There is a
tax doctrine known as the Cohan rule. It is named after the American composer
and playwright George M. Cohan, the subject of the movie Yankee Doodle Dandy. While a renown musician, composer and
playwright, he was not much of a recordkeeper, and he found himself in front of
the Court defending his business expenses against challenge by the IRS. The Court
took an extremely friendly stance and allowed him to estimate his deductions.
While the
Cohan rule still exists (in some capacity) today, it should be noted that the
tax Code has been changed to disallow the next George Cohan any tax deduction
for estimated meals, travel and entertainment. Those particular deductions have
to be substantiated or no deduction will be allowed, with or without a friendly
judge.
I just read
a case where (I believe) a variation on the Cohan rule came up.
The case has
to do with cancellation of indebtedness income.
Did you know
you could be taxed if a credit card company forgives your balance?
The reason is that the tax Code considers an "accession to wealth" to be "income" (with exceptions, of course). Take the conventional definition of wealth as
... assets owned less debts owed ...
and you can
see that the definition has two moving parts. The asset part is easy - your paycheck
increases your bank account, if only fleetingly. The liability part in turn is
the reason you can borrow money and not have it considered income (assets and
liabilities increase by the same amount, so the difference is zero). Have the
bank forgive the debt, however, and the difference is no longer zero.
Newman did
something odd. He wrote a check on his Wells Fargo account and opened a new
account at Bank of America. He withdrew money from the new account. Meanwhile
the check on Wells Fargo bounced.
Bank of
America wanted its money back. Newman did not have it anymore.
Impasse.
You may know
that a bank will issue a Form 1099 (Form 1099-C, specifically) when it cancels
a debt. That 1099 informs the IRS about the forgiveness, and it is a heads-up
to them to check for that income on your tax return.
Question: when does the the bank issue the 1099?
In general
it will be after 36 months of inactivity. Newman bounced the check in 2008 and
received the 1099 in 2011.
Newman left
the 1099 off his tax return. The IRS put it back on.
The Court
decided Newman had - potentially - income in 2011.
Newman fired
back: he did not have income because he was insolvent in 2011, and the tax Code
allows one to avoid debt income to the extent one is insolvent.
You and I
use another word for "insolvent" in our day-to-day conversation: bankrupt.
Bankrupt
means that you owe more than you are worth. The tax Code has an exception to
debt income for bankruptcy, but it only applies if one is in Bankruptcy Court. But
what if you are trying to work something out without going to Bankruptcy Court?
The Code recognizes this scenario and refers to it as "insolvency."
So Newman had
to persuade the Court that he was insolvent.
One would
expect him to bring in a banker's box of bank statements, credit card bills,
car loan balances and so forth to substantiate his argument.
The Court
looked and said:
At trial petitioner provided credible testimony that his assets and liabilities were what he claimed they were."
"Testimony?"
What about
that banker's box?
Newman ran a
Hail Mary play with time expiring on the game clock. While a low-probability
play, he connected for a touchdown and the win.
To a tax
advisor, however, Newman was decided differently from Shepherd, another Tax Court case from 2012 where the taxpayer needed
much more than his testimony to substantiate his insolvency.
Why the
difference between the two Court decisions?
With that question
you have an insight into the headaches of professional tax practice.
