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Must a Person Owe Tax to be Guilty of Tax Evasion?

By Barry C. Feldman

The United States Supreme Court has resolved a split in the circuits on what would seem to be an elemental rule of tax law – to be guilty of Federal income tax evasion, there must be a tax due that the person sought to evade. In a recent case, the defendant was charged with tax evasion based upon his having diverted funds from his closely-held (though not solely owned) corporation. At trial, he tried to introduce evidence to establish that the corporation had no earnings and profits, either current or retained, at the close of the years in issue, so that the distributions or diversions of funds amounted to a non-taxable return of capital, as provided in the Internal Revenue Code of 1986. The District Court refused to permit the introduction of such evidence, relying upon a 1976 decision which held that a defendant must first establish an intent to make a return of capital at the time of diversion before he can argue that the diversion was such a return of capital.

The Supreme Court unanimously reversed the decision and sent the case back to the District Court for a new trial. The Court pointed out that the 1976 opinion was inconsistent with the Internal Revenue Code which says that a distribution is a dividend only to the extent that there are corporate earning and profits. If the distribution exceeds earnings and profits (current and retained), the excess is treated as a non-taxable return of capital to the extent of the shareholder’s basis in his stock, with any excess above that constituting capital gain. Thus, intent is irrelevant in determining the nature of the distribution, as it is computational in nature.

The Court’s decision is in agreement with a 1998 opinion which noted that, in the absence of a tax deficiency, there is merely an intent to evade taxation and the Internal Revenue Code does not punish bad intentions alone. This avoids convicting a person of tax evasion where the distributions did not result in a deficiency in tax, and therefore no tax being evaded.

The Supreme Court’s decision puts to rest a controversy which should have been obvious – a person cannot be guilty of tax evasion unless there was a tax to be evaded and the determination of whether there was a tax due rests not with anyone’s intent, but rather lies with the provision of the Code dealing with the computation of tax for civil purposes.

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