The U.S. Circuit Court of Appeals has built up a track record in recent years of being the Circuit Court with the highest rate of reversal by the U.S. Supreme Court – with many of those reversals being unanimous. Well, chalk another one up – this time in a case involving the most basic of federal income tax principles.
In the case, the taxpayer was convicted of criminal tax fraud for filing a false tax return because, as the government claimed, the taxpayer did not report funds distributed to him by his wholly-owned corporation. The taxpayer diverted funds from his C corporation for personal use. Normally such a distribution would be treated as a “constructive dividend” and the amount would be included in the taxpayer’s income. However, the taxpayer argued that the funds were a return of capital, not gross income, so there could not be any tax fraud – there wasn’t any income to report. The trial court, relying on United States v. Miller, 545 F. 2d 1204 (9th Cir. 1976), refused to permit the taxpayer to introduce evidence that the distribution was a return of capital. The Ninth Circuit affirmed and Supreme Court agreed to hear the case.
To convicted a taxpayer of criminal tax evasion, the government must prove that the taxpayer not only evaded tax but alsothat the taxpayer did so willfully. Similarly, to convict a taxpayer of filing a false return, the government must prove that the taxpayer filed a false return and that the taxpayer did so willfully. There is no tax evasion or filing of a false return if what the taxpayer allegedly fails to report is not gross income. When a corporation makes a distribution to a shareholder, whether the shareholder has income to report is determined by I.R.C. §301. Under that Code section, here is how the shareholder is to treat the distribution:
- The shareholder has income to the extent the corporation has earnings and profits. To that extent, the distribution is a dividend that must be included in gross income (i.e., there can only be dividends if the corporation has earnings and profits);
- Any portion of the distribution exceeding earnings and profits is treated as a return of capital, reducing the shareholder's adjusted basis in the shareholder's stock;
- If, after adjusted basis is reduced to zero, there remains a portion of the distribution not accounted for, it is treated as gain from the sale of the stock (i.e., taxed as capital gain).
Thus, if a corporation makes a distribution when it has no earnings and profits, and the distribution does not exceed the shareholder's adjusted basis in the stock, there is no gross income. On that point, tax law is absolutely crystal clear. But, it apparently wasn't clear to the trial court on the Ninth Circuit.
As mentioned above, the taxpayer wanted to offer evidence that the corporation had no earnings and profits. That evidence goes to the heart of establishing that the taxpayer didn't have income from the distribution. But, the district said “no” based on the Miller decision. In Miller, the Ninth Circuit held that the receipt of funds in a criminal tax evasion case may be treated as a return of capital only if the taxpayer or corporation demonstrates that the distribution was intended to be such a return. The Ninth Circuit affirmed, but the Supreme Court saw the matter differently and took the Ninth Circuit to task. The Court stated rather stingingly:
“Miller’s view that a criminal defendant may not treat a distribution as a return of capital without evidence of a corresponding contemporaneous intent sits uncomfortably not only with the tax law’s economic realism, but with the particular wording of §§301 and 316(a), as well. As those sections are written, the tax consequences of a “distribution by a corporation with respect to its stock” depend, not on anyone’s purpose to return capital or to get it back, but on facts wholly independent of intent: whether the corporation had earnings and profits, and the amount of the taxpayer’s basis for his stock. ... When the Miller court went the other way, needless to say, it could claim no textual hook for the contemporaneous intent requirement, but argued for it as the way to avoid two supposed anomalies.”
The Supreme Court then explained why the two anomalies that the Ninth Circuit thought it had to fix did not exist. First, the Ninth Circuit didn’t want to apply I.R.C. §301 in criminal cases because it considered that provision to emphasize exact amounts of a tax deficiency while ignoring the willfulness element. The Supreme Court noted the Ninth Circuit's mistake by focusing attention on the difference between willfulness as one element of the crime and the deficiency as another. The Court stated:
Those two sections [sections 301 and 316] as written simply address a different element of criminal evasion, the existence of a tax deficiency, and both deficiency and willfulness can be addressed straightforwardly (in jury instructions or bench findings) without tacking an intent requirement onto the rule distinguishing dividends from capital returns.
The Supreme Court also dismissed the Ninth Circuit's other notion that if a taxpayer "could claim capital treatment without showing a corresponding and contemporaneous intent, '[a] taxpayer who diverted funds from his close corporation when it was in the midst of a financial difficulty and had no earnings and profits would be immune from punishment (to the extent of his basis in the stock) for failure to report such sums as income; while that very same taxpayer would be convicted if the corporation had experienced a successful year and had earnings and profits.'" The Supreme Court noted that in such an instance there is no tax deficiency and if there is no tax deficiency there cannot be a tax evasion crime.
The Supreme Court also pointed out that I.R.C. §301 is applied at the end of the year, after earnings and profits have been computed. Thus, even if there was intent that a taxable distribution made during the year be taxable because the corporation expected to have earnings and profits, it could turn out that a turn-around in business fortunes would cause the corporation to have zero earnings and profits at the end of the year. Thus, according to the Supreme Court:
"And since intent to make a distribution a taxable one cannot control, it would be odd to condition nontaxable return-of-capital treatment on contemporaneous intent, when the statute says nothing about intent at all."
The Court also chided the Ninth Circuit for turning I.R.C. §301 into a section "of merely partial coverage" that leaves distributions "in a tax status limbo" when a criminal case arises. The Court explained that I.R.C. §61 did not serve as a backstop to salvage the Ninth Circuit's coverage gap, because that section does not apply if another section provides otherwise, which is precisely what I.R.C. §301 does. What the Ninth Circuit tried to do was characterized by the Supreme Court as "yet another eccentricity." The end result was that the taxpayer’s conviction was reversed, but the case got remanded to deal with another issue.
It's strange that the government pursued this case, and one wonders whether they would have pursued it outside the Ninth Circuit. While the taxpayer was taking funds out of the corporation to the detriment of at least one other shareholder, that is not a federal tax crime. It may violate state corporate laws, but it doesn't run afoul of the Internal Revenue Code. At least the Supreme Court has wiped out some really poor caselaw from the Ninth Circuit. Boulware v. United States, No. 06-1509, 2008 U.S. LEXIS 2356 (U.S. Sup. Ct. Mar. 3, 2008).