The issue before the Tax Court in Huzella v. Commissioner, T.C. Memo. 2017-210, centered around a coin business on eBay, and whether the petitioner, Thomas Huzella, could substantiate his cost of goods sold and expense deductions for his business.
The petitioner had been collecting coins as far back as 1958. The problem was that the petitioner did not keep records to establish the basis in any of his coins. In 2013, the petitioner actively bought and sold coins on eBay and was paid through PayPal. PayPal issued the petitioner a Form 1099-K, Payment Card and Third Party Network Transactions, which reflected the payments he received from PayPal. The petitioner earned $37,000 from almost 400 separate transactions in 2013. But he also incurred eBay fees and Paypal fees, as well as packaging and shipping costs.
When he filed his tax return, the petitioner did not report anything on his Schedule C, and the IRS audited his return and issued a notice of deficiency. The IRS alleged that the petitioner had unreported income of $37,000 from his eBay business and asserted penalties. At trial, the IRS conceded that the petitioner was engaged in a trade or business in 2013. The IRS also conceded that the petitioner was entitled to deduct the eBay and PayPal fees, and the Tax Court held that he was entitled to deduct $700 of postage and packaging costs. The petitioner conceded that he earned – but did not report – gross proceeds of $37,000 from his eBay business.
The court then turned to the cost of goods sold issue. Taxpayers are required to substantiate any amount they claim as cost of goods sold, and they must maintain sufficient records. If a taxpayer with insufficient records, however, proves he incurred expenses but cannot substantiate the exact amount, the Tax Court may, in certain circumstances, estimate the amount.
Here, the Tax Court (and the petitioner) relied on the Cohan decision. See Cohan v. Commissioner, 39 F.2d 540 (2d Cir. 1930). In that case, the taxpayer was an actor, playwright, and producer who spent large sums travelling and entertaining actors, employees, and critics. Although Cohan did not keep a record of his spending on travel and entertainment, he estimated that he incurred $55,000 in expenses over several years.
The Board of Tax Appeals, now the Tax Court, disallowed these deductions in full based on Cohan’s lack of supporting documentation. On appeal, however, the Second Circuit concluded that Cohan’s testimony established that legitimate deductible expenses had been incurred, holding that “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.” The Cohan rule has been followed by the Tax Court and other federal courts in numerous decisions.
The petitioner in Huzella did not have any records to establish his cost or bases in the coins. He purchased some coins and inherited others. But the Tax Court relied on Cohan and, after evaluating the evidence and the petitioner’s testimony, held that the petitioner could substantiate a cost of goods sold of $12,000. Thus, the petitioner had taxable income of just under $20,600 (gross receipts of $37,000, less cost of goods sold and deductions).
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