Tax Court Allows Partial Deductions Despite Missing Records: Cohan Rule Saves Business Owner from Full IRS Penalty
In a recent Tax Court ruling (Pak, TC Memo 2024-86, 9/11/24), a Japanese hibachi and sushi restaurant owner in Alabama successfully invoked the Cohan rule to secure partial tax deductions. The court allowed reasonable approximations of expenses when detailed business records were missing. This case serves as a reminder that while documentation is critical for tax filings, the Cohan rule can offer a lifeline in some situations.
What Is the Cohan Rule?
The Cohan rule dates back to a famous 1930 tax case involving George M. Cohan, the vaudeville star and composer of patriotic songs like “Yankee Doodle Dandy.” Cohan claimed business deductions for travel and entertainment expenses but lacked proper records. Despite this, Judge Learned Hand allowed deductions based on credible approximations, famously stating that denying all deductions would be inconsistent if expenses were clearly incurred.
Restaurant Owner’s Tax Troubles
In this new case, the restaurant owner operated a high-end Japanese hibachi and sushi restaurant in a leased space at an Alabama shopping mall. The restaurant featured elaborate hibachi grills, a 25-foot-long sushi bar, and a 16-foot martini bar.
To open the restaurant in 2008, the owner had to invest heavily in construction and permanent improvements to the undeveloped mall location. The expenses reportedly included:
- $1.1 million for construction and build-out
- $400,000 for purchasing and installing hibachi tables
- $100,000 for fixtures and equipment, including sushi and martini bars
However, when the IRS audited the taxpayer, he could not provide sufficient records for these expenditures. The audit took place 12 years after the initial build-out, by which time the documentation had been lost.
Tax Court’s Decision
The Tax Court acknowledged that the restaurant’s expenses were legitimate, given the scale and nature of the business. Importantly, the court found the taxpayer’s testimony credible and noted that the original tax returns had been prepared by a professional.
Applying the Cohan rule, the court allowed 50% of the claimed deductions, reasoning that the taxpayer had undoubtedly incurred substantial expenses.
Key Takeaways for Business Owners
- Maintain Accurate Records: Keep detailed documentation for all major business expenses, especially for long-term investments like property improvements.
- Professional Tax Preparation: Having returns prepared by reputable tax professionals can strengthen your credibility in court.
- Cohan Rule as a Last Resort: The Cohan rule may save taxpayers in a pinch, but relying on it is risky. Courts can limit or deny deductions if they aren’t convinced of the legitimacy of the claims.
Final Thought
While the taxpayer in this case managed to avoid a “raw deal,” business owners should treat the Cohan rule as a safety net, not a strategy. Proper record-keeping remains the best way to avoid tax troubles and secure full deductions.
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