Lumbard, Chief Judge, and Smith and Kaufman, Circuit Judges.
Patsy DiZenzo and his wife appeal from that portion of a Tax Court decision which held them liable for additional taxes on their joint returns for 1946 through 1948.*fn1 The issues on this appeal stem from the Tax Court's finding that Patsy DiZenzo diverted to his own use, but did not report on the appellants' tax returns, a part of the income of Patsy Frank, Inc. ("Patsy Frank"), a corporation controlled by him and engaged in general masonry and carpentry work in Bridgeport, Connecticut. Patsy DiZenzo owned 98 per cent of its stock; the balance was owned by his wife and son.
The appellants do not dispute that substantial amounts were diverted from Patsy Frank. However, they dispute that the net amounts diverted were as large as found by the Tax Court, and they contend that the court erred in holding that the entire amount should be treated as ordinary income to them without regard to whether Patsy Frank then had earnings and profits equal to the diversions.
We affirm the Tax Court's findings as to the net amounts diverted from Patsy Frank. With respect to whether these should be treated as ordinary income, however, we remand for a finding as to whether the appellants have established that these amounts were greater than the earnings and profits of Patsy Frank at that time.
As the appellants concede, adequate business records were not kept for Patsy Frank. An accountant, employed parttime at $75 per year, made entries in a cash disbursement book from check stubs, but no regular record was kept of payments made in cash or of the corporation's receipts. The corporation's tax returns were prepared by the accountant from the cash disbursements book and from information obtained from Patsy DiZenzo.
Income tax deficiencies were assessed against Patsy Frank from 1946 through 1950 and against the appellants for 1946 through 1951. The parties stipulated the gross receipts of Patsy Frank, which were over half again as much as had been reported. These unreported receipts were in part set off by the Commissioner's allowance of operating expenses greater than claimed in the corporation's returns, and additional unreported operating expenses were allowed by the Tax Court -- $14,000 for 1946, $42,000 for 1947, and $38,000 for 1948.
The deficiencies assessed against the appellants as individual taxpayers resulted principally from the Commissioner's determination that substantial sums had been diverted by Patsy DiZenzo from Patsy Frank and Putnam Realty Company -- another corporation controlled by him. (No diversion of corporate income had been reported on the appellants' returns.) The Tax Court accepted the Commissioner's determination as to the gross amounts diverted. However, it found that appellants had made payments on behalf of Patsy Frank in addition to those assumed by the Commissioner, and it reduced accordingly the net amounts diverted from Patsy Frank.
Of relevance to this appeal are the reductions related to the court's allowance of additional operating expenses to Patsy Frank. The court concluded that a portion of these additional expenses had been paid for Patsy Frank by the appellants. Faced with an almost total lack of direct evidence as to what that portion was, it estimated that the appellants had paid $1,000, $4,000, and $3,000 respectively for 1946 through 1948.
After making the several adjustments, the Tax Court found that the net amounts diverted from Patsy Frank during 1946, 1947 and 1948 were $10,699.16, $59,190.84 and $46,174.50.*fn2 These amounts, the court held, should have been reported by the appellants as ordinary income.
The appellants first argue that the net diversions should have been reduced by the full amounts of the additional operating expenses which the Tax Court allowed to Patsy Frank for those years. They reason as follows: Substantially all of Patsy Frank's receipts had been accounted for prior to allowance of the additional operating expenses, and the net assets of the corporation remained approximately unchanged during the years in question. Therefore, the additional operating expenses either must have been paid out of the receipts which were assumed to have been diverted to the appellants or they must have been paid for Patsy Frank by the appellants -- in either case the net amounts diverted should have been reduced by the full amounts of the additional expenses. We do not agree.
The flaw in this reasoning is in the assumption that Patsy Frank's net assets remained unchanged. The appellants cite as support for this assumption the balance sheet prepared for Patsy Frank's 1949 tax return, which shows its net assets as having varied less than a thousand dollars from 1946 to 1948. But the fact that the balance sheet was drawn up to accord with the corporation's tax returns for those years destroys whatever probative value it might otherwise have had. Patsy Frank's additional expenses may have been paid out of accumulated cash reserves, or the corporation may have borrowed for this purpose. It is not our task to weigh the probability that one of these, rather than the appellants or the corporation's current receipts, was the source of the necessary funds. Because neither Patsy DiZenzo nor his corporate alter ego kept adequate business records, the Tax Court was required to rely in part on estimates in determining the appellants' tax liability. We cannot say that its estimates were clearly erroneous. See Finley v. Commissioner of Internal Revenue, 255 F.2d 128, 133 (10 Cir. 1958); cf. Cohan v. Commissioner of Internal Revenue, 39 F.2d 540, 544 (2 Cir. 1930).
The appellants' second argument, also directed at the net amounts diverted from Patsy Frank, is that at least $10,000 of these amounts constituted non-taxable repayment of a loan. In 1942 or before, Patsy Frank constructed apartments for Putnam Realty, subcontracting a part of the work to Anthony Battistelli. When Putnam was unable to pay the full amount due on the contract, Patsy Frank was in turn unable fully to pay Battistelli. The appellants then undertook to pay Battistelli and did pay him at least $10,000.
It was the appellants' position in the Tax Court that the amounts diverted from Putnam, for which they were taxed, constituted repayment by that company of an obligation to the appellants arising out of their payment to Battistelli, thus making the rentals diverted nontaxable to the extent of the purported repayment. The Tax Court rejected this argument, principally on the ground that the debt to Battistelli had been owed by Patsy Frank, not by Putnam. The appellants do not challenge the Tax Court's conclusion but now argue that it was Patsy ...