## Facts

- Mazzocchi Bus Co., Inc. (MBC) was a closely held school-bus transportation corporation using the cash method for federal income tax reporting.
- From 1974–1979, MBC failed to record numerous customer checks in its cash receipts records and did not report those receipts as corporate income.
- Nicholas Mazzocchi, MBC’s controlling shareholder and president, diverted the unrecorded corporate receipts (over $700,000) for personal use.
- Mazzocchi invested some diverted funds and underreported the resulting interest income on the Mazzocchis’ joint returns.
- The Commissioner determined corporate and individual income tax deficiencies and asserted civil fraud penalties against MBC, Nicholas Mazzocchi, and the estate of Rose Marie Mazzocchi.
- In the civil case, the Commissioner treated the diverted receipts as constructive dividends to Mazzocchi to the extent of MBC’s earnings and profits (E&P) for each year.
- The Tax Court sustained the deficiencies, the constructive dividend characterization, and the civil fraud penalties.
- The taxpayers appealed, primarily disputing how MBC’s E&P should be computed and challenging the fraud findings.

## Issues

1. Whether a corporation using the cash method to compute taxable income may use the accrual method to compute E&P, including reducing E&P by accrued but unpaid income taxes, penalties, and interest.
2. Whether the diverted, unreported corporate receipts were properly treated as taxable constructive dividends to the shareholder to the extent of corporate E&P.
3. Whether the evidence supported imposition of civil fraud penalties against the corporation and the shareholder.
4. Whether claimed offsets (including alleged cash-paid business expenses) were allowable without adequate substantiation.

## Decision

- The Third Circuit affirmed the Tax Court in full.
- A cash-method corporation must compute E&P using the same accounting method it uses for taxable income; MBC could not accrue unpaid taxes, penalties, and interest to reduce E&P.
- The diverted receipts were properly treated as constructive dividends to Mazzocchi to the extent of MBC’s E&P.
- The civil fraud findings and fraud penalties were upheld based on evidence of concealment, unrecorded receipts, and underreporting of related income.
- The court upheld denial of unsubstantiated deductions and rejected remaining taxpayer arguments.

## Legal Principles

- Under Treas. Reg. § 1.312-6, E&P is computed using the accounting method employed for taxable income; a cash-basis corporation generally cannot compute E&P on an accrual basis.
- Unpaid corporate income taxes, penalties, and interest do not reduce E&P for a cash-method corporation until actually paid.
- Diverted corporate receipts used for a shareholder’s personal benefit may be treated as constructive dividends taxable to the shareholder to the extent of corporate E&P.
- Civil fraud penalties may be sustained when the record shows intentional concealment of income, inaccurate or incomplete books, and consistent underreporting.
- Taxpayers bear the burden to substantiate claimed deductions; unsupported assertions of cash expenditures are insufficient.

## Conclusion

The court held that a cash-method corporation must compute E&P on the cash method, preventing accrual-based reductions for unpaid tax liabilities, and affirmed constructive dividend treatment of diverted receipts and the imposition of civil fraud penalties for intentional concealment and underreporting.


Mazzocchi Bus Co. v. Commissioner, 14 F.3d 923 (3d Cir. 1994)