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October Term, 2007 

March 3, 2008

Today the Supreme Court issued one decision, described below, of interest to the business community.

Boulware v. United States, No. 06-1509 (previously discussed in the September 25, 2007 Docket Report). 26 U.S.C. 7201 makes it a felony willfully to "attemp[t] in any manner to evade or defeat any tax imposed" by the U.S. Tax Code. Petitioner Boulware was convicted of criminal tax evasion under Section 7201 for diverting funds from a closely held corporation of which he was the president, founder, and controlling shareholder. Boulware attempted to argue that the distributions he received were nontaxable returns of capital. The Ninth Circuit, relying upon an earlier decision, held that a diversion of funds in a criminal tax evasion case may be deemed a return of capital only if the taxpayer or corporation demonstrates that the distributions were intended to be such a return. The Supreme Court, in a unanimous opinion, vacated and remanded, holding that one of the elements of tax evasion under Section 7201 is "the existence of a tax deficiency," and the intent of the taxpayer and the corporation in making the distribution was irrelevant if Boulware could show that there was no actual tax deficiency.

Boulware is significant because it prevents a disconnect between civil and criminal tax liability that the court below had openly acknowledged and accepted. The Supreme Court held that if there is no actual tax deficiency under the civil code, there can be no tax evasion. The Court determined that because the tax classifications of "dividend" and "return of capital" turn on the objective economic realities of a transaction rather than on the form or intent of the parties, a criminal defendant need not show an intent to treat a distribution as a return of capital to argue that there was no tax deficiency and, therefore, no tax evasion.

The allegations in Boulware were "colorful." The defendant was charged with using various techniques to pull millions of dollars out of a corporation of which he was the president, founder, and controlling (though not sole) shareholder. Whether corporate distributions are nontaxable returns of capital is governed by 26 U.S.C. 301 and 316(a). Under Section 301(a), a distribution of property that is "made by a corporation with respect to its stock" shall be taxed as income if it is a dividend (as defined by Section 316(a)). If it is not a dividend, then it is nontaxable up to the shareholder's basis for his stock, and taxable as a capital gain above that basis. Section 316(a) defines a dividend as a distribution out of a company's "earnings and profits of the taxable year." When Section 301 and 316 are taken together, a distribution with respect to stock from a company with profits in the past year will be treated as a taxable dividend, while a distribution from a company without profits will be treated as a return of capital and/or a capital gain, depending on the distributee's basis for the stock.

Boulware attempted to introduce evidence that the corporation had no retained or current earnings and profits, and therefore under the civil tax code the distributions he received constituted nontaxable returns of capital up to his basis in his stock. The government moved in limine to bar evidence in support of this theory, arguing that it was irrelevant in a criminal tax case because, for criminal tax evasion, a diversion of funds may be deemed a return of capital only after some demonstration on the part of the taxpayer and/or the corporation that the distribution was intended to be such a return. The district court granted the government's motion, and the Ninth Circuit affirmed. Acknowledging the "disconnect between civil and criminal liability," the Ninth Circuit nonetheless held that "the characterization of diverted corporate funds for civil tax purposes does not dictate their characterization for purposes of a criminal tax evasion charge." Instead, the Ninth Circuit reasoned, the test in a criminal case is whether the defendant "willfully attempted to evade the payment or assessment of a tax."

The Supreme Court opinion focused on an "analytical mistake" in the lower court's focus on the "willful intent to evade taxes." The Court noted that under its prior opinions, one element of tax evasion under Section 7201 is "the existence of a tax deficiency." Willfulness is, of course, also an element of tax evasion, and on that score nothing in the civil code "relieves the Government of this burden of proving willfulness or impedes it from doing so." But the civil code is relevant to address "a different element of criminal evasion, the existence of a tax deficiency." Sections 301 and 316 function "wholly independent of intent." Therefore, Boulware did 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."

In reaching its conclusion, the Court left open a number of more specific questions as to whether the diversions in the case could be nontaxable returns of capital. The Government, before the Court, had backed away from the Ninth Circuit's differential treatment of civil and criminal tax liability, instead arguing that the diversions in the case were not "with respect to stock," and were unlawful and therefore could not be nontaxable under Sections 301 and 316. The Court left consideration of these questions for remand, noting that the facts in this case were not "raked over" with these questions in mind, and the jury was never asked whether the funds were unlawfully diverted.


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