Fifth Circuit Allows Tax Court Discretion in the Application of the Cohan Rule (1/28/14)

In Shami v. Commissioner, 741 F.3d 560 (5th Cir. 2014), here, the Fifth Circuit affirmed the Tax Court's denial R&D credits claimed by the taxpayer.  One of the taxpayer's arguments was that the Tax Court should have applied the Cohan rule, named for named for Cohan v. Commissioner, 39 F.2d 540 (2d Cir. 1930), here,  to allow some credits.  In rejecting the argument, the Fifth Circuit explained the "venerable" Cohan rule and its limitations, including the discretion allowed the trier of fact (bold facing supplied by JAT]:

Petitioners next assert that "[t]he use by [FSI] of [estimates of the amount of time Shami and McCall spent performing qualified services] was indisputably permissible" and that the type of documentation provided was adequately supportive. We disagree. 

First, Petitioners' claim is waived. In their initial brief, the extent of Petitioners' argument is the sentence quoted above and a citation to this court's precedent in United States v. McFerrin [570 F.3d 672 (5th Cir. 2009)], which, following the venerable Second Circuit case Cohan v. Commissioner, held that "[i]f the taxpayer can establish that qualified expenses occurred . . . , then the court should estimate the allowable tax credit." Aside from a parenthetical to the citation, Petitioners make no effort to explain the Cohan rule or how it would apply to their case. Petitioners make only the bare assertion that their use of estimates was appropriate. Petitioners therefore have waived this issue by failing to brief it adequately. 

In the alternative, Petitioners' claim fails on the merits. A line of case law—beginning with the Second Circuit's decision in Cohan—holds that if a taxpayer proves that he is entitled to a tax benefit but does not substantiate the amount of the tax benefit, the court "should make as close an approximation as it can, bearing heavily if it chooses upon the taxpayer whose inexactitude is of his own making." The underlying logic of the rule is that allowing no benefit at all "appears . . . inconsistent with [the finding] that something was spent." In McFerrin, this court held that the Cohan rule applies in the context of the § 41 credit. 

Cohan did not compel the Tax Court to make an estimate in this case. As the preceding discussion makes clear, the Cohan rule is not implicated unless the taxpayer proves that he is entitled to some amount of tax benefit. In the context of the § 41 credit, a taxpayer would do so by proving that its employee performed some qualified services. In this case, a careful reading of the Tax Court's opinion reveals that the Tax Court made no such finding. 

Even if the Tax Court had determined that Petitioners proved that Shami and McCall performed some amount of qualified services, Cohan and McFerrin are not the only case law on this issue. As the Tax Court observed, another decision of this court issued between those two cases explains that the Tax Court has discretion to make an estimate under Cohan. In Williams v. United States [245 F.2d 559 (5th Cir. 1957)], this court made clear that, even though the Tax Court "might have considerable latitude in making  estimates of amounts probably spent," the Cohan rule "certainly does not require that such latitude be employed." Our decision in Williams explicitly held that the Tax Court "may not be compelled to estimate even though such an estimate, if made, might have been affirmed." This was so because "the basic requirement is that there be sufficient evidence to satisfy the trier that at least the amount allowed in the estimate was in fact spent or incurred for the stated purpose," and "[u]ntil the trier has that assurance from the record, relief to the taxpayer would be unguided largesse."

Neither Williams nor any other exception to the Cohan rule was before the court in McFerrin, and we do not read McFerrin to hold that Cohan is untempered by any exceptions. Petitioners also make no attempt to explain why Williams would not apply to their case. Even assuming that there were some conflict between Williams and McFerrin, Williams is our earlier precedent. "When panel opinions appear to conflict, we are bound to follow the earlier opinion." Therefore, the Tax Court was entitled to decline to make an estimate if it found that Petitioners had not provided a reasonable basis on which to make one. 

The Tax Court's finding that the record did not contain a reasonable basis on which to make an estimate is not clearly erroneous. The documentary evidence submitted by Petitioners is silent about the amount of time Shami and McCall spent performing qualified services. Even though they and two FSI employees testified regarding the amount of time, the Tax Court, per its prerogative, disregarded this testimony as contradictory, self-serving, and noncredible. When the Tax Court's finding depends on the assessment of credibility, "we will not depart from such assessment except in the very rarest of circumstances." This case does not provide occasion to depart from the Tax Court's finding. Accordingly, the Tax Court did not err in refusing to estimate the amount of credit due Petitioners for the qualified services performed, if any, by Shami and McCall.

The lesson is that, while the Cohan rule is very useful, there must be a factual predicate for it and the case must be won at the trial level.  And, of course, credibility will be the key to getting any court to exercise discretion.  The Court found the key witnesses for the plaintiff not credible.

I note that taxpayer's counsel in the case was Jeremy M. Fingeret who, according to his website, here, also represented the successful taxpayer in McFerrin, which figured so prominently in this decision.

Now, a little bit of history for the younger generation.

First, the key part of the Cohan case for purposes of the Cohan rule is:

In the production of his plays Cohan was obliged to be free-handed in entertaining actors, employees, and, as he naively adds, dramatic critics. He had also to travel much, at times with his attorney. These expenses amounted to substantial sums, but he kept no account and probably could not have done so. At the trial before the Board he estimated that he had spent eleven thousand dollars in this fashion during the first six months of 1921, twenty-two thousand dollars, between July first, 1921, and June thirtieth, 1922, and as much for his following fiscal year, fifty-five thousand dollars in all. 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 or 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, bearing heavily if it chooses upon the taxpayer whose inexactitude is of his own making. But to allow nothing at all appears to us inconsistent with saying that something was spent. True, we do not know how many trips Cohan made, nor how large his entertainments were; yet there was obviously some basis for computation, if necessary by drawing upon the Board's personal estimates of the minimum of such expenses. The amount may be trivial and unsatisfactory, but there was basis for some allowance, and it was wrong to refuse any, even though it were the traveling expenses of a single trip. It is not fatal that the result will inevitably be speculative; many important decisions must be such. We think that the Board was in error as to this and must reconsider the evidence.

Second, the Cohan decision was written by Judge Learned Hand, Wikipedia entry here, one of the giants in the law.  Here are a few of the opening paragraphs from Wikipedia:

Billings Learned Hand (/ˈlɜrnɨd/ lurn-id; January 27, 1872 – August 18, 1961) was a United States judge and judicial philosopher. He served on the United States District Court for the Southern District of New York and later the United States Court of Appeals for the Second Circuit. Hand has been quoted more often than any other lower-court judge by legal scholars and by the Supreme Court of the United States. 

Born and raised in Albany, New York, Hand majored in philosophy at Harvard College and graduated with honors from Harvard Law School. After a short career as a lawyer in Albany and New York City, he was appointed at the age of 37 as a Federal District Judge in Manhattan in 1909. The profession suited his detached and open-minded temperament, and his decisions soon won him a reputation for craftsmanship and authority. Between 1909 and 1914, under the influence of Herbert Croly's social theories, Hand supported New Nationalism. He ran unsuccessfully as the Progressive Party's candidate for Chief Judge of the New York Court of Appeals in 1913, but withdrew from active politics shortly afterwards. In 1924, President Calvin Coolidge promoted Hand to the Court of Appeals for the Second Circuit, which he went on to lead as the Senior Circuit Judge (later retitled Chief Judge) from 1939 until his semi-retirement in 1951. Scholars have recognized the Second Circuit under Hand as one of the finest appeals courts in the country's history. Friends and admirers often lobbied for Hand's promotion to the Supreme Court, but circumstances and his political past conspired against his appointment. 

Hand possessed a gift for the English language, and his writings are admired as legal literature. He rose to fame outside the legal profession in 1944 during World War II after giving a short address in Central Park that struck a popular chord in its appeal for tolerance. During a period when a hysterical fear of subversion divided the nation, Hand was viewed as a liberal defender of civil liberties. A collection of Hand's papers and addresses, published in 1952 as The Spirit of Liberty, sold well and won him new admirers. Even after he criticized the civil-rights activism of the 1950s Warren Court, Hand retained his popularity. 

Hand is also remembered as a pioneer of modern approaches to statutory interpretation. His decisions in specialist fields, such as patents, torts, admiralty law, and antitrust law, set lasting standards for craftsmanship and clarity. On constitutional matters, he was both a political progressive and an advocate of judicial restraint. He believed in the protection of free speech and in bold legislation to address social and economic problems. He argued, however, that the United States Constitution does not empower courts to overrule the legislation of elected bodies, except in extreme circumstances. Instead, he advocated the "combination of toleration and imagination that to me is the epitome of all good government".

Third, the Cohan case involved George M. Cohan, Wikipedia entry here.  Here are the opening paragraphs from Wikipedia:

Cohan began his career as a child, performing with his parents and sister in a vaudeville act known as "The Four Cohans." Beginning with Little Johnny Jones in 1904, he wrote, composed, produced, and appeared in more than three dozen Broadway musicals. Cohan published more than 300 songs during his lifetime, including the standards "Over There", "Give My Regards to Broadway", "The Yankee Doodle Boy" and "You're a Grand Old Flag" As a composer, he was one of the early members of the American Society of Composers, Authors, and Publishers (ASCAP). He displayed remarkable theatrical longevity, appearing in films until the 1930s, and continuing to perform as a headline artist until 1940. 

Known in the decade before World War I as "the man who owned Broadway", he is considered the father of American musical comedy. His life and music were depicted in the Academy Award-winning film Yankee Doodle Dandy (1942) and the 1968 musical George M!. A statue of Cohan in Times Square in New York City commemorates his contributions to American musical theatre.

Cohan's obituary from the New York Times on November 6, 1942 is here.