This is a common law rule that allows a taxpayer to use a reasonable estimate of business expenses based on some factual foundation, when they are unable to produce records of said expenses. The legal citation is Cohan vs. Commissioner, 39 F. 2d 540 (2d Cir. 1930).
George M. Cohan was an American entertainer who is famous for his stage work, and standard songs like “Over There,” “Give My Regards to Broadway,” and “Yankee Doodle Boy.” George was one of the first lucky souls to get an IRS audit, and because he did not keep records the auditors disallowed fifty-five thousand dollars of business expenses.
In his work George had to travel all over the country – sometimes with his attorney; take trains, cabs, pay for hotels, eat in restaurants, leave tips and any other legitimate expenses that an entertainer and his entourage would incur when on the road. Of course claims of luxurious business expenses continue to catch the attention of the IRS to this day.
The IRS took the hard position that the claims had to follow regulation and be fully documented. George took the IRS to court, and convinced the court of the necessity of his expenses based on other credible evidence. The court agreed but only to the extent of forcing the IRS to consider a reasonable estimate, and not the exact numbers he originally claimed.
“The Board refused to allow him any part of this, on the ground that it was impossible to tell how much he had in fact spent, in the absence of any items of details. The question is how far this refusal is justified in view of the finding that he had spent much and that the sums were allowable expenses. Absolute certainty in such matters is usually impossible and is not necessary; the Board should make as close an approximation as it can,” Circuit Court Judge Learned Hand. The complete decision can be found here: http://pegasus.cc.ucf.edu/~bandy/cohan.htm
The Cohan rule does afford a taxpayer the ability to present a logical estimate of a reasonable expense based on fact, but the final decision is always discretionary. The taxpayer, because she used an estimate of her business expenses, does not automatically get to keep the approximated expense and resulting tax, because Judge Hand decided that the Board should at least afford “For some allowance;” not necessarily all of it.
If you plan to present an estimated expense to the IRS during an audit, be prepared to compromise because is has been our experience that the IRS will start with the position that your number is too high, and it is up to you to prove that it is not. The technology we use in the modern business environment makes producing expense records easier, and you should use third-party proof whenever possible. But if you do have to rely on an estimate make sure you can support it before you put it on your tax return. If the IRS questions your estimated expense, raise the Cohan rule and explain your logic. In George’s case, how could he have visited all of those cities and made his money without incurring some expenses? Your licensed tax professional will know what to do.