On Appeal From the Decision of the United States Tax Court. Tax Court Nos. 86-36768, 86-36769.
Before: Becker, Nygaard, and Weis, Circuit Judges.
This appeal is from a decision of the United States Tax Court which upheld the Commissioner's determinations of federal income tax deficiencies for the years 1974 through 1979 against Mazzocchi Bus Co., Inc. ("MBC"), a closely held corporation; Nicholas Mazzocchi ("Mazzocchi"), its controlling shareholder; and the estate of Mazzocchi's late wife, Rose Marie Mazzocchi, who had filed joint returns with him.*fn1 The Commissioner's determination stems from Mazzocchi's diversion of receipts totalling more than $700,000 from MBC for his personal use and benefit during the years in question, taken together with his failure to report that income on both his and MBC's tax returns.
The principal question presented by the appeal is whether MBC, a corporation using the cash method of accounting for computing its income taxes, should be entitled to use the accrual method for calculating its earnings and profits.*fn2 As applied to the facts, the question is whether the tax court correctly held that the earnings and profits of MBC during the taxable years in question should not be reduced by income taxes, penalties, and interest owed but not paid by the corporation during those years. Relying on a reasonable treasury regulation directly on point, we conclude that the tax court properly held that MBC must use the same accounting method for calculating its earnings and profits as it uses in calculating its income taxes. Finding no merit to the taxpayer's remaining contentions, with which we deal summarily, see infra at n., we will affirm.
I. FACTS AND PROCEDURAL HISTORY
Mazzocchi was the president and controlling shareholder of MBC, which engaged in the school bus transportation business. During the years in question, MBC failed to record in its cash receipts books numerous checks totalling large payments for transportation services MBC provided several schools, and concomitantly failed to report those checks as receipts on its income tax returns. More precisely, for its fiscal years 1975 through 1978, MBC earned unreported business receipts in the respective amounts of $129,558.81, $188,710.47, $185,774.56, and $151,051.25. In the fiscal year ended June 30, 1979, MBC failed to include on its corporate tax return income in the amount of $56,575.02.
The omitted checks were mainly customer checks issued to Mazzocchi and/or MBC, 60 of which contained the single endorsement of Mazzocchi and 19 of which contained the initial endorsement of MBC followed by the second endorsement of Mazzocchi. As MBC's president, Mazzocchi was able surreptitiously (without the knowledge of corporate accountants or other officers) to negotiate these checks either at Midlantic Bank or the First National State Bank of West Jersey, thus affecting the diversion. During the corporation's 1975 through 1978 fiscal years, Mazzocchi utilized $371,126 of the unreported corporate business receipts to make commercial paper investments in his name at Midlantic Bank; he invested an additional $91,359 in commercial paper at Midlantic from undetermined sources. In due course, he rolled over or redeemed much of these investments. Having learned of bank reporting requirements from an Internal Revenue Service ("IRS") special agent, he structured his subsequent withdrawals so that he simultaneously received multiple cashier's checks, each for an amount under $10,000. During the years 1975 through 1979, Mazzocchi earned interest income on his commercial paper investments at Midlantic totalling over $88,000, but either failed to report or substantially underreported this interest income on his tax returns for each of those tax years.
The IRS ultimately commenced a criminal investigation of the business affairs of MBC and Mazzocchi, leading to Mazzocchi's indictment for income tax evasion. On October 30, 1981, he pleaded guilty to attempted willful evasion of his individual income taxes in violation of § 7201 of the Internal Revenue Code for the year 1976. Later, in 1986, the Commissioner determined that Mazzocchi had diverted money from MBC for his personal use and benefit and had failed to report it both on the joint returns he filed with his wife and on MBC's tax returns. Consequently the Commissioner assessed the tax deficiencies and additions for fraud to the taxes against Mazzocchi and MBC which are at issue here.
The taxpayers challenged the Commissioner's deficiency determinations in the tax court, but the tax court rejected their efforts and held for the Commissioner. The court concluded that Mazzocchi had fraudulently diverted funds from MBC for his personal use and benefit and that neither Mazzocchi nor MBC had reported the proceeds on Mazzocchi's individual or MBC's corporate tax returns, respectively.
Mazzocchi additionally argued to the tax court that the earnings and profits of MBC, a cash basis taxpayer, should be reduced in the years at issue by the amount of accrued but unpaid taxes, penalties, and interest attributable to its income tax deficiencies for those years. This argument is premised on the Code's treatment of corporate distributions out of earnings and profits as ordinary income but its differing treatment of corporate distributions in excess of earnings and profits as either a return of capital or a capital gain, depending on the taxpayer's basis in the corporate securities. Had Mazzocchi prevailed on that point, then some unspecified portion of the income Mazzocchi diverted from MBC (depending on MBC's earnings and profits in the relevant tax years, an issue the tax court did not resolve) would represent some combination of a nontaxable return of capital and a capital gain with respect to Mazzocchi (in turn depending on his basis in the corporate securities), instead of a constructive dividend taxable at ordinary income tax rates. The tax court, however, rejected his argument, reasoning that there was no basis to adjust earnings and profits for unpaid expenses incurred by MBC, a cash basis taxpayer.
The tax court also declined Mazzocchi's invitation to reduce his and MBC's unreported income by the business expenses that he claims he paid in cash on behalf of MBC with the unreported funds. Mazzocchi testified that he spent between $50,000 and $75,000 cash in each of the relevant tax years entertaining MBC's clients. However, the court determined that Mazzocchi's generalized and uncorroborated testimony did not meet the substantiation requirements set by § 274(d) of the Internal Revenue Code ("Code")*fn3 and its implementing regulation, see Treas. Reg. § 1.274-5, for deducting such expenses. The court also refused to allow deductions for funds Mazzocchi declared that he expended on wages, equipment, and renovations to MBC's corporate headquarters. Additionally, the court found that expenditures for summer bus driver wages and equipment purchases had already been taken into account as deductions on MBC's corporate returns for each of the years in issue. Furthermore, it decided that Mazzocchi and MBC had failed to establish the year in which Mazzocchi (allegedly) paid in cash for the renovation of MBC's corporate headquarters, or to substantiate the amounts he (allegedly) so expended.
The tax court also sustained the imposition of civil fraud penalties against both Mazzocchi and MBC. The court found that Mazzocchi: furtively arranged to have payments from his major school customer made directly to him; cannily arranged to have that school issue him checks in amounts under $10,000; willfully failed to apprise MBC's bookkeeper of his cash receipts; and purposefully withdrew the diverted funds from his accounts in a series of transactions structured to avoid detection by the IRS. In short, the court found that Mazzocchi carried out "the diversion of corporate funds . . . in this manner with the purpose and design of concealing their existence and avoiding income tax on these amounts." Additionally, the court found that Mazzocchi had made false representations to an IRS ...