Estimates and the Cohan rule.

• Author: Brophy, Joseph D.

When dealing with clients who have incomplete records, return preparers are frequently forced to use estimates whether they want to or not. A recent Fifth Circuit decision that a district court should consider estimates--using the Cohan rule as guidance--when taxpayer records do not strictly comply with the Sec. 41 research credit regulations serves as a reminder that practitioners also have a responsibility to clients to consider estimates while preparing many tax filings.

In McFerrin, No. 08-20377 (5th Cir. 6/9/09), the taxpayer owned several S corporations. McFerrin was a well-known and respected chemical engineer. For the 1999 tax year, McFerrin's companies did not claim an R&D tax credit but later filed amended returns that included the credit. The IRS issued a refund but later sued McFerrin for return of the refund on the grounds that McFerrin was not entitled to the credit and that it had issued the refund erroneously.

The IRS argued that even if McFerrin had incurred creditable expenses, he was not entitled to the credit because he had failed to substantiate his claim. The parties agreed that McFerrin had not strictly complied with the record-keeping requirements under Regs. Sec. 1.41-4 (despite producing nearly 70 boxes of records). The Fifth Circuit held that under the Cohan rule, "if a qualified expense occurred, ... the court should estimate the expenses associated with those activities," despite the taxpayer's lack of substantiation.

The Cohan rule is based on a Second Circuit decision from 1930 in which George M. Cohan, a great entertainer but a lousy bookkeeper, claimed substantial travel and entertainment expenses but could not provide adequate records (Cohan, 39 F.2d 540 (2d Cir. 1930)). Today, Cohan would lose this battle because the Code has been amended by the addition of Sec.

274(d), which requires substantiation for travel, entertainment, business gifts, and expenses with respect to listed property. Luckily for Cohan, his case predated those rules, and the Second Circuit held that he should be permitted to use estimates to establish his entitlement to business expense deductions.

The rule allowing deduction of expenses is based on the principle that if the IRS asserts a deficiency but other evidence clearly indicates that some deduction should be allowed, the court can develop its own estimate. However, relying on the Cohan rule is anything but certain.

In many cases the courts have refused to apply the rule. For...