In the case of Fagenboym v. Commissioner [1] we see a taxpayer unsuccessfully attempt to make use of the most-cited case in federal income tax cases—the case of Cohan v. Commissioner, 39 F.2d 540 (2d Cir. 1930).

For those who aren’t familiar with the Cohan case, the case involved vaudeville producer and entertainer George M. Cohan and produced what is often referred to as the Cohan doctrine or rule. The opinion summarizes this rule as follows:

Under the Cohan rule, when a taxpayer establishes that he or she has incurred a deductible expense, but is unable to substantiate the exact amount, the Court is permitted to estimate the deductible amount. Id. at 543-544. But we can do so only to estimate the amount of the deductible expense when the taxpayer provides evidence sufficient to establish a rational basis upon which the estimate can be made. See Vanicek v. Commissioner, 85 T.C. 731, 743 (1985). In estimating the amount allowable the Court bears heavily upon the taxpayer who failed to maintain required records and to substantiate expenses as the Code requires. See Cohan v. Commissioner, 39 F.2d at 544; Keenan v. Commissioner, T.C. Memo. 2006-45, aff’d, 233 F. App’x 719 (9th Cir. 2007).[2]

Essentially, a taxpayer looks to use the Cohan rule when the taxpayer has deficient or non-existent records to support a deduction, a problem which George M. Cohan successfully was able to overcome in his 1930 case.

However, this also means the taxpayer is generally working from a position of weakness. Two major hurdles face a taxpayer looking to use this rule which the Court pointed out.

The taxpayer has to show a rational basis upon which the Court can make an estimate and
The Court “bears heavily” against the taxpayer based on his/her amount of culpability that led to the lack of records.

In reality, the second factor has an impact on the first—the more responsible the taxpayer was for the lack of records, the less likely it generally is that the Court will find that the taxpayer had provided a rational basis upon which to estimate the expenses in question.

In this case Mr. Fagenboym was a shareholder in an S corporation (Alcor Electric) that could not document certain amounts paid for purchases from one of the corporation’s suppliers. The taxpayer offered the following information upon which he asked the Court to grant an allowance for purchases related to the supplier.

Mr. Fagenboym submitted four pages of handwritten calculations that attempt to reconstruct Alcor Electric's purchases and other expenses related to four alleged business contracts. Mr. Fagenboym testified that he created the handwritten document because he was unable to produce original records of the amounts paid to one of Alcor Electric's electrical suppliers, Alameda Electrical Distributors (AED), on the four business contracts. In support of his calculations Mr. Fagenboym testified that he was able to estimate the amount paid to AED by Alcor Electric during the year in issue by taking the total amount paid to the S corporation on each of the four contracts and subtracting a 12% profit margin to produce an estimated total for the hard costs of each project. Mr. Fagenboym then subtracted all known labor and materials costs from the resulting total hard costs to produce the estimated total paid to AED on each contract. During the trial Mr. Fagenboym did not produce contemporaneous records or any other business records pertaining to Alcor Electric's operations. He testified that he had previously provided substantiating documents to respondent for all hard costs on the four contracts except for the amounts paid to AED.[3]

However, the Tax Court found that this fell short of what was necessary to provide the Court with a rational basis upon which to calculate a deduction:

Although Mr. Fagenboym’s testimony about industry operations was generally reliable, the amounts included in the handwritten calculations proffered are not backed by any underlying bank statements, receipts, or other documentation. Mr. Fagenboym testified that the 12% profit margin on which his calculations hinge was a rough estimate based on similar contracts in the industry. He stated that the 12% figure was “potential profit” but noted that Alcor Electric’s actual profit was “much less than that”.

Although we have no doubt that Mr. Fagenboym produced his calculations in good faith, the reconstruction of expenses on the basis of an individual’s estimate of industry standard profit margins does not take the place of substantiation or provide a rational basis upon which an estimate can be made under the Cohan rule. The record includes no reliable evidence establishing error in respondent’s determinations in the notice disallowing petitioners’ claimed loss deductions related to certain expenses reported by Alcor Electric during the year in issue. On the record before us, we conclude that petitioners have failed to carry their burden of establishing that Alcor Electric paid or incurred the expenses underlying the deductions that respondent disallowed for its 2015 tax year. We therefore sustain respondent’s determination in the notice of deficiency disallowing a portion of petitioners’ claimed Schedule E loss deductions for the year in issue.[4]

What makes this case somewhat unusual is that while the judge found the taxpayer’s testimony credible and even appears to have some sympathy for the taxpayer, he still found the methodology too flawed to be used to estimate the deduction in question.

[1] Fagenboym v. Commissioner, TC Summ. Op. 2021-19, July 19, 2021, https://www.taxnotes.com/research/federal/court-documents/court-opinions-and-orders/couple-swerved-too-far-from-substantiation-rules%2c-tax-court-says/76wnf (retrieved July 19, 2021)

[2] Fagenboym v. Commissioner, TC Summ. Op. 2021-19, July 19, 2021

[3] Fagenboym v. Commissioner, TC Summ. Op. 2021-19, July 19, 2021

[4] Fagenboym v. Commissioner, TC Summ. Op. 2021-19, July 19, 2021