Editor: John L. Miller, CPA
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 instance, in Sam Kong Fashions, Inc., T.C. Memo. 2005-15, the Tax Court concluded that the taxpayer could not use general income estimates when it had failed to keep adequate records to document its expenses. The Tax Court reached a similar conclusion in Stewart, T.C. Memo. 2005-212. In addition, the Tax Court would not allow estimates when taxpayer documents were destroyed by a wind and hail storm but the taxpayer failed to make efforts to reconstruct the records (Harlan, T.C. Memo. 1995-309). While not impossible to meet, the taxpayer burden remains high in missing record cases.
Because taxpayers relying upon the Cohan rule frequently lose, this makes the use of estimates a very difficult decision for preparers. The Fifth Circuit said the district court should have used estimates, with no mention of whether the return preparer should have considered estimates. This leaves preparers uncertain about their authority to use estimates when the client’s records do not strictly adhere to the regulation requirements.
There is some support in the regulations for taxpayers’ use of estimates. For instance, when records are missing or incomplete, Temp. Regs. Sec. 1.274-5T(c) (3) allows substantiation by other means, subject to IRS approval. Granted, this means the taxpayer is at the mercy of the Service, but a reasonable interpretation of the rules suggests that the Service should not be arbitrary in using its authority.
Tax preparers face sanctions for improperly using estimates, including the penalties under Sec. 6694 (understatement of taxpayer’s liability by tax return preparer), Sec. 6695 (miscellaneous preparer penalties), Sec. 7407 (action to enjoin tax return preparers), and other sections. These penalties require the preparer to make a professional call as to when, if ever, estimates may be relied upon in an original return for reporting purposes and what, if any, added disclosures are required.
For instance, is a Form 8275, Disclosure Statement, required if a preparer uses estimates and cannot strictly comply with record-keeping requirements under Regs. Sec. 1.41-2? The Fifth Circuit has held that the taxpayer is entitled to at least partial research credits if the taxpayer can prove that it incurred creditable expenses. What should the preparer do on original filings? Can a credit be claimed or should it be left off totally if a taxpayer does not have all the records required by the regulations? When does an estimate of income or deduction give rise to the need to attach a Form 8275 disclosing the use of an estimate?
When common sense dictates that the taxpayer had some expense (or credit) but strict compliance with documentation standards may not be possible, practitioners must use their professional judgment in deciding whether to use estimates. For further guidance, CPAs should refer to AICPA Statement on Standards for Tax Services (SSTS) No. 4, Use of Estimates.
John Miller is a faculty instructor at Metropolitan Community College in Omaha, NE. Joseph Brophy is president of Joseph D. Brophy, CPA, P.C., in Dallas, TX. Mr. Miller and Mr. Brophy are members of the AICPA Tax Division’s IRS Practice and Procedures Committee. For further information about this column, contact Mr. Miller at firstname.lastname@example.org.