Argument Preview

When a corporation without any profits diverts funds to a shareholder, is this diversion a nontaxable return on capital up to the shareholder's basis in the corporation under 26 U.S.C. § 301(c)(2), even if the shareholder did not intend it as such? On January 8, 2008, the Supreme Court will consider this question in No. 06-1509, Boulware v. United States.


26 U.S.C. § 301 provides that a distribution of property from a corporation to a shareholder is taxed as ordinary income if it is a dividend and as a capital gain if it is a return on capital that exceeds basis. However, such a distribution is not taxed if it is not a dividend and does not exceed the shareholder's basis in the corporation. 26 U.S.C. § 316 in turn defines dividends as distributions of the earnings or profits of a corporation; absent an exception, all distributions are dividends to the extent of the corporation's earnings or profits. In combination, these statutes establish the "return of capital" rule: a shareholder is not taxed on disbursements of corporate funds when he is merely recovering his basis in the stock.

Petitioner Michael Boulware was the founder, president, and majority shareholder of Hawaiian Isles Enterprises ("HIE"), a closely held corporation selling tobacco, coffee, bottled water, and other goods. Boulware was convicted on several counts of tax evasion and tax fraud arising out of his failure to report approximately $10 million in funds he had diverted from the corporation. However, the Ninth Circuit initially reversed this conviction based on the trial court's failure to admit the holding of a related state case as evidence concerning the ownership of a portion of the dispersed funds.

On retrial, Boulware was again convicted on all counts, and the Ninth Circuit affirmed on appeal. The Ninth Circuit rejected Boulware's argument that because the disbursements were a return on capital, there was no tax deficiency upon which to rest a criminal conviction. Relying on its precedent in United States v. Miller, the court of appeals held that the disbursement could not be considered a return on capital unless Boulware could show that he intended them as such when they were made.

Petition for Certiorari

Boulware filed a petition for certiorari asking the Court to review (1) whether the Hawaii state court adjudication of some of the diverted funds from HIE is controlling and (2) whether evidence of intent is needed to argue return of capital in a criminal case. The petition highlighted the circuit split between the Ninth Circuit's Miller case and the Second Circuit's 1998 holding that no showing of intent is required for a defendant to make a return-of-capital defense. Opposing certiorari, the government acknowledged the circuit split but argued that this case was not an appropriate vehicle for resolving it. The government maintained that even if Boulware did not need to show intent to put forward a return-of-capital defense, the case's outcome would not change because the diversion of funds from HIE to Boulware was unlawful. D'Agostino explicitly carves out unlawful distributions from its holding. The Supreme Court granted Boulware's petition, but limited its review to the question of "[w]hether the diversion of corporate funds to a shareholder of a corporation without earnings and profits automatically qualifies as a non-taxable return of capital up to the shareholder's stock basiseven if the diversion was not intended as a return of capital." This formulation of the question mirrors that of the government's brief, and is a departure from the question presented in Boulware's petition.

Merits Briefing

In his merits brief, Boulware reiterates the arguments he made at the cert. stage concerning the return-of-capital rule. First, he contends that the Ninth Circuit had no statutory basis for creating the Miller contemporaneous intent requirement. Boulware argued that, under the federal statutes, a criminal defendant may rely on a return-of-capital defense as long as he can show that (1) the corporation had no profits; and (2) the shareholder's basis exceeded the amount distributed. Thus, there is no statutory basis for Miller's additional requirement that the defendant show that the distribution was intended as a return of capital when made. He also asserts that Miller's rationale for the contemporaneous intent requirement ignores the statutory requirement that a tax deficiency must exist to prosecute criminal tax evasion cases. In Miller the Ninth Circuit reasoned that criminal tax statutes are concerned with the taxpayer's intent to file a fraudulent tax return, rather than whether a tax deficiency actually exists. Moreover, Boulware contended that the divergence between civil and criminal law creates the potential for anomalous situations in which a taxpayer has no deficiency under civil law, but can nonetheless be convicted of criminal tax evasion based on a deficiency.

Boulware next turns to the government's argument that any error was harmless because the return-of-capital defense cannot be asserted when the distributions are unlawful. He contends that Sections 301 and 316 do not distinguish between lawful and unlawful distributions, and although unlawful distributions may have other civil and criminal consequences, this issue is irrelevant to tax treatment under the return-of-capital rule.

Finally, Boulware maintains that even if the government prevails and the return-of-capital rule does not apply to unlawful distributions, a new trial is required to determine whether the distributions at issue in this particular case were lawful or not.

In its brief on the merits, respondent United States argues that, pursuant to Section 301(a), the return-of-capital rule applies only to distributions "with respect to [the corporation's] stock." The United States contends that because this phrase "limits return-of-capital treatment to payments that are made to a shareholder by reason of his status as such," the rule does not apply to shareholders who receive funds in a non-shareholder capacity, such as that of an employee or embezzler.

The United States further contends that failing to impose Miller's contemporaneous intent requirement would promote fraud. Specifically, it explains, if such fraud is detected, the return-of-capital rule would immunize the shareholder from prosecution; however, if it is not detected, years later the shareholder could again receive corporate funds tax-free as a return of capital. The United States next argues that Miller's contemporaneous intent requirement does not create a disparity in the tax status of distributions to shareholders in the criminal and civil contexts because both areas of law apply essentially the same "facts and circumstances" test.

Finally, the United States argues that even if the Court were to adopt the D'Agostino test, eliminating Miller's contemporaneous intent requirement, Boulware would still be guilty because the distribution of funds were unlawful, not "with respect to [the corporation's] stock," and thus not subject to the return of capital rule.

Oral argument in the case is scheduled for January 8, 2008.

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