When the IRS challenges deductions on your tax return, you don’t have to choose between accepting their position entirely or going to Tax Court.
The IRS Independent Office of Appeals uses a principle called Hazards of Litigation to evaluate settlement possibilities based on what would likely happen if your case went to trial.
Understanding how Appeals evaluates these risks—and how rules like the Cohan Rule and IRC § 274(d) affect your case—can significantly impact your settlement outcome.
Key Takeaways
- Appeals evaluates “Hazards of Litigation”—the risks both sides face if a case goes to court—to determine fair settlement terms
- The Cohan Rule allows courts to estimate reasonable deductions when exact records are unavailable, creating litigation risk for the IRS
- IRC § 274(d) overrides the Cohan Rule for travel, meals, entertainment, gifts, and listed property, requiring strict documentation
- Understanding these principles helps set realistic settlement expectations and strengthens your negotiating position
Understanding the IRS Independent Office of Appeals
The IRS Independent Office of Appeals provides taxpayers with a neutral forum to resolve federal tax disputes without litigation. Strengthened by the Taxpayer First Act, Appeals operates independently from IRS examination and collection functions.
Appeals’ Mission Statement (IRM 2024)
According to the Internal Revenue Manual (IRM 8.1.1.1.2, effective January 9, 2024), Appeals’ mission is:
“To resolve Federal tax controversies without litigation on a basis which is fair and impartial to both the Government and the taxpayer, promotes a consistent application and interpretation of, and voluntary compliance with, the Federal tax laws, and enhances public confidence in the integrity and efficiency of the IRS.”
This mission emphasizes not just fairness, but also consistency, voluntary compliance, and maintaining public trust in tax administration.
Types of Cases Appeals Handles
Appeals reviews a diverse range of tax disputes, including:
- Examination disputes: Challenges to audit findings and proposed adjustments
- Collection cases: Liens, levies, installment agreements, and offers in compromise
- Penalty disputes: Accuracy-related, fraud, late-filing, and late-payment penalties
- Innocent spouse relief claims: Requests for relief from joint tax liability
- Docketed Tax Court cases: Cases referred to Appeals for possible settlement after petition filing
- Specialized matters: Pension plan disputes, exempt organizations, and excise taxes
Regardless of the issue type, most Appeals settlements are grounded in an analysis of Hazards of Litigation.
What Are Hazards of Litigation?
Hazards of Litigation refers to the principle that both taxpayers and the IRS face risks and uncertainties if a case proceeds to trial. Courts can rule either way, witnesses may be credible or not, and legal interpretations can go in unexpected directions.
Appeals Officers evaluate these potential risks to determine fair settlement terms that reflect realistic litigation outcomes.
Why Hazards of Litigation Are Essential to Appeals
The Hazards of Litigation framework provides critical benefits:
- Enables fair compromises: Rather than all-or-nothing outcomes, settlements can reflect percentage probabilities of success
- Saves time and money: Both taxpayers and the government avoid costly litigation expenses
- Promotes consistency: Similar cases receive similar treatment based on objective risk assessment
- Aligns with Appeals’ mission: Facilitates impartial, non-litigated resolutions
Legal Hazards vs. Factual Hazards of Litigation
Appeals Officers analyze two distinct types of litigation risks when evaluating cases.
Legal Hazards of Litigation
Legal hazards arise when the law itself is unclear, ambiguous, or subject to reasonable dispute.
Common sources of legal hazards include:
- Ambiguous statutory language or regulations
- Conflicting judicial precedent across different circuit courts
- Lack of IRS guidance on emerging tax issues
- Novel legal theories being tested for the first time
- Changes in law that create transition issues
Example of Legal Hazards:
A corporation claims a deduction for a new renewable energy credit. The regulations are vague, and different Tax Court judges have interpreted similar provisions inconsistently. Appeals may assess a 40% chance the taxpayer would prevail in court and offer to settle by allowing 40% of the disputed deduction.
Factual Hazards of Litigation
Factual hazards arise from uncertainties about evidence, witness credibility, or expert valuations.
Common sources of factual hazards include:
- Lost, destroyed, or incomplete records
- Disputed appraisals of property or business interests
- Questions about witness credibility or reliability
- Reliance on reconstructed or estimated evidence
- Conflicting expert testimony
Example of Factual Hazards:
A taxpayer claims $20,000 in business travel expenses but lost receipts in an office flood. They reconstruct records using travel logs, bank statements, calendar entries, and affidavits from clients. Appeals may assess a 50% chance that a court would accept the reconstructed evidence and settle by allowing $10,000 of the deductions.
This example brings us to one of the most important principles in substantiation disputes: the Cohan Rule.
The Cohan Rule: Estimating Deductions When Records Are Missing
The Origin: Cohan v. Commissioner (1930)
The Cohan Rule comes from the landmark case Cohan v. Commissioner, 39 F.2d 540 (2d Cir. 1930). George M. Cohan, the famous Broadway producer and composer, deducted substantial travel and entertainment expenses but lacked receipts to substantiate the exact amounts.
The Board of Tax Appeals (predecessor to the Tax Court) denied the deductions entirely due to lack of documentation.
On appeal, the Second Circuit Court of Appeals reversed, holding:
If it is clear that expenses were actually incurred, but the exact amount cannot be determined with precision, courts should make a reasonable estimate rather than deny the deduction entirely.
How the Cohan Rule Works
The Cohan Rule allows courts—and by extension, Appeals—to approximate deductions when:
- There is credible evidence that deductible expenses were actually incurred
- The taxpayer cannot prove the exact amount due to lost or incomplete records
- Some basis exists for making a reasonable estimate
This principle creates significant litigation hazards for the IRS when taxpayers have some evidence supporting their claimed deductions, even without perfect documentation.
Impact on Appeals Settlements
When the Cohan Rule applies, Appeals Officers must consider that Tax Court might allow a substantial portion of disputed deductions based on reasonable estimates. This creates factual hazards that support compromise settlements rather than full disallowance.
IRC § 274(d): The Statutory Override of Cohan
Congress recognized that the Cohan Rule could be abused, particularly for expense categories prone to inflated or fabricated claims. In response, Congress enacted IRC § 274(d), which imposes strict substantiation requirements that override the Cohan Rule for specific expense types.
Expenses Covered by IRC § 274(d)
Section 274(d) requires strict substantiation for:
- Travel expenses (including lodging away from home)
- Meals and entertainment (though most entertainment is now non-deductible under TCJA)
- Business gifts
- Listed property (vehicles, computers, and certain other assets)
Substantiation Requirements Under § 274(d)
For expenses subject to § 274(d), taxpayers must maintain:
- Amount: The specific dollar amount of each expense
- Time and place: When and where the expense occurred
- Business purpose: The business reason for the expense
- Business relationship: For meals and entertainment, the business relationship of persons entertained
Documentation must be contemporaneous—created at or near the time of the expense—and typically requires receipts for expenses over $75.
Critical Limitation: Cohan Does Not Apply
For § 274(d) expenses, the Cohan Rule does not apply. Without proper substantiation, deductions are completely disallowed—even if the taxpayer credibly demonstrates that legitimate business expenses were incurred.
This dramatically reduces litigation hazards for the IRS in § 274(d) cases with inadequate documentation.
Comparing Cohan and § 274(d) in Practice
Scenario A: Cohan Applies (Non-§274(d) Expense)
A small business owner deducted $15,000 for office supplies and equipment. A fire destroyed business records, but the owner provides:
- Bank statements showing purchases from office supply stores
- Credit card statements
- Some surviving invoices totaling $8,000
- Photos of the office showing equipment
Analysis: Office supplies and equipment are not § 274(d) expenses, so the Cohan Rule applies. Appeals may determine there’s a 60-70% chance Tax Court would allow most expenses based on the available evidence and reasonable estimates. Settlement might allow $10,000-$12,000 of the claimed $15,000.
Scenario B: § 274(d) Controls (Travel Expenses)
The same business owner deducted $20,000 for business travel. The fire destroyed records, but the owner provides:
- Travel logs reconstructed from calendars
- Bank statements showing charges at hotels
- Affidavits from clients confirming meetings
- No contemporaneous expense reports
- No receipts
Analysis: Travel expenses fall under § 274(d), which requires strict contemporaneous substantiation. The Cohan Rule cannot be used. Appeals may conclude litigation hazards are low—perhaps only 10-20%—because Tax Court would likely sustain full disallowance under § 274(d). Settlement terms would be much less favorable, possibly allowing only the small portion supported by actual receipts.
How Appeals Uses Hazards Analysis with Cohan and § 274(d)
Appeals’ Evaluation Framework
When handling substantiation disputes, Appeals Officers consider:
Step 1: Identify the Expense Type
- Is this a § 274(d) expense requiring strict substantiation?
- Or a general business expense where Cohan may apply?
Step 2: Evaluate Available Evidence
- What documentation exists?
- Is there credible testimony or corroborating evidence?
- Can expenses be reasonably estimated?
Step 3: Assess Litigation Hazards
- If Cohan applies: Higher risk for IRS, greater settlement value for taxpayer
- If § 274(d) applies: Lower risk for IRS, less favorable settlement for taxpayer
Step 4: Negotiate Fair Settlement
Appeals balances the legal and factual hazards to reach settlements that reflect realistic litigation outcomes while avoiding the cost and uncertainty of trial.
Why Hazards of Litigation Benefit Both Parties
Benefits for Taxpayers
- Partial relief: Possibility of recovering some disputed deductions rather than all-or-nothing outcomes
- Cost savings: Avoiding expensive Tax Court litigation and professional fees
- Time efficiency: Resolving cases in months rather than years
- Certainty: Achieving finality and closure without trial uncertainty
Benefits for the IRS
- Resource conservation: Preserving limited administrative and judicial resources
- Risk management: Avoiding potentially adverse precedents
- Consistent administration: Promoting fair, uniform treatment of similar cases
- Public confidence: Demonstrating fairness and reasonableness in tax enforcement
Conclusion: Using Hazards Analysis to Your Advantage
The IRS Independent Office of Appeals serves as a crucial safeguard for taxpayers, offering impartial resolutions without court battles. At the heart of this process lies the principle of Hazards of Litigation, ensuring that settlements reflect real-world risks and realistic trial outcomes.
Understanding the interaction between legal hazards, factual hazards, the Cohan Rule, and IRC § 274(d) is essential for anyone facing substantiation disputes. These principles determine whether your case presents significant litigation risk for the IRS—and therefore substantial settlement value—or whether strict documentation requirements limit negotiation possibilities.
When you understand how Appeals evaluates your case through the lens of litigation hazards, you can better prepare your documentation, set realistic expectations, and work toward fair settlements that avoid the cost and uncertainty of Tax Court.
Facing an IRS examination or Appeals case involving disputed deductions? Contact Brian Gilroy—a former IRS Appeals Officer who is also a Board Certified Tax Attorney, CPA, and EA—for representation that understands exactly how Appeals evaluates Hazards of Litigation.
Frequently Asked Questions About Hazards of Litigation and the Cohan Rule
What are Hazards of Litigation in IRS Appeals?
Hazards of Litigation refers to the risks and uncertainties both the IRS and taxpayers face if a case goes to Tax Court. Appeals Officers evaluate these risks—both legal (unclear law) and factual (evidence issues)—to determine fair settlement terms that reflect realistic trial outcomes.
What is the Cohan Rule?
The Cohan Rule, from the 1930 case Cohan v. Commissioner, allows courts to estimate reasonable deductions when taxpayers can show expenses were actually incurred but cannot prove exact amounts due to lost or incomplete records. This principle creates litigation risk for the IRS in many substantiation disputes.
Does the Cohan Rule apply to all types of expenses?
No. Congress overrode the Cohan Rule for specific expense categories through IRC § 274(d), which requires strict contemporaneous substantiation for travel, meals, entertainment, gifts, and listed property. For these expenses, courts cannot estimate amounts—deductions are completely disallowed without proper documentation.
What documentation does IRC § 274(d) require?
Section 274(d) requires contemporaneous records showing: (1) the amount of each expense, (2) time and place, (3) business purpose, and (4) for meals/entertainment, the business relationship of persons involved. Receipts are generally required for expenses over $75.
How do Hazards of Litigation affect my settlement with Appeals?
Appeals evaluates the likelihood the IRS would prevail if your case went to Tax Court. If you have strong arguments or evidence creating substantial hazards for the IRS, Appeals may offer more favorable settlement terms. If the law and facts strongly favor the IRS (such as § 274(d) cases without documentation), settlement options will be limited.
Can I use reconstructed records if I lost original documentation?
It depends on the expense type. For general business expenses not subject to § 274(d), reconstructed records combined with other evidence may support Cohan Rule estimates. For § 274(d) expenses (travel, meals, entertainment, gifts, listed property), reconstructed records generally will not satisfy strict substantiation requirements, and the Cohan Rule cannot be used.
Should I hire a tax attorney for an Appeals case involving substantiation issues?
Substantiation disputes require sophisticated understanding of both the Cohan Rule and § 274(d) requirements, as well as knowledge of how Appeals evaluates litigation hazards. Working with a former IRS Appeals Officer who is also a Board Certified Tax Attorney, CPA, and EA provides the strategic advantage of knowing exactly how Appeals will analyze your case and what settlement terms are realistic.