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March 04, 2008

The U.S. Supreme Court yesterday issued a tax decision. It is always notable when the Supreme Court issues a tax case, as they don't seem to much like them. This one, though, doesn't give much for tax planners to work with.

The case involved an owner of a C corporation who diverted funds from the corporation for personal use. Normally these are treated as "constructive dividends" of corporate earnings. The taxpayer was convicted of failing to pay taxes on the constructive dividends.

Under the tax law, you can only have "dividends" if the corporation has "earnings and profits," or "E&P." While E&P is a ancient and obscure tax law concept, it basically means undistributed taxable income, increased by non-taxable income and reduced by non-deductible expenses (like federal income taxes paid) and by prior dividends. If distributions exceed E&P, they are a non-taxable return of capital to the extent the taxpayer has basis in corporate stock; distributions in excess of E&P and basis are taxed as capital gains.

The taxpayer, a Michael Boulware, was prohibited at trial from trying to show that he diverted funds from a corporation with no E&P; that would mean there couldn't be unreported dividends under the tax law. If he can show an absence of E&P, his diversion of may not taxable income by a happy accident. A unanimous Supreme Court reversed the decision and ordered a new trial for Mr. Boulware.

It's hard to see where this does anything for tax planners. We can't exactly recommend that our clients only loot corporations without E&P (This is, however, a strange but true argument for S corporations, as S corporation distributions normally contain no E&P).

The practical effect will be seen in criminal defense. Tax Analysts ($link) got this comment from attorney Bryan Skarlatos:

"Perhaps the most significant aspect of the decision," he said, "is that it reminds criminal tax lawyers to examine whether there really is tax due and owing in every criminal tax case."

If I were facing criminal tax charges, I'd sure hope my attorney wouldn't need that sort of reminder.

Cite: Boulware v. United States, No. 06-1509

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