Defendant May Claim Improper Diversions of Corporate Funds Were Returns of Capital

By James Beavers, J.D., LL.M., CPA

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.


Michael 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 to evade tax through a diversion of corporate funds might avoid conviction for criminal tax evasion by using Secs. 301 and 316 as a shield.

Citing Miller, the IRS argued that Boulware had not offered proof that it was his or HIE’s intent that the distri-butions be treated as a return of capital, so the evidence that the funds diverted to him were a return of capital under Secs. 301 and 316 was irrelevant. The district court agreed with the IRS and did not allow Boulware to present the evidence. Boulware was convicted of four counts of tax evasion, and on appeal the Ninth Circuit affirmed his conviction (Boulware, 470 F3d 931 (9th Cir. 2006)). Boulware appealed the decision to the Supreme Court. The Supreme Court agreed to hear the case to resolve a split in opinion among the circuits about the issue. (Compare Bok, 156 F3d 157 (2d Cir. 1998) (criminal defendant can invoke Secs. 301 and 316 without contemporaneous evidence of intent to treat funds as return of capital), with Williams, 875 F2d 846 (11th Cir. 1989); Goldberg, 330 F2d 30 (3d Cir. 1964); and Davis, 226 F2d 331 (6th Cir. 1955) (Secs. 301 and 316 are inapplicable in cases involving informal distributions).)

Supreme Court’s Opinion

In a unanimous opinion, the Supreme Court reversed the Ninth Circuit and held that a shareholder accused of criminal tax evasion related to a diversion of corporate funds for his own use could claim as a defense that the funds he received were a return of capital without proving that when the diversion of funds occurred either he or the corporation intended a return of capital. According to the Court, in the Miller case the Ninth Circuit (through its requirement of a contemporaneous intent to treat a receipt of corporate funds as a return of capital) had eliminated the requirement of the existence of a tax deficiency from Sec. 7201, which impermissibly enlarged the scope of the crime.

Citing its decision in Sansone, 380 US 343 (1965), the Court first held that the existence of a tax deficiency was an essential element of criminal tax evasion under Sec. 7201. In Boulware’s case (and in the Miller case), the Court found that the determination of the existence of a tax deficiency depended on the application of Secs. 301 and 316. It further found that under these sections, intent was irrelevant in determining the character of a distribution of funds to a shareholder.

The Court then addressed the Ninth Circuit’s holding that, for purposes of criminal tax evasion, a shareholder’s diversion of corporate funds for his or her own use could not be a return of capital under Secs. 301 and 316 unless it was intended as such by the taxpayer or the corporation at the time it occurred. The Court held that while intent is an element in criminal tax evasion, it is a distinct element of the crime, independent of the existence of a deficiency element. The Court stated that the government must prove intent separately and that the lack of an intent element in Secs. 301 and 316 did not in any way relieve the IRS of its burden of proving intent on the part of the taxpayer or prevent it from proving that intent. Therefore, there was no need or reason to add an intent requirement to the rules governing the determination of a deficiency under Secs. 301 and 316.

The Court acknowledged that, as the Ninth Circuit had pointed out in Miller, as a result of the operation of Secs. 301 and 316, the determination of whether a taxpayer who was improperly diverting funds from a corporation was guilty of criminal tax evasion might depend on the corporation’s financial performance and the taxpayer’s basis in the corporation’s stock. However, the Court noted that this was simply a result of the tax deficiency requirement in Sec. 7201. The Court stated that Sec. 7201 was intended to punish the actual evasion of tax, not the intent to evade tax, and that it was not the federal judiciary’s place to enlarge the reach of enacted laws, even if there were compelling reasons to do so.


The Supreme Court came to the sensible (and seemingly obvious) conclusion in this case that in order to be convicted of tax evasion, a taxpayer must actually evade tax. While there is little doubt that Boulware had every intention of evading tax through his schemes, if he could prove that under the applicable rules he had not evaded paying tax, he simply was not guilty of criminal tax evasion under Sec. 7201 as it is written.

Boulware, S. Ct. Dkt. 06-1509 (U.S. 3/3/08)

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