Mazzei v. Commissioner

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In Mazzei v. Commissioner, 61 T.C. 497 (1974), the United States Tax Court ruled that a taxpayer could not consider $20,000 lost to a fraudulent counterfeiting scheme as a basis for a deduction under section 165(c)(3) of the Internal Revenue Code (“Code”).

1 Background
2 Tax Court Holding
3 Implications
4 Citations

[edit] Background

Petitioner (taxpayer) operated a sheet metal company in Hopewell, Virginia. An employee introduced petitioner to several individuals who claimed to be in possession of a machine capable of reproducing U.S. currency. Petitioner agreed to provide $100 bills to the counterfeiters to be used in the reproduction process. Upon completion of the process, the bills (and presumably some compensation) were to be returned.

Petitioner acquired $20,000 in $100 bills and brought them to New York City to meet with the counterfeiters. While meeting with the counterfeiters at an apartment, two armed men claiming to be law enforcement officers entered and took the money at gunpoint. Petitioner found a legitimate police officer shortly thereafter but was unable to secure the return of the $20,000. The police discovered that the “counterfeiting device” was nothing more than a black box incapable of reproducing currency.

Petitioner took a deduction of $19,900 (the first $100 of a section 165(c)(3) loss is not deductible) on his federal income tax return under section 165(c)(2) or (3) of the Code. The IRS issued a notice of deficiency, informing petitioner that the loss lacked adequate substantiation, and that even were the loss substantiated, allowing the deduction would contradict public policy.

Section 165(c)(2) allows a deduction for “losses incurred in any transaction entered into for profit, though not connected with a trade or business,” and section 165(c)(3) allows a deduction for losses not incurred in connection with a business or income-producing venture, which “arise from fire, storm, shipwreck, or other casualty, or from theft.”

[edit] Tax Court Holding

The Tax Court found that the $20,000 loss was substantiated by the evidence presented, but ultimately ruled against petitioner on grounds of public policy. A strict interpretation of section 165(c)(3) places no restrictions on the allowance of deductions for theft losses. However, the court was bound by the public policy declared in Luther M. Richey, Jr., 33 T.C. 272 (1959).

In Richey, a factually-similar case in which the taxpayer also provided currency for a counterfeiting scheme, the taxpayer actually assisted with some of the chores involved with the “counterfeiting process” before he realized that his cash had been stolen. The Tax Court found that petitioner, therefore, “was part and parcel of the attempt to duplicate the money” and “to allow the loss deduction in the instant case would constitute a severe and immediate frustration of the clearly defined policy against counterfeiting….” Richey.

In Mazzei, the court reasoned that petitioner’s act of participating in a conspiracy to produce counterfeit currency fell clearly within the public policy declared in Richey. Petitioner attempted to distinguish the instant case from Richey by arguing that the Richey taxpayer directly participated in chores contributing to a scheme which was capable of actually reproduce currency. On the other hand, in the instant case, petitioner merely provided the cash to a sham scheme which lacked the capacity to reproduce currency. The court rejected this argument, finding that although petitioner did not participate in the counterfeiting “process” in the same capacity as the Richey taxpayer, his actions did constitute a conspiracy in violation of U.S. law.

[edit] Implications

Despite its colorful facts, the decision in this case appears very dry and academic. In reality, it has significant implications.

The court rejected Mazzei's tax deduction on public policy grounds. Since Mazzei was involved in an illegal conspiracy that directly resulted in his losses, the court reasoned that those losses were not deductible. The exact public policy grounds are not explicitly explained but surely revolved around the reasonable assumption that recognizing such a deduction would amount to official government support of unlawful conduct damaging to society. Remember, however, that the gains made from an illegal business are, probably, still income and should be reported and taxed. This is openly inconsistent.

Furthermore, nothing in the tax code gives the courts the authority to decide whether or not to accept a deduction based on public policy. This is not a case of statutory interpretation. The court does not examine statutes at all. It merely decided, originally in Richey, that there should be a public policy exception to the tax code. It extended that exception here. If a court can decide there is a public policy exception in this situation, what is stopping it from making policy decisions in other situations. Most people are comfortable with the decision in Mazzei, most likely because they have little sympathy for someone who tried to cheat the system. However, the result has potentially wide-ranging impact far beyond the facts of this case.