Defendant may claim improper diversions of corporate funds were returns of capital.

AuthorBeavers, James

The Supreme Court, reversing the Ninth Circuit, held that where a taxpayer is charged with criminal tax evasion related to funds he diverted from a corporation for his own use, the taxpayer may claim as a defense that the funds he received were a nontaxable return of capital without proving that they were intended as a return of capital at the time the diversion occurred.

Background

Michad Boulware was charged with several counts of criminal tax evasion (under Sec. 7201) and filing a false income tax return. The charges stemmed from his diversion of funds from Hawaiian Isles Enterprises (HIE), a closely held corporation of which he was the president, founder, and controlling shareholder. The IRS asserted that Boulware had through a variety of devices (e.g., submitting false invoices to the company) diverted funds from HIE for his own use that he did not report as income.

At trial, Boulware attempted to introduce evidence that HIE had no retained or current earnings and profits in the relevant tax years and that therefore, under Secs. 301 and 316, the fund diversions were nontaxable returns of capital, up to his basis in his HIE stock. He argued that if they were nontaxable distributions, he had no tax deficiency as a result of his receipt of the funds, and consequently he could not be convicted of criminal tax evasion.

The IRS sought to bar Boulware from introducing the evidence that the funds he diverted from HIE were a return of capital, based on the Ninth Circuit's decision in Miller, 545 F2d 1204 (9th Cir. 1976). In Miller, the court held that for purposes of criminal tax evasion under Sec. 7201, a diversion of funds from a corporation to a shareholder is a return of capital only if the shareholder or the corporation shows that the diversion of funds was intended as a return of capital at the time it occurred. According to the Ninth Circuit, while the focus of a civil tax evasion proceeding is the actual amount of a taxpayer's tax deficiency under the applicable law, the focus of a criminal tax evasion proceeding is whether the taxpayer intended to evade tax, regardless of the amount the taxpayer owed. Therefore, in a prosecution for criminal tax evasion involving a diversion of corporate funds, it was irrelevant whether the application of Secs. 301 and 316 resulted in a civil tax deficiency, unless the taxpayer could show that the diversion of funds was intended to be a nontaxable return of capital. Otherwise, a taxpayer that intended...

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