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Question: Will the IRS disallow my deductions because my tax records are lost or destroyed?

Answer: Loss or destruction of tax records is common problem for taxpayers during a tax audit. Here in New Jersey, my clients have expressed frustration over the loss of records due to Superstorm Sandy and other events outside of their control such as a computer crash. My experience is that IRS tax auditors while ostensibly sympathetic penalize taxpayers that have lost their tax records. This is because Congress codified, under USC §6001, the requirement that every person liable to pay a tax has the duty to retain records. But considering that audits typically take place years after filing and there are circumstances where records get destroyed or lost, the requirement is draconian.

There are ways to overcome the loss or destruction of tax records; however, the burden is on the taxpayer to prove the deduction.

Cohan v. the IRS, a 1930 federal case, set the precedent for proving a tax deduction without tax records. The case created a rule known amongst tax attorneys and tax practitioners called the Cohan rule.

In Cohan v. IRS, the taxpayer, George Cohan, who was known as “Mr. Broadway” for his preeminent role in American musical theater, lost all of his tax records. Mr. Cohan incurred numerous ordinary and necessary business expenses associated with his entertainment business. Upon audit, the government denied all of his expenditures. His tax attorneys argued that the IRS was wrong because although his records were missing, he had presented other credible evidence as to the amount of the expenses on which approximations of the true amounts could be made. The Second Circuit agreed. Cohan was allowed a reasonable estimation of his expenses despite the loss of tax records. Therefore, the Cohan rule stands for the proposition that a court will allow the taxpayer a deduction for an estimated amount of expenses where it is clear the taxpayer is entitled to a deduction but cannot establish the exact amount of the deduction.

Since the original Cohan case, the courts and Congress have created strict substantiation requirements for travel and entertainment expenses.

If you are claiming the loss of records due to storm or other exceptional circumstances, there are regulations that address the tax controversy. Treasury regulations are the IRS’s interpretation of the law and can be relied upon for precedent. According to Treasury Regulation §1.274-5A, if the taxpayer during a audit cannot fully substantiate an item, then the tax auditor should allow alternative treatment or verification especially in the case of exceptional circumstances. The regulations go on to state that “where the taxpayer establishes that the failure to produce adequate records is due to the loss of such records through circumstances beyond the taxpayer’s control, such as destruction by fire, flood, earthquake, or other casualty, the taxpayer shall have a right to substantiate a deduction by reasonable reconstruction of his expenditures or use.”

Generally speaking, audits must be conducted within three years from the date of filing a tax return, six years if there is a substantial understatement of income. A substantial understatement of income is defined as a 25% omission of gross income. The government has an unlimited amount of time to conduct an audit if it can there is tax fraud. Typically, audits take place years after the return was filed. Therefore, I advise scanning and backing up documentation on an external drive. Audits are stressful and having adequate records will greatly facilitate a favorable resolution or tax settlement.

Utilizing the Cohan rule and substantiating a deduction by reasonable reconstruction of expenditures is difficult. Before relying on the Cohan rule or the aforementioned tax regulation, you must do your best to contact the merchant/supplier, credit card company, bank, etc, to request a copy of records. If that is not possible, then you must rely on the Cohan rule and treasury regulation §1.274-5A, the latter if you are arguing the loss of tax records due to fire, flood, earthquake, or, as an example, Superstorm Sandy. Remember, the burden is on you, the taxpayer, to provide the auditor with a reasonable reconstruction of that the expenditure was ordinary and necessary and paid for or incurred during the taxable year.

Tax controversy work is a battle and oftentimes, you must be persistent and realistic in presenting your case to a tax auditor. If you are undergoing a tax audit and require help because of the loss of records, then contact the Law Offices of Todd S. Unger, Esq. LLC. Todd S. Unger, Esq., is a tax attorney whose practice is devoted exclusively to assisting taxpayers with IRS audits and collection activities such as bank levies, liens, seizures, and wage garnishments. Contact the Law Offices of Todd S. Unger, Esq. LLC today for a free confidential consultation.

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