Funneling millions to wife, mistress is not illegal

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It’s not tax evasion to funnel millions of dollars from a closely-held corporation to a mistress without paying taxes on the money.

At least it’s not illegal, as long as the corporation earned no profits that year, and the distributions are less than the shareholder’s basis in the corporate stock.

When those facts are present, the U.S. Supreme Court unanimously held on Mar. 3, the distribution can be classified as a nontaxable return of capital, rather than a dividend.

Michael H. Boulware was charged in federal court with tax evasion and filing a false income tax return, stemming from his diversion of millions of dollars from a corporation he controlled to his wife and his girlfriend.

In defense, he sought to present evidence that the corporation had no profits in the relevant taxable years, and therefore, the distributions were nontaxable returns of capital.

The district court held the evidence inadmissible, because Boulware presented no evidence that, at the time the diversions were made, he intended that they be treated as capital returns.

Relying on binding Ninth Circuit precedent, U.S. v. Miller, 545 F.2d 1204 (9th Cir. 1976), the court of appeals affirmed.

The U.S. Supreme Court granted certiorari and vacated the convictions, in an opinion by Justice David H. Souter.

The Court concluded that the issue was controlled by the definition of “dividend” in 26 U.S.C. 316(a), which defines the term as a distribution of property from a corporation to a shareholder “out of its earnings and profits.”

The Ninth Circuit’s view, in the Court’s opinion, conflicts with both the language of the statute and economic realities.

In Miller, the Ninth Circuit had concluded that it would elevate form over substance to make tax evasion contingent on whether or not the corporation had earnings that year.

However, the Supreme Court concluded that it would do no such thing, but would merely require the government to prove all the elements of the crime, specifically, a tax deficiency.

The Court reasoned, “A defendant in a criminal tax case does 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.”

The Court further noted that, at the time a distribution is made, it may be unknown whether or not the corporation will show a profit at the end of the year, negating any rationale for tax treatment to be contingent on intent at the time of the distribution.

Analysis

The decision does not expressly overrule any Seventh Circuit precedent, but it does so implicitly.

Boulware was charged with two offenses: tax evasion in violation of 26 U.S.C. 7201; and filing a false tax return in violation of sec. 7206. Only the tax evasion charge was at issue in this case.

However, a footnote suggests that the Court’s holding applies equally to filing a false tax return.

In the footnote, the Court wrote, “The Government does not argue that Boulware’s secs. 7201 and 7206(1) convictions should be treated differently at this stage of the proceedings, however, and we will accede to the Government’s working assumption here that the secs. 7201 and 7206(1) convictions stand or fall together.”

The Seventh Circuit has not previously addressed the issue in the tax evasion context, but has in the false tax return context, U.S. v. Peters, 153 F.3d 445 (7th Cir. 1998).

Florence Peters was charged with filing a false tax return, for paying personal expenses with funds from a personal services corporation. She argued that the evidence was insufficient to support the conviction, but the district court and Seventh Circuit disagreed.

The court acknowledged the split in authority over whether the government must prove a tax deficiency to prove tax evasion under sec. 7201, but held the issue irrelevant in a prosecution for filing a false return under sec. 7206. The court affirmed the conviction, because there was no evidence Peters intended the distributions to be a return of capital when made.

In light of the Supreme Court’s holding, and its assumption that secs. 7201 and 7206 should be treated the same, Peters, without being mentioned, is overruled on this issue.

However, lower courts remain free, at this point, to allocate the burden of proof on the issue. In the case at bar, Boulware was not even permitted to present evidence that the corporation had no earnings.

In a footnote, the Supreme Court declined to decide which party should bear the burden of proof when a defendant makes a return-of-capital defense.