Song-and-dance saves undocumented deductions

The 2017 tax filing deadline was last week. Often people extend their return because they lack all of the information needed to complete the return.

Sometimes the culprit is a third-party provider of information. But some taxpayers simply cannot pull together their own tax records by the due date. What does a taxpayer do when the records are not available and will never be available?

Missing records may be the original cost of an asset that was sold during the year. They may also be missing receipts or other documentation for the amount of an allowed deduction.

Certain deductions are not available without documentation required by the statute. These include charitable deductions and travel and entertainment expenses.

If the law does not explicitly require substantiation, then can an estimate be sufficient to claim a deduction?

The answer is maybe. Maybe requires some reflection on the facts of the specific case.

The starting point for estimates on a tax return is George M. Cohan. For you young kids, say 75 or younger, who did not grow up watching Mr. Cohan perform, he was the most famous producer, performer and writer in American theatre until his death in 1942.

Mr. Cohan was forced to spend large sums entertaining actors and others in his business. In Mr. Cohan’s day, there was no statutory substantiation rule for such expenses.

Mr. Cohan didn’t keep records. So he estimated his entertainment expense. The government said he could not deduct costs that were estimated. The 2nd Circuit Court of Appeals disagreed.

Mr. Cohan was able to prove to the court that his role in the entertainment business required him to incur entertainment expenses. The court then adopted what it though was a reasonable estimate of his costs.

The lasting result of Mr. Cohan’s successful career is songs, films, and plays that many people recall. It is also the “Cohan rule,” which may be known only to those who make a living as tax advisers.

Last month, the Tax Court again applied the Cohan rule to allow a taxpayer to report a tax basis to offset the gain from an IRA distribution. The taxpayer, Andrew Shank, made IRA contributions during the 1990s when his income was too high to claim a deduction.

Mr. Shank had no records of the contributions that he made. Shank’s IRA custodian began as Legg Mason, then it became Citibank, and finally Morgan Stanley.

Shank had an old statement from Citibank that showed a contribution of $4,760. He had no proof other than this statement that he had made a contribution. He also had no proof that this contribution was aftertax (nondeductible when made).

The IRS said that Shank had no proof that he had any basis in his IRA, so it treated all distributions as taxable. The Tax Court disagreed. Although Shank had no specific proof that he had basis from nondeductible contributions, the court said it was reasonable to infer that his $4,760 contributions as reported by Citibank had not been deducted.

Shank was a highincome taxpayer during the years in question, and as an active participant in his employer’s retirement plan, he would have been unable to claim a deduction for an IRA contribution. If a taxpayer wants to estimate some item on his tax return, the AICPA has specific guidelines for CPAs to follow. There must be sufficient evidence that would allow a reasonable estimate.

Shank’s old Citibank statement probably satisfied this AICPA standard of professional practice. Without that old statement, I don’t think a CPA could accept Shank’s estimate, and I doubt the Tax Court would have ruled in his favor.

The AICPA also prohibits a CPA from presenting information in a way that implies greater accuracy than exists. So an estimate of $900 cannot be shown as $897.

Finally, a CPA may have to disclose that an estimate is being used if failure to do so would mislead the IRS to believe that the reported number was not an estimate. This is required if the taxpayer’s records were destroyed.

George M. Cohan was born 139 years ago and died 75 years ago. He was once the toast of Broadway. Now he is the toast of tax law classes.

Jim Hamill is the director of Tax Practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at jimhamill@rhcocpa.com.