United States Court of Appeals, Third Circuit
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71-2 USTC P 9764
ESTATE of Josephine MAZZONI, Deceased, Peter Mazzoni,
Executor and Peter Mazzoni
v.
COMMISSIONER OF INTERNAL REVENUE.
Appeal of Peter MAZZONI, individually and as Executor of
the
Estate of Josephine Mazzoni, in No. 19338.
Charles J. RUNZO and Lena Runzo, Appellants in No. 19339,
v.
COMMISSIONER OF INTERNAL REVENUE.
Nos. 19338, 19339.
United States Court of Appeals,
Third Circuit.
Argued Oct. 21, 1971.
Decided Nov. 29, 1971.
Edmund W. Ridall, Jr., McCann, Garland, Ridall & Burke, Pittsburgh,
Pa., for appellants.
Bruce I.Kogan, Dept. of Justice, Tax Div., Washington, D. C. (Johnnie M.
Walters, Asst. Atty. Gen., Meyer Rothwacks, Richard W. Perkins, Attys.,
Tax Div., Dept. of Justice, Washington, D. C., on the brief), for appellee.
Before ALDISERT, GIBBONS and ROSENN, Circuit Judges.
OPINION OF THE COURT
ALDISERT, Circuit Judge.
These appeals form the Tax Court question the propriety of the application here
of the net worth method of reconstruction of income and the determination that
the Commissioner of Internal Revenue satisfied his burden of proving fraud by
the taxpayers.
2
Taxpayers, owners of two grocery stores in western Pennsylvania,1 petitioned
the Tax Court for a redetermination of their federal income tax liabilities after
the Commissioner, applying the net worth reconstruction of income method,
determined that there had been unreported income, deficiencies in tax, and
additions to tax due for fraud. The Tax Court, also using net worth
computation, sustained substantial deficiency and fraud penalties for several of
the years reviewed by the Commissioner.2
There is no disagreement that taxpayers maintained substantial personal cash
reserves.3 Indeed, the net worth method of reconstruction of income was
utilized because only a portion of the gross receipts from taxpayers' stores was
deposited in bank accounts, there was excessive commingling of taxpayers'
personal and business funds, and, at best, only informal bookkeeping methods
were employed. Thus, it is the size and source of the cash reserves maintained
by taxpayers which underlie this dispute.
This court has heretofore described the net worth income computation formula:
the "increase in net worth plus non-deductible disbursements minus non-taxable
receipts equals taxable net income." Clark v. Commissioner of Internal
Revenue, 253 F.2d 745, 747 (3d Cir. 1958). In Holland v. United States, 348
U.S. 121, 75 S.Ct. 127, 99 L.Ed. 150 (1954), the Supreme Court placed its
imprimatur on the use of the net worth method under certain restricted
circumstances. 4 The compliance with three requirements will legitimate its
implementation: first, the Commissioner must reliably establish a net worth for
taxpayer as of the beginning of the period under review; second, investigation
is required of the taxpayer's explanation for his net worth increases, if such
"leads" are "reasonably susceptible of being checked," Holland, supra, 348 U.S.
at 135-136, 75 S.Ct. 127;5 finally, the government must suggest a "likely
source" of the unreported income.
The Tax Court adopted the Commissioner's finding that the taxpayers' stores
constituted the "likely source" of the unreported income. Thus, the validity of
the net worth reconstruction truned on a finding that the inventory turnover and
gross profit margins were sufficient to generate the quantum of income found to
be understated in the returns filed during the years in question. Gross receipts in
each store averaged between $500,000 and $1,000,000. The Tax Court found
that the gross profit margin of the two stores was fourteen (14%) per cent, and
that there was an inventory turnover "generally in excess of 20 to 1." These
findings are presumptively correct, and we cannot disturb them unless we find
them to be clearly erroneous. Vaira v. Commissioner of Internal Revenue, 444
F.2d 770, 774 (3d Cir. 1971); Farcasanu v. Commissioner of Internal Revenue,
140 U.S.App.D.C. 398, 436 F.2d 146, 148 (1970). We have no difficulty in
accepting the Tax Court's determinations. Indeed, taxpayer Lena Runzo
testified that the gross profit margin ranged from seventeen (17%) per cent to
twenty (20%) per cent, and taxpayers' returns disclosed turnover rates ranging
from 18 to 1 up to 56 to 1. Thus, we will not disturb the finding that the grocery
stores constituted a "likely source" of the unreported income. See United States
v. Hom Ming Dong, 436 F.2d 1237, 1239-1242 (9th Cir. 1971).
6
In reconstructing taxpayers' annual incomes from 1956 to 1963, the
Commissioner found that there had been an overstatement of income in some
years during the period. Aware that some asset was not being recognized, both
the Commissioner and the Tax Court assumed the asset to be cash income, and
plugged the imputed income into their net worth computations. Appellants
argue that it would be as consistent to attribute the asset not being recognized to
personal cash which the taxpayers urged they had on hand as of January 1,
1956, as it would be to accept the imputations of the Commissioner and the Tax
Court. Moreover, appellants contend that the substantial discrepancies between
income computed and income reported uncovered in each of these years renders
the entire accounting method, as applied to these taxpayers, a complete
"mockery."
Though taxpayers seek shelter in Holland, their arguments provide them no
safe passage.6 Whether it be as consistent to conclude that the source of the
unrecognized asset is that suggested by the taxpayers, we emphasize that the
respective theories cannot at this juncture be weighed in apposition: "[o]ur
review of such findings is narrowly limited, for the findings of the Tax Court
are presumptively correct." Vaira, supra, 444 F.2d at 774. And though the
findings by the Commissioner and the Tax Court may, when based on mere
inference, generate difficult problems relating to burden of proof in criminal
matters, Holland, supra, 348 U.S. at 126, 75 S.Ct. 127, the Court there
expressly recognized that no such impediments inhere in civil proceedings for
the recovery of deficiencies.7 Indeed, upon a careful review of the record, we
find no reason to reject the Tax Court's refusal completely to credit taxpayers'
accounts of their personal cash reserves as of the beginning of the period. See
Marcello v. Commissioner of Internal Revenue, 380 F.2d 509, 511 (5th Cir.
1967); 2 Rabkin & Johnson, Federal Income Gift and Estate Taxation, Sec.
12.03A, p. 1231a. In any event, the Tax Court correctly recognized that any
error in computation for those years challenged by appellants could only inure
to taxpayers' benefit; had the Commissioner or the Tax Court failed to
acknowledge the asset not being recognized, the net worth increase for any
subsequent year would increase the taxpayers' liabilities in each of the years
immediately following those in which the income was found to be overstated.
8
We must reject as well appellants' contention that the magnitude of the
discrepancies between income computed and income reported in the years in
which income was found to be overstated is so substantial that the computations
for the entire period are rendered defective. As the government suggests, where
income for a period of successive years is subjected to retrospective
examination, use of the net worth method of computation may indeed produce
unlikely variations in attributed income as between individual years. But as the
Fifth Circuit noted in Conway v. United States, 278 F.2d 710, 712 (1st Cir.
1960), only the weight of the testimony is affected thereby:
9
Risk
of anachronous allocation is inherent in any case where a taxpayer fails to
maintain full and accurate records. He cannot be heard to complain if the record
shows sufficient basis for the findings, in spite of possible criticism of the pattern of
the result. * * * In these circumstances we would not hold plainly wrong a rule of
thumb allocating the income to the year in which it first came to light.
10
We hold that use of the net worth method was fully warranted by the
circumstances of this case. Holland, supra, 348 U.S. at 125, 75 S.Ct. 127; see
United States v. Hom Ming Dong, supra, 436 F.2d at 1240. Its implementation
here adequately comported with the procedural safeguards required by Holland.
Hence, the deficiency findings of the Tax Court are not clearly erroneous.
11
Although the Commissioner's findings usually are presumptively correct, fraud
must be proved to the Tax Court by clear and convincing evidence. Valetti v.
Commissioner of Internal Revenue, 260 F.2d 185, 188 (3rd Cir. 1958);
Goldberg v. Commissioner of Internal Revenue, 239 F.2d 316 (5th Cir. 1956).
Nonetheless, "because the question of fraud is an issue of fact, the Tax Court's
findings settle the matter unless they are clearly erroneous." Estate of Upshaw
v. Commissioner of Internal Revenue, 416 F.2d 737, 741 (7th Cir. 1969).8 As
the court in Upshaw there noted:
12
Some
of the factors the Tax Court may take into consideration in determining
whether the taxpayer was guilty of fraud with intent to evade taxes are: persistent
understatement of income over a period of years; failure to keep adequate records
and books; misstatement of facts to a revenue agent and concealing ownership of
property. All of these factors are present here.9
13
Here, too, there is a series of findings suggesting fraud: repeated and substantial
understatement of income; an abject failure to keep adequate books and
records; misstatements to revenue officers regarding cash reserves at the
beginning of the investigated period; excessive dealings in suspiciously large
amounts of cash; and a basic lack of credibility in taxpayers' account of the
alleged cash hoard. Taxpayers argue that all the indicia of fraud in this case
establish no more than "averments" or "suspicion" of deliberate understatement
of income with the intent to defraud the government. But there is more than
ample evidence to satisfy the rigorous standards heretofore rehearsed. And as
the Fifth Circuit noted in Webb v. Commissioner of Internal Revenue, 394 F.2d
366, 380 (5th Cir. 1968):
14 evaders seldom leave tracks and therefore circumstances can be convincing.
Tax
Though an isolated erroneous tax figure cannot be escalated or pyramided into
fraud, a confraternity of similar errors can take on more sinister tax aspects.
15
The decisions of the Tax Court will be affirmed.
Appellant Charles Runzo is sole proprietor of one store located in Blairsville,
Pennsylvania. His sister, Josephine, served as manager for the store during the
years in question. Appellants Runzo and Mazzoni operated the second store in
Homer City, Pennsylvania, as a 50-50 partnership. Joint individual income tax
returns were filed by the Mazzonis and the Runzos for the years 1956-1963
The Tax Court assessed the following deficiencies and penalties:
Year
1957
1958
1959
1960
Year
1956
1957
1960
Mazzonis' Tax Deficiency
$ 5,501.29
14,146.34
5,337.76
2,016.85
Runzos' Tax Deficiency
$ 3,718.22
28,785.01
27,025.10
Addition for Fraud
$ 2,750.65
7,073.17
4,500.99
1,008.43
Addition for Fraud
$ 2,602.02
14,392.50
13,512.55
Taxpayers introduced testimony that the Runzos possessed a cash reserve of
approximately $150,000 on January 1, 1956, the beginning of the period under
review; the Mazzonis' personal cash was estimated at $100,000. Although the
Commissioner determined that taxpayers had no personal cash on hand at the
beginning of the period, the Tax Court credited the Runzos with $90,000 and
the Mazzonis with $65,000 personal cash at that time
Though Holland arose as a criminal prosecution, both parties acknowledge that
it established the guidelines for use of the net worth method in civil tax
deficiency and fraud cases as well. See Hoffman v. Commissioner of Internal
Revenue, 298 F.2d 784, 786 (3rd Cir. 1962), and Fuller v. Commissioner of
Internal Revenue, 313 F.2d 73, 77 (6th Cir. 1963); Phillips Estate v.
Commissioner of Internal Revenue, 246 F.2d 209, 211 (5th Cir. 1957);
Fairchild v. United States, 240 F.2d 944, 948 (5th Cir. 1957)
5
Referring specifically to the "cash hoard" defense in net worth cases, the Court
noted in Holland that "this favorite defense asserts that the cache is made up of
many years' savings which for various reasons were hidden and not expended
until the prosecution period. Obviously, the Government has great difficulty in
refuting such a contention." Holland, supra, 348 U.S. at 127, 75 S.Ct. at 131
Indeed, we are not at all sure that the imputed cash technique, as utilized by the
Tax Court in the years complained of by appellants, is properly before this
court. Because the Tax Court sustained no imposition of tax liability against the
Mazzonis in 1961 or 1962, or against the Runzos in 1958, 1959, 1961, 1962, or
1963, review of the Tax Court's determinations for those years appears to be
both unnecessary and inappropriate
"[In] civil actions for the recovery of deficiencies, * * * the determinations of
the Commissioner have prima facie validity." Holland, supra, 348 U.S. at 126,
75 S.Ct. at 130. Thus, because in Tax Court proceedings the Commissioner's
determinations are presumptively correct, the burden of disproving them rests
upon the taxpayer. Tax Court Rule 32; Baird v. Commissioner of Internal
Revenue, 438 F.2d 490, 492 (3rd Cir. 1971); Hoffman v. Commissioner of
Internal Revenue, 298 F.2d 784, 788 (3rd Cir. 1962)
Reviewing the application of the "clear and convincing evidence" test by the
"clearly erroneous" standard is rarely a simplistic semantical affair:
The appellate court's role in reviewing cases of civil tax fraud entails unique,
though not exclusive, dualistic frustrations. To affirm for the Commissioner, we
must agree that he has proved fraud by "clear and convincing evidence." * * *
On the other hand, to reverse we must find that the Tax Court's determination
of fraud was "clearly erroneous" as to all items which comprise the deficiency
* * * A summary of the above standards demonstrates their tutorial limitations:
We must determine whether it is clearly erroneous that the taxpayer's intent to
defraud the government was proven, as to any part of the deficiency, by clear
and convincing evidence.
Webb v. Commissioner of Internal Revenue, 394 F.2d 366, 377-378 (5th Cir.
1968).
See also Friedman v. Commissioner of Internal Revenue, 421 F.2d 658, 659
(6th Cir. 1970); Merritt v. Commissioner of Internal Revenue, 301 F.2d 484,
487 (5th Cir. 1962); Shahadi v. Commissioner of Internal Revenue, 266 F.2d
495, 501 (3rd Cir. 1959); Schwarzkopf v. Commissioner of Internal Revenue,
246 F.2d 731, 734 (3rd Cir. 1957); Balter, Tax Fraud and Evasion, pp. 8-54 and
8-55 (3 ed. 1963); 10 Mertens, Federal Income Taxation, Sec. 55.10 et seq
