Boulware v. United States (06-1509)

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Oral argument: January 8, 2008

Appealed from: United States Court of Appeals, Ninth Circuit (December 13, 2006)

RETURN OF CAPITAL, U.S. TAX CODE, TAX EVASION, "CONTEMPORANEOUS INTENT REQUIREMENT"

Michael Boulware was convicted of filing false tax returns, tax evasion, and conspiracy to make false statements to a federally insured financial institution in Hawaii District Court in 2001. He appealed his conviction to the Ninth Circuit on various grounds multiple times. In his current appeal, he argues that the funds he diverted from his closely held corporation, Hawaiian Isles Enterprises, qualified under Sections 301 and 316 of the U.S. Tax Code as a non-taxable return of capital. If this is true, he argues, the government failed to meet its burden of proof in showing a tax deficiency because it did not establish that the funds Boulware diverted were taxable as income. However, the Ninth Circuit upheld his conviction based on its decision in United States v. Miller, which established that in a criminal tax evasion case, a defendant must show not only that a diversion of funds meets the requirements in the Tax Code to be a non-taxable return of capital, but also that the shareholder and/or corporation intended it to be one at the time the diversion was made. Since Boulware could not make this showing, he failed to demonstrate that the diversion qualified as a nontaxable return of capital under Miller. Boulware has challenged his conviction and argues that the Miller "contemporaneous intent" requirement has no basis in the statutory text of the Tax Code and creates a disparity in treatment of defendants in civil and criminal tax cases, and for these reasons should be overturned. The Supreme Court, in answering the question of what requirements must be fulfilled for a diversion to qualify as a return of capital, will resolve a conflict in positions between the Second and the Ninth Circuits.

Question(s) presented

Whether the diversion of corporate funds to a shareholder of a corporation without earnings and profits automatically qualifies as a nontaxable return of capital up to the shareholder's stock basis, see 26 U.S.C. 301(c)(2), even if the diversion was not intended as a return of capital.

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Issue(s)

What is required in order for a diversion of funds from a corporation to be a nontaxable return of capital? Must the diversion be intended as a nontaxable return at the time it was made, or is it sufficient that the diversion meets the requirements of 26 U.S.C. �� 301 and 316 that it (1) comes from a corporation that lacks earnings and profits and (2) does not exceed the shareholder's basis in stock.

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Facts

Former telephone repairman Michael Boulware's meteoric rise to success began with his founding in 1979 of a small company, M & S vending, which placed video games in bars and restaurants. United States v. Boulware 384 F.3d 794, 799 (9th Cir., 2004) (Boulware I). Shortly before the IRS began investigating him in 1993, Boulware's company, which was renamed Hawaiian Isles Enterprises (HIE) and had expanded into bottled water, coffee, and cigarette sales, was boasting annual sales of $85 million. Id. His good fortune ended in 2001, when a jury in the District Court of Hawaii found him guilty of nine tax related charges, including filing false tax returns, conspiracy to make a false statement to a federally insured financial institution, and tax evasion. Id. The thrust of the charges was that Boulware had systematically and unlawfully diverted millions of dollars from HIE, the company in which he owned all stock, without paying taxes that were due. He did so by transferring huge amounts of money to both his wife and his girlfriend, submitting fraudulent invoices to HIE, and laundering HIE money through foreign bank accounts. Id. On his first appeal, the Ninth Circuit reversed his convictions for filing false tax returns and tax evasion because the District Court erred in not admitting a former state court judgment involving a financial dispute between Boulware and his girlfriend. Id. at 800-09. He was convicted again on re-trial, and his second appeal is the subject of the current case. See United States v. Boulware 470 F.3d 931 (9th Cir., 2006) (Boulware II).

In this second appeal Boulware argues that the District Court, in his retrial, erred in excluding evidence that the funds Boulware had diverted from HIE were in fact nontaxable returns of capital, and therefore not required to be included in his income on his tax return. Boulware II,470 F.3d at 933-34. The taxability of a distribution of property made by a corporation to a shareholder with respect to its stock is determined under Section 301(c) of the U.S. Tax Code.If the corporation had earnings or profits that year, the distribution is generally considered to be a dividend up to the amount that the corporation earned. See 26 U.S.C. � 301(c)(2); 28 U.S.C. � 316. Under Section 301, dividends are taxable. Amounts that exceed a corporation's earnings or profits are not considered to be dividends, and under Section 301 reduce the recipient's adjusted basis in the stock. See 26 U.S.C. � 301(c)(2). Any such distribution that exceeds the shareholder's basis in stock is a taxable capital gain. 26 U.S.C. �301(c)(3). However, under the "return of capital rule" recognized by the United States Tax Court in Truesdell v. Commissioner, the amount of the adjustments to the taxpayer's basis under Section 301 is considered a "nontaxable return of capital." See 89 T.C. 1280, 1294-95 (1987).

Essentially, Boulware's argument was that since HIE had no earnings or profits at the time he diverted funds, those funds constituted nontaxable returns of capital under Section 301, and not taxable income. Boulware II, 470 F.3d at 933-34. Therefore he was not filing false returns or evading taxes by failing to report them. The government's failure to show a tax deficiency would effectively pull the rug out from under its tax evasion case. Id. The Ninth Circuit, however, disagreed that the funds were returns of capital. It found that according to precedent established in United States v. Miller, the return of capital rule available to defendants in civil tax matters is not automatically available in criminal cases such as Boulware's. Id. at 935, citing 545 F.2d 1204 (9th Cir., 1976). Under Miller, it explained, criminal defendants trying to claim that diversions fall under the return of capital rule have to show not only that the corporation had no earnings, but also that the distributions were intended to be returns of capital at the time they were made. Id. Since Boulware was unable to make this preliminary showing of intent, the Ninth Circuit found, the District Court was correct in ruling that he could not use the return of capital rule as a defense. Id.

Boulware appealed to the Supreme Court, asking it to resolve the issues of how the return of capital rule should apply in criminal tax cases, and what weight federal courts should give state court tax judgments. Petition for Writ of Certiorari at 7-8, 11-13. The Court granted certiorari solely on the issue of how to interpret the return of capital rule in criminal tax cases. Boulware v. United States, 128 S.Ct. 32 (2007).

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Discussion

The question presented in this case concerning the appropriate tax classification for a multimillion dollar fund diversion may not have been the most exciting story to hit Hawaiian newspapers when Michael Boulware was convicted of tax evasion and tax fraud. But the scheme itself did receive a fair share of coverage in the Honolulu Star Bulletin both because of the harsh sentence Boulware will receive if his conviction is affirmed, and because the accountant who created the offshore bank accounts Boulware used to hide money was a former state representative.

It is also likely that his case garnered the attention it did because Boulware's conviction and first appeal sandwiched the announcement and development of the Enron scandal in 2001 and 2002, which ignited controversy about corporate crime, the government's role in stopping it, and the huge effect it could have on unknowing investors. Securities fraud was at the core of Enron's illegal activity, but Boulware's case presents a different kind of crime - tax fraud - that also falls within the genre of white collar crime, which is defined by the FBI as those nonviolent crimes which "involve traditional notions of deceit, deception, concealment, manipulation, breach of trust, subterfuge or illegal circumvention."

The appropriate definition of and prosecution for white collar crime is still under debate, and has been since prominent sociologist and criminologist Edwin Sutherland introduced the term in 1949. Sutherland's definition of white collar crime, which has since been largely abandoned, is criticized by groups like the Heritage Foundation for its focus on the social status of the perpetrator more than on the crime itself. Today, the widely recognized problem with white collar crime prosecutions is how the government should exercise its discretion in targeting defendants, especially in those cases in which civil penalties are also available, as they were in Boulware's. See Kelly Strader, Understanding White Collar Crime (2006), 7-8.

It is undisputed that white collar crime, and tax fraud specifically, can wreak havoc on the American economy if unchecked, allowing corporations to earn billions of dollars without paying the appropriate taxes and thereby burdening individual taxpayers. The Tax Whistleblower Legal Network cites statistics showing that the government loses $170 billion annually due to corporate tax avoidance. Yet another problem with prosecutions for tax fraud has traditionally been proving the requisite mens rea. This means the government must show that a defendant purposefully evaded tax payments which he knew were due, and was not either lawfully attempting to take advantage of complications in the tax code to minimize payments, or genuinely confused about what amounts were due. See Understanding White Collar Crime, 8-10.

In fact, the Supreme Court imposed an intent element in tax fraud cases specifically because of the complexity in the tax code, holding in Cheek v. United States that as part of proving intent in a criminal case, the government has to show the defendant's "actual knowledge of the pertinent legal duty" and must as well "[negate] a defendant's claim of ignorance of the law or a claim that because of a misunderstanding of the law, he had a good-faith belief that he was not violating any provisions of the tax laws." 498 U.S. 192, 201-02 (1991).

What the Court did not take the time to discuss at length in Cheek was the basic tax deficiency element of a tax fraud case, which is at issue here. While it seems that both sides in Boulware's case have conceded the fact that Boulware had the intent to evade tax payments, the question is whether he actually did so, or whether taxes were due in the first place. This poses the interesting quandary of what it will mean if the Court approves the Ninth Circuit's additional intent requirement - which is essentially that, even when there is a chance that no tax payment will eventually be due, a defendant must have actually intended the diversion to be legally nontaxable at the time it was made. This is an entirely different intent requirement than the one the government currently has the burden of proving, and this case puts the Court in the position of having to discuss whether, essentially, intent to defraud or evade can impose criminal liability even when there is a showing that there may have been no taxes due to begin with.

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Analysis

Every individual earning income that exceeds a certain amount is required to file income tax returns under 26 U.S.C. 6151(a). Michael Boulware was convicted of violating statutes that punish a person "who willfully attempts in any manner to evade or defeat any tax imposed" or who "willfully makes and subscribes any return, statement, or other document.which he does not believe to be true and correct as to every material matter." See 26 U.S.C. � 7201, � 7206(1). To successfully prosecute an individual for tax evasion under �7201, or for filing false tax returns under �7206(1), the government must prove the existence of an underlying tax deficiency, which means that taxes were not filed, or were filed improperly, on income that is taxable. See Sansone v. United States, 380 U.S. 343, 351 (1965).

A return of capital is considered non-taxable income, and the essence of Boulware's argument is that if his diversions were a return of capital, he was not required to report them as income and therefore was not evading taxes or filing fraudulently when he didn't. See Brief for Petitioner at 15-16. This would mean the government failed to show a tax deficiency in his case. The government claims that under 26 U.S.C. �� 301 and 316, there can only be a return of capital when there is a corporate distribution to a shareholder from a corporation with no earnings or profits, and the corporation and/or shareholder intended the distribution to be a return of capital. See Brief for Respondent at 11. Boulware alleges that only the first part is necessary to show a return of capital, and that addition of an intent element in criminal cases is not supported in the statutory text and unfairly shifts the burden of proof in tax evasion cases to the defendant. See Brief for Petitioner at 11-12.

The government responds first that the requirement of contemporaneous intent does appear in the civil tax code, under which all the circumstances of a shareholder distribution are relevant in determining whether it falls under Sections 301 and 316. See Brief for Respondent at 24-26. However, it also (and in contrast) seems to acknowledge the addition of an intent requirement in criminal tax cases, but argues that this does not shift the burden of proof to the defendant, and instead merely reflects a valid recognition of a different legal standard in criminal cases. See id. at 32-33.

What Constitutes a Return of Capital

Boulware argues that a plain reading of Sections 301 and 316 of the Tax Code reveals fairly straightforward classifications that should be applied in his case. First, dividends are "any distribution of property made by a corporation to its shareholders out of its earnings and profits" and are taxable as ordinary income. 26 U.S.C. �� 301, 316. Returns that exceed a shareholder's basis in stock are capital gains to the extent that they exceed the shareholder's basis in stock, and are also taxable income. Finally, returns to a shareholder that 1) come from a corporation that has no earnings or profits and 2) do not exceed the shareholder's basis in stock, and so cannot be dividends or capital gains, are nontaxable returns of capital. See Brief for Petitioner at 10-13. Boulware cites Truesdell v. Commissioner 89 T.C. 1280 (1987) for the proposition that Tax Courts have consistently applied Sections 301 and 316 to shareholder diversions since its decision was issued. See id. at 11-12. Following the decision, the IRS acquiesced in the extension of the Tax Code classification to shareholder diversions of capital when it ruled that funds diverted to a shareholder should be regarded as constructive distributions, unless those funds were salary or other non-shareholder funds. See id. at 12-13. Boulware argues that from the definition of constructive distribution comes the analogous definition of constructive dividend, which is any distribution to a shareholder that comes out of a corporation's earnings and profits. Accordingly, he claims, if the corporation lacks earnings and profits, a shareholder diversion is not a constructive dividend, and is instead a non-taxable return of capital. See id. at 13-14.

In response, the government claims that Boulware failed to recognize the importance of the phrase "with respect to its stock" in Section 301, which it says implies an intention that "a distribution of property.made by a corporation to a shareholder" must be because of that person's status as a shareholder to fall under the classification of Section 301. Brief for Respondent at 16. In the government's view, this establishes a threshold requirement of contemporaneous intent that was not met in Boulware's case. See id. at 17. Since Boulware took elaborate measures to hide the fact that corporate funds were being diverted, the government argues, he could not take advantage of the return of capital rulesince those funds were clearly not intended to be distributions because of his status as a shareholder. See id. at 17-18.

The government also contends that this intent requirement comes from civil tax cases as well, and that Truesdell v. Commissioner does not require that all corporate distributions presumptively be treated as distributions with respect to stock in civil cases. See Brief for Respondentat 25-27. It argues that intent should be considered since courts are to consider all the facts and circumstances in determining whether a distribution was because of a taxpayer's status as a shareholder. See id. at 24.

The government also argues that the Second Circuit's position, which Boulware relies upon, is wrong. Brief for Respondent at 24. The Second Circuit grants the presumption that distributions of corporate funds in criminal cases are automatically treated as distributions with respect to stock, and the government claims that its rationale for this position is faulty. See id. at 24. Second Circuit decisions have essentially held that adding the additional requirement of corporation or shareholder intent would place too much emphasis on this element and is a misapplication of Truesdell. This argument is based on the fact that the court in Truesdell refused to adopt an automatic rule that diverted funds are automatically taxable as ordinary income. See id. at 25. The government points out that the court also refused to adopt the position that constructive distribution rules automatically apply to shareholder diversions of corporate funds, indicating an unwillingness to apply any automatic rule, and a decision to focus on the capacity in which funds were received. See id. at 26-27. Moreover, when the IRS acquiesced in this decision, it emphasized that a diversion of corporate funds cannot be a constructive distribution if the funds were received in a non-shareholder capacity. See id. at 27. So in effect, the government claims that to receive the benefit of any of the civil classifications - dividend, return of capital, or capital gain - a distribution of property must have been from a corporation to a shareholder with respect to its stock. See id. at 28. It is not entirely clear how the government would classify the diversions at issue in this case, since it fails to address this question.

Bouleware responds that the connection the government alleges between the phrase "with respect to its stock" and the Miller rule requiring contemporaneous intent is wrong, since that phrase appears in the statute to distinguish returns that have nothing to do with stock, like loan repayments and salaries, from distributions that are stock-related. See Brief for Petitioner at 26. He contends that since neither party now claims that Boulware's diversions were loan repayments or salary, the diversions in his case should fall under Section 301. See id. at 29.

"Contemporaneous Intent" and the Burden of Proof

The explicit holding in Miller that is challenged in this case is that civil classifications of diverted corporate funds do not control in criminal cases. Specifically, then, in order to show that a diversion of funds in a criminal tax case was a nontaxable return of capital, the burden of proof shifts to the defendant to show that, in addition to the distribution otherwise qualifying as a return of capital under Section 301 at the time the diversion was made, it was contemporaneously intended by the shareholder and/or corporation to be a return of capital. Miller, 545 F.2d at 1215.

Boulware argues that if the government's position is accepted by the Court, this will unfairly shift the burden of proof in criminal tax cases. See Brief for Petitioner at 15-16. Boulware claims that since the government has to prove a tax deficiency in a prosecution for tax evasion, a defendant should simply be able to show that diverted funds were a return of capital by nature of their coming from a corporation with no earnings or profits and not exceeding the shareholder's basis in stock. See id. He argues that Miller's added contemporaneous intent requirement is wrong because it eliminates proof of tax deficiency as an element of a Section 7201 violation. He claims that if there is no taxable diversion, there can be no tax deficiency and thus no criminal offense. See id. at 20-21.

He also argues that there is no justification for shifting the burden of proof in this way, because application of the Miller rule produces the anomalous situation in which corporate distributions that would not count as income in a civil tax assessment would count as income in a tax evasion or tax perjury case, unless the defendant can meet the contemporaneous intent requirement. See id. at 21-22. He also argues that there is no basis for this requirement in the statutory text of Section 301 and 316. Specifically, in his view Section 316 operates to make the shareholder and/or corporation intent irrelevant at the time a distribution is made. Since dividends are defined simply as distributions made from company's earnings and profits at the end of the taxable year, and earnings and profits aren't calculated until the end of the year, it is possible that a distribution made while the company did have earnings and profits will not ultimately qualify as a dividend, if at the end of the taxable year there are no earnings and profits. See id. at 24-25.

The government responds that the contemporaneous intent requirement does not shift the burden of proof unfairly in criminal cases, seemingly acknowledging a point that does not comport with its Truesdell argument that the contemporaneous intent requirement is not found in civil cases. It cites Holland v. United States, 348 U.S. 121, 129-32, 137-38 (1954) for the proposition that the government can show criminal tax evasion by proving an increase in net worth that is not reflected in reported income, and that the government is "not required to negate every possible source of nontaxable income." Brief for Respondent at 32. Here, it argues, it met its burden in proving a case for unreported income by showing that Boulware had received $10 million in unreported funds that were likely diversions from HIE. See id.

The government also argues that this case isn't really about the burden of proof anyway, and that the more important question is what standard to apply in criminal tax cases. This, it says, should be taken from Miller, which holds that for a defendant to meet his burden of proof in a tax evasion case, he must show an intention that the diverted funds were intended to be a distribution with respect to the corporation's stock in addition to the civil elements. See Brief for Respondent at 33.

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Conclusion

The basic argument in this case is whether, for a diversion to qualify as a nontaxable return of capital, the corporation and/or shareholder must have intended it to be one at the time. It is unclear what the long-range effects of this decision will be, since the specific factors that put Michael Boulware in the position he is in - of having been the recipient of a diversion that did not exceed his basis in stock from a corporation that had no earnings or profits - could be unique. But the broader question, of whether the intent requirement imposed by the Ninth Circuit is based in the text of the U.S. Tax Code, and whether it creates an unfair disparity between defendants in civil and criminal tax cases, could have an impact on future criminal tax defendants.

Authors

Prepared by: Carrie Evans

Edited by: Cecelia Sander Cannon

Additional Sources

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