Proving Tax Evasion - IRC and Tax Deficiency | Criminal Tax Blog

Proving Tax Evasion – The IRC and Tax Deficiency

Boulware v. United States

In criminal tax cases, the government often chooses to prosecute the story instead of the law.  To the government, if a taxpayer is living a lavish lifestyle and paying no federal income tax, they must be cheating the government out of millions in unpaid taxes.  While those facts may persuade a jury that something is awry, they are unhelpful in meeting a central fact in every tax evasion case – a tax deficiency.  In Boulware v. United States, 552 U.S. 421 (2008), the Supreme Court clarified the legal undertone in all criminal tax cases by discarding the “lifestyle” argument and stripping the case down to the elements.

In this blog, we will look at the Supreme Court’s decision in Boulware and provide takeaways from this important decision from the nation’s highest court.

Internal Revenue Code Background

Under the Internal Revenue Code (IRC), a distribution from a corporation to a shareholder can take multiple forms.  Only some of these forms are taxable income to the shareholder.  If earnings and profit from the corporation is distributed to a shareholder, the distribution is classified as a dividend.  Dividends are taxable as ordinary income.  This process is common and probably best understood by stockholders who receive a percentage of earnings and profit as quarterly dividends from publicly traded companies.

Not all capital distributions are dividends or taxable income.  If the corporation does not have earnings and profit for the taxable year, distributions do not qualify as a dividend.  The distribution must be considered either a capital gain or a return of capital previously invested by the shareholder.   In Boulware, the issue related to a shareholder’s return of capital.

If a shareholder has put money into a corporation, and the corporation does not have earnings and profit for the taxable year, any capital distribution may be considered a return of capital.  Because the return of capital is essentially a repayment of previously invested funds, the transaction is not taxable income to the shareholder.  The return of capital is capped at the shareholders basis in the corporation.

Calculating a shareholder’s basis in a corporation is a complicated exercise in the real world.  I will provide an easy example for a basic understanding of the process.  If a person buys one share of Google for $1,000, the shareholder’s stock basis is $1,000.  If the shareholder gets a return of capital of $800, the shareholder’s new basis is $200.  The $800 distribution is not taxable.  If the next year the shareholder receives a distribution of $300, the entire $300 cannot be classified as a return of capital.  The return of capital is capped at the shareholder’s basis of $200. The remaining $100 would have to classified as a capital gain if the corporation did not have earnings and profit.  Though a realistic business example will never be this easy, hopefully, this example gives a foundation for understanding the Supreme Court’s decision in Boulware.

Facts in Boulware

The defendant was the president, founder and controlling shareholder for a C-Corporation, Hawaiian Isles Enterprises (HIE).  The defendant received various distributions from HIE throughout the tax years under indictment.  The distributions were often funds diverted through phony “business related” checks made payable to the defendant’s friends in the name of the corporation.  These distributions funded a lavish lifestyle which involved millions in gifts to the taxpayer’s girlfriend and wife.  The defendant did not declare these distributions on his tax returns.

The government indicted the defendant on several counts of tax evasion for taking affirmative steps to avoid the payment of taxes.  As previously discussed here, the tax evasion statute (26 U.S.C. § 7201) requires the government to prove an actual tax deficiency.  In other words, the government must prove that because of the scheme the taxpayer avoided paying taxes to the government.  The government’s case centered on the defendant’s lavish lifestyle, diversion of funds, and minimal tax payments.

The defendant attempted to put forward evidence at trial showing the distributions were capital returns, and thus, not taxable income.  If true, the government would be unable to prove the tax deficiency element of tax evasion.  The district court refused to permit any evidence relating to the return of capital theory or instruct the jury on the law behind capital returns under the IRC.  The district court found the defendant must show that he intended for the distribution to be a return of capital when the distribution was made.  This ruling was grounded in a contemporaneous intent requirement established by the Ninth Circuit in United States v. Miller, 545 F.2d 1204 (9th Cir. 1976).  Miller was one of many cases that addressed this issue.  Ultimately, the circuit courts were split on the intent requirement until the Supreme Court delivered the opinion in Boulware.  

The Ninth Circuit upheld the conviction and agreed with the district court’s contemporaneous intent requirement.  Though the Ninth Circuit was unanimous, they struggled with the decision.  The final decision was largely based on their inability to overturn Miller under the doctrine of orderliness.

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Supreme Court Rules on Contemporaneous Intent Requirement

The Supreme Court of the United States granted certiorari to resolve the circuit split.  The Supreme Court noted that the IRC was the controlling statute when determining whether a tax deficiency existed under the criminal tax evasion statute.  Under the IRC, a distribution from a corporation is not always taxable.  If the corporation does not have earnings and profit, the IRC views the distribution as either a return of capital or a capital gain, but not ordinary income.

The IRC’s mandates are purely objective requirements.  There is no intent required under the IRC.  In fact, the IRC requires taxpayers to wait until the end of the year to classify a distribution. At that time, the corporation can provide complete information regarding their earnings and profit for the taxable year.

There is nothing in the IRC that requires a taxpayer to show intent when the distribution is made.  Likewise, there is nothing that prevents a taxpayer from reclassifying the transaction on the corporate books before filing their tax return.  In short, as long as the corporation has no earnings and profit for the taxable year, the taxpayer can classify the distribution as a return of capital or a capital gain.  The only limitation is the shareholder’s basis in the corporation.

On appeal, the government continued to highlight the defendant’s diversion of funds and low tax liability.  Further, the government pointed out the unfairness in determining a taxpayer’s guilt on the corporation’s profitability in the tax year.  The Supreme Court shut down the government’s arguments at each step reverting to the statutory guidance in the IRC.

The Supreme Court overturned the defendant’s conviction and remanded the case for further proceedings.  The defendant will receive a trial where he is allowed to present evidence and argue the distributions were in fact returns of capital.  If he is successful, the government will fail to prove the tax deficiency required by the tax evasion statute.

Impact of Boulware Decision and Practice Implications

Alongside Cheek (reviewed in a previous article), Boulware is one of the most important cases in criminal tax litigation.  The Supreme Court has overtly gone back to the basics of a criminal tax prosecution.  At its core, tax evasion requires the government to classify the transactions and prove a tax deficiency.   That finding does not consider lavish lifestyles or the nature of a transaction.  The IRC, and resulting classification to the taxpayer, is the only relevant inquiry.  This is true with simple filings as well as complicated corporate filings.

The first step in any tax prosecution is to determine the actual tax due and owing.  This number is pivotal in determining tax loss under the sentencing guidelines, attacking the tax deficiency element under the tax evasion statute, and bolstering any willfulness challenges under Cheek (the Cheek decision is discussed fully here).  This requires a complete analysis of the defendant’s business, and a recreation of the true tax liability for each taxable year.  This analysis should be conducted using all tax strategies supported by the IRC.  If a criminal tax attorney can show the defendant had a limited increase in tax liability without the falsity or evasive act, there is a great foundation for defending against the government’s accusations.

This business analysis was pivotal for Boulware and should be adopted by any tax attorney accepting criminal cases.  There is no doubt that Boulware did not envision the millions in distributions as being a return on capital when the distributions were made.  He was living a high lifestyle and refused to pay taxes on that money.  But under the IRC and tax deficiency element, none of that matters.  The only relevant inquiry is whether the IRS lost money due to his actions. If HIE had no earnings and profit, and Boulware’s basis was sufficient, the distributions were not taxable income.  Period.  The Boulware case does a great job of keeping the focus in the right place.  When it comes to challenging the government’s proof of a tax deficiency, the IRC is all that matters.