Criminal Tax Evasion and Taxpayer Intent

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Supreme Court Says No Harm, No Foul

In Boulware v. United States, the United States Supreme Court rued that a conviction for tax evasion requires proof of a tax deficiency. Furthermore, the court held that in prosecutions predicated on a shareholder's unreported diversion of corporate funds, the characterization of such distributions as nontaxable returns of capital or taxable dividends depends solely upon the existence of corporate earnings and profits and the taxpayer's stock basis, without regard for the taxpayer's intent at the time of the distribution. This ruling resolved a long-standing split between the Circuit Courts of Appeal and has attracted the attention of tax professionals and the white-collar criminal defense bar. Writing for a unanimous court, Justice David Souter summarized the basis for the decision as follows:

Sections §301 and 316(a) govern the tax consequences of constructive distributions made by a corporation to a shareholder with respect to its stock. A defendant in a criminal tax case does not need to show a contemporaneous intent to treat diversions as returns of capital before relying on those sections to demonstrate no taxes are owed. . . .

Thus, the fact that a shareholder distributee of a successful corporation may have a different tax liability from a shareholder or corporation without earnings and profits merely follows from the way §301 and 316(a) are written (to distinguish dividend from capital return), and from the requirement of tax deficiency for § 7201 crime. Without deficiency, there is nothing but some act expressing the will to evade, and, under § 7201, acting on "bad intentions alone [is] not punishable" [128 S.Ct 1168, 170 L.Ed.2d 34 (2008)].

The Supreme Court adopted the Second Circuit's rule that in criminal tax cases, corporate funds diverted by shareholders constitute taxable income only to the extent the corporation had earnings and profits in the year the funds were diverted, approving the logic that a contrary rule would effectively excuse the government from the requirement that it prove the necessary element of a tax deficiency required to establish an IRC section 7201 violation [United States v. D'Agostino, 145 F.3d 69, 72-73 (2d Cir. 1998); United States v. Bok, 156 F.3d 157, 162 (2d Cir. 1998)]. On the other side of the split stood the Ninth Circuit, which, for more than 30 years, had required the criminal defendant in such cases to prove that, at the time the questioned distributions were made, either the taxpayer or the corporation intended them to be nontaxable returns of capital [United States v. Miller, 545 F.2d 1204 (9th Cir. 1976)]. According to the Ninth Circuit, the contrary rule places form over substance by allowing a taxpayer diverting funds from a corporation in financial difficulty (i.e., without earnings and profits) to avoid criminal liability, yet sanctioning the conviction of another taxpayer for the same conduct solely because he took money from a more successful corporation.

One element of the Second Circuit's "no earnings and profits, no income" rule places the burden on the criminal defendant to produce evidence in support of a return-of-capital defense. The Supreme Court specifically declined to consider the constitutionality of this requirement in light of Holland v. United States [348 U.S. 121, 75 S.Ct 127, 99 L.Ed. 150 (1954)] and Sandstrom v. Montana [442 U.S. 510, 99 S.Ct. 2450, 61 L.Ed.2d 39 (1979)].

The Return of Capital Rule

When Boulware arrived at the Supreme Court, two diametrically opposed positions had developed in the Courts of Appeal with respect to the application of the return-of -capital defense in criminal tax cases. The Second Circuit had established the rule that criminal defendants have the right to avail themselves of the defense that their withdrawals from closely held corporations amount to nontaxable returns of capital (up to the basis of their stock) if the subject corporation had no earnings and profits in the pertinent tax years. …