What documentation does Virginia require to keep a Schedule C business-expense deduction, and can the Cohan rule or a federal Tax Court win on another year save undocumented expenses?

Plain-English summary

A sole proprietor claimed Schedule C business-expense deductions on the couple's 2021 Virginia return. Because Virginia taxable income starts from federal adjusted gross income (FAGI) (Va. Code § 58.1-301), Schedule C income and expenses flow straight into the state return — so when the Department audits those expenses, the same substantiation rules apply. The auditor asked for documentation and, getting no response, disallowed the deductions and assessed tax. The taxpayers then sent in some records; the Department allowed the expenses backed by bank or credit-card statements but kept disallowing the rest, for which there was no proof of payment. On appeal, the taxpayers made three arguments. The Commissioner rejected essentially all of them, allowing only one additional $589 expense.

An invoice is not proof of payment

The core rule: to deduct a business expense you must substantiate that you paid it — with receipts, cancelled checks, or bank/credit-card statements (following P.D. 14-155, 19-78, and 22-44). The taxpayers argued their invoices, which showed a zero remaining balance, proved payment. The Commissioner disagreed: a zero balance could come from something other than payment — a corrected billing error or an expense write-off — so it doesn't establish that the taxpayer actually paid during 2021. Of the documents submitted, only a credit-card receipt for a $589 legal expense met the standard, so that one expense was allowed on top of what the auditor had already accepted.

A federal Tax Court win on a different year doesn't carry over

The taxpayers pointed to a U.S. Tax Court decision that allowed similar deductions on their 2022 federal return. The Commissioner acknowledged that decision supports the deductibility of legal expenses in general, but it says nothing about whether the taxpayers substantiated payment of similar expenses in the different 2021 year. Deductibility in principle and proof of payment in a specific year are two different questions.

The Cohan rule is discretionary — and doesn't bind the Department

Finally, the taxpayers invoked the Cohan rule (Cohan v. Commissioner, 39 F.2d 540 (2d Cir. 1930)), under which a court may estimate an expense when the taxpayer proves the expense exists but can't document the exact amount. The invoices did tend to show the expenses existed — but not that they were paid in 2021. More fundamentally, Cohan is a discretionary judicial doctrine; it does not require the Department to estimate expenses when substantiation is lacking (P.D. 22-140).

Bottom line: the burden of proof is on the taxpayer because an assessment is prima facie correct (Va. Code § 58.1-205). Except for the $589 receipt, the deductions stay disallowed, and the taxpayers get an updated bill (pay within 30 days).

What this means for you

Sole proprietors and small-business owners (Schedule C)

Keep proof of payment, not just invoices. An invoice — even one stamped "paid" or showing a zero balance — documents that you were billed; the Department wants to see that money actually left your hands: a receipt, a cancelled check, or a bank or credit-card statement tied to the expense. Organize this by year, because you must show payment in the year you claim the deduction.

Don't count on the Cohan rule or a federal win

The Cohan "estimate" rule is a court's discretion, and the Virginia Department is not obligated to apply it — so treat it as a last resort, not a filing strategy. And a favorable IRS or Tax Court outcome on one year (or one issue) doesn't automatically substantiate your expenses in a different year; each year stands on its own records.

On audit

When the Department requests documentation, respond — the auditor's letter spells out exactly what's needed for each expense type. Silence leads to full disallowance, and once assessed, the assessment is presumed correct and the burden is on you to prove otherwise (Va. Code § 58.1-205).

Common questions

Q: My invoice shows a zero balance. Isn't that proof I paid?
A: No. A zero balance can result from a billing-error correction or a write-off, not just payment. Virginia wants proof of payment — a receipt, cancelled check, or bank/credit-card statement.

Q: The Tax Court let me deduct similar expenses in another year. Doesn't that settle it?
A: No. That may confirm the expenses are deductible in principle, but it doesn't prove you substantiated payment in the specific year Virginia is auditing.

Q: Can I use the Cohan rule to estimate expenses I can't fully document?
A: Not as of right. The Cohan rule is a discretionary judicial doctrine and does not require the Department to estimate your expenses. You still need to substantiate payment.

Q: Who has to prove the deduction — me or the Department?
A: You. Under Va. Code § 58.1-205 an assessment is presumed correct, so the taxpayer bears the burden of showing it is wrong.

Citations and references

Statutes and regulations:

• IRC § 162 — deduction of ordinary and necessary business expenses; Treas. Reg. § 1.162-1
• Treas. Reg. § 1.6001-1(a) — taxpayers must keep records sufficient to determine the correct tax
• Va. Code § 58.1-301 — Virginia conforms to the Internal Revenue Code; Virginia taxable income starts from federal adjusted gross income
• Va. Code § 58.1-219 and § 58.1-310 — the Department may examine federal returns and adjust FAGI where it is inconsistent with the IRC
• Va. Code § 58.1-205 — an assessment is deemed prima facie correct; the burden of proof is on the taxpayer

Case law and prior documents (described here rather than linked): Cohan v. Commissioner, 39 F.2d 540 (2d Cir. 1930) (courts may estimate expenses shown to exist but lacking documentation — a discretionary doctrine); and Department determinations P.D. 14-155, 19-78, 22-44 (proof of payment required to substantiate deductions) and P.D. 22-140 (Cohan rule does not compel the Department to estimate).

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 26-2

Original ruling text

February 4, 2026

Re: § 58.1-1821 Application: Individual Income Tax

Dear *:

This will respond to your letter in which you seek correction of the individual income tax assessment issued to you (the “Taxpayers”) for the taxable year ended December 31, 2021.

FACTS

The Taxpayers filed a Virginia individual income tax return for the 2021 taxable year claiming business expense deductions on federal Schedule C. Under audit, the Department requested documentation to support those deductions. When no response was received, the Department disallowed the deductions and issued an assessment.

Subsequently, the Taxpayers submitted some documentation. The Department allowed the expenses that were supported by bank or credit card statements, but continued to disallow the remaining deductions for which no proof of payment was provided.

The Taxpayers applied for correction, contending that they provided sufficient documentation and that similar expense deductions were allowed by the United States Tax Court on their federal income tax return for the 2022 taxable year. In the alternative, the Taxpayers assert that the business expenses are allowable under the “Cohan rule” even without documentation.

DETERMINATION

Conformity

Virginia Code § 58.1-301 provides, with certain exceptions, that terminology and references used in Title 58.1 of the Code of Virginia will have the same meaning as provided in the Internal Revenue Code (IRC) unless a different meaning is clearly required. Conformity does not extend to terms, concepts, or principles not specifically provided in the Code of Virginia . For individual income tax purposes, Virginia conforms to federal law, in that it starts the computation of Virginia taxable income with federal adjusted gross income (FAGI). Income properly included in the FAGI of a Virginia resident is subject to taxation by Virginia, unless it is specifically exempt as a Virginia modification pursuant to Chapter 3 of Title 58.1 of the Code of Virginia .

Generally, the Department relies on the accuracy of information and computations reflected on the federal income tax return when reviewing Virginia individual income tax returns. If the information provided on the federal return appears reasonable, then, typically, the Department does not look behind those computations. The Department, however, may examine and adjust the FAGI and itemized deductions where there is clear evidence that the amounts reported on the federal or Virginia income tax return are inconsistent with the IRC. See Virginia Code § 58.1-219 and
§ 58.1-310.

Schedule C Expenses

Under IRC § 162, taxpayers are permitted to deduct all of the ordinary and necessary business expenses paid or incurred during the taxable year in carrying on any trade or business. Such expenses must be directly connected with or pertaining to the taxpayer’s trade or business. See Treas. Reg. § 1.162-1.

Schedule C is used to report income or loss from a business, including a sole proprietorship. Income from the business is offset by expenses. This income or loss is reported on a taxpayer’s federal income tax return and thus is reflected in FAGI reported on the Virginia return.

The auditor requested that the Taxpayers provide documentation supporting the expenses claimed on Schedule C for the 2021 taxable year. The request clearly indicated the documentation required to substantiate each type of expense.

Substantiating payment of expenses through items such as receipts or cancelled checks is required to claim a deduction. See Public Document (P.D.) 14-155 (8/28/2014), P.D. 19-78 (7/29/2019), and P.D. 22-44 (3/15/2022). With their application for correction, the Taxpayers submitted numerous invoices, some bank and credit card statements, and one credit card receipt. The Department adjusted the initial assessment based on the documentation provided, but that part of the deduction for which no proof of payment was provided remained denied.

The Taxpayers contend that all of the business expenses should be allowed because the invoices submitted indicated the amount billed and a zero remaining balance. As discussed above, however, substantiating payment of expenses through items such as receipts or cancelled checks is required to claim the expenses. This is because, in part, a zero-balance invoice could result from actions other than bill payment such as the correction of a prior billing error or an expense write-off. A review of the documentation submitted shows that the Taxpayers submitted a credit card receipt for a $589 legal expense. As such, in addition to the expenses previously allowed by the auditor, that expense will be allowed for the 2021 taxable year.

In addition, the Taxpayers argue that the deductions should be allowed because the United States Tax Court allowed similar deductions following an IRS audit of their 2022 federal income tax return. The court’s decision supports the deductibility of the legal expenses generally, but does not impact the determination of whether the Taxpayers have substantiated the payment of similar expenses in a different taxable year.

The Taxpayers further assert that the expenses should be allowed under the “Cohan rule.” In Cohan v. Comm’r , 39 F.2d 540 (2d Cir. 1930), the court established a judicial doctrine in which courts may allow estimates of certain business expenses when the taxpayer proves the existence of the expense but lacks documentation proving the amount of the expense. The Taxpayers provided invoices that tend to establish the existence of the claimed expenses. However, such invoices by themselves do not establish that the expenses were paid by the Taxpayers during the 2021 taxable year. In any event, the “Cohan rule” is a discretionary judicial doctrine, and it does not mandate that the Department estimate expenses in the absence of sufficient substantiation. See Public Document (P.D.) 22-140 (9/28/2022).

CONCLUSION

Taxpayers must maintain records sufficient to allow the IRS to determine their correct tax liability. See Treas. Reg. § 1.6001-1(a). Similarly, Virginia Code § 58.1-310 provides:

Whenever in the opinion of the Department it is necessary to examine the federal income returns or any copy thereof of any individual, estate, trust, partnership or corporation in order properly to audit such returns, the Department or the commissioner of the revenue shall have the right to require such taxpayer to provide such return or a copy thereof and all statements, inventories, and schedules in support thereof.

Under the provisions of Virginia Code § 58.1-205, in any proceeding relating to the interpretation of the tax laws of Virginia, an “assessment of a tax by the Department shall be deemed prima facie correct.” As such, the burden of proof is on the Taxpayers to show that the assessment was erroneous.

With the exception of the credit card receipt discussed above, the Taxpayers have not provided sufficient documentation to support the remaining expenses. The assessment will be adjusted to allow the $589 expense supported by a credit card receipt. The Taxpayers will receive an updated bill that will include accrued interest to date. The Taxpayers should remit the balance due within 30 days of the bill date to avoid the accrual of additional interest and possible collection actions.

The Code of Virginia sections and regulations cited are available online at law.lis.virginia.gov. The public documents cited are available at tax.virginia.gov in the Laws, Rules, & Decisions section of the Department’s website. If you have any questions regarding this determination, you may contact * in the Office of Tax Policy and Legal Affairs, Tax Adjudication and Resolution Division, at or **@tax.virginia.gov.

Sincerely,

Kristin L. Collins
Tax Commissioner
Commonwealth of Virginia

AR/5208.T

Related Documents

14-155

19-78

22-44

22-140