allowance, no matter how trivial or unsatisfactory to the taxpayer, whose difficulty is of their own making. That is why I think here that if the Court was truly convinced that Mr. Nurumbi had made cash payments to some of the Uber drivers, it should have allowed some amount, even if the amount was “inevitably...speculative.”
What may make this case different is the under-the-table payments. In Cohan there was no issue of the taxpayer there helping other taxpayers evade taxes by paying them compensation and failing to report those payments to the IRS. Mr. Cohan simply had no third-party reporting obligation the way Mr. Nurumbi had. So that’s a distinction that I think makes a difference. The Court is not going to use the Cohan rule to help taxpayers who disregard not only good accounting practices, but also who disregard the law.
Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law. He invites readers to return each week to TaxProf blog for another Lesson From The Tax Court.