Mazzocchi Bus Co. v. Commissioner

Nicholas Mazzocchi (plaintiff) diverted funds from closely held corporation Mazzocchi Bus Company, Inc. (MBC) (plaintiff). These funds were not reported either by Mazzocchi on his individual tax returns or by MBC on its corporate returns. Mazzocchi had pleaded guilty in an earlier proceeding for criminal income tax evasion on his diversion of these funds. Mazzocchi and MBC were also assessed income tax deficiencies for the years 1974–1979 by the commissioner of the Internal Revenue Service (defendant). Mazzocchi and MBC disputed the assessments in the United States Tax Court. MBC used the cash method of accounting, in which all income or expenses were recognized for tax purposes during the tax year in which they were received or paid. However, Mazzocchi and MBC contended that the tax liabilities for the diverted funds should be deducted from MBC’s earnings and profits in the year the liabilities accrued, as would occur if MBC used the accrual method of accounting, in which income and expenses were recognized at the time the right or obligation existed. Attributing the unpaid taxes to the year that they accrued would mean that MBC’s earnings for that year would be reduced. Thus, any amounts diverted by Mazzocchi in excess of earnings for that year would be characterized as nontaxable return of investment or capital gains rather than as dividends that were taxable at the higher, ordinary income rates. The United States Tax Court rejected this argument and ruled in the commissioner’s favor. MBC and Mazzocchi appealed to the United States Court of Appeals for the Third Circuit.