Thursday, January 29, 2009

How Does US Tax Court Decide Amount of Deduction?

Q. I wasn't able to keep complete records of my Schedule A deduction for ______________, but I was able to estimate the deduction pretty accurately. If I am audited and the deduction is disallowed, how will the US Tax Court decide if I am entitled to the deduction?

A. While the IRS requires a taxpayer to keep sufficient records to establish the amount of a deductible expense, the Courts have been more accepting of human behavior. In 1930, a Federal Court of Appeals established a rule of law known as the "Cohan Rule." This rule is named after George M. Cohan whose case prompted the Court to adopt the rule. The Cohan Rule is still alive and well and applied by the Tax Court as recently as this month.

The Cohan Rule was stated this way in a recent Tax Court opinion: "Generally, when evidence shows that a taxpayer incurred a deductible expense, but the exact amount cannot be determined, the Court may approximate the amount, bearing heavily if it chooses against the taxpayer [because it is the taxpayer's fault that an exact amount cannot be established]. . . . The Court, however, must have some basis upon which an estimate can be made."

I believe the Rule could be used in the following situation. Taxpayer volunteers at her church (or synagogue or mosque) once a week doing office work. Taxpayer has recorded from her car's odometer that it is 13.2 miles from her home to the church (26.4 miles round trip). Taxpayer also knows that she did not volunteer every week, because she had the flu once or twice, and she was away on vacation for three weeks. She thinks she also missed one or two other days. Taxpayer decides to take a mileage deduction for her charitable volunteer work at the church by multiplying 45 days by 26.4 miles to get 1188 miles. She takes this figure and multiplies it by the standard mileage rate of 14 cents per mile for charitable volunteering. 1188 times $.14 equals $166.32.

IRS audits taxpayer. Even though the auditor knows the Cohan Rule and should apply it in the audit, he denies taxpayer the entire $166.32 deduction, because the taxpayer does not have a log or calendar showing exactly which weeks she did and did not volunteer at the church. Perhaps there are other audit changes made by the IRS, and the IRS sends taxpayer a report stating that taxpayer owes an additional $100 in taxes and $65 in penalties and interest. The taxpayer is so angry about this, she decides to file a Tax Court petition herself.

If no satisfactory settlement is arrived at prior to trial, the case will be tried to one of the tax court judges or special trial judges. At the trial, the taxpayer calmly explains to the Judge how she arrived at the mileage deduction for her volunteering at her church. (She might also present testimony from another volunteer to prove that she did, in fact, volunteer quite regularly.) The Judge decides that she is a credible witness, that her calculations make sense, but the Judge is not completely convinced that 45 days was correct. Applying the Cohan Rule, the Judge decides that the evidence showed that the taxpayer incurred the deductible expense and decides that the taxpayer should receive a deduction for 43 days, believing that the taxpayer probably missed a few more days than she remembered. Therefore, the Judge allows a deduction calculated as 43 days times 26.4 miles times $.14 per mile or $158.93.

The moral of this example is that the taxpayer should have kept a complete and accurate log of her volunteer days at her church, but, even though she failed to do so, she shouldn't lose the entire deduction for lack of specificity.


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