Diversion of Funds Not Tax Evasion Where Firm Has No Earnings And Profits

The sole shareholder of a corporation that had no earnings and profits and owed money to the shareholder is not liable for income tax evasion under §7201 for diverting funds from corporation, the Second Circuit held.

At trial, T contended he did not owe any tax on the diverted corporate funds. T argued that the diverted funds constituted a nontaxable reduction of the shareholder loan account. The jury found T guilty.

The Second Circuit reversed the conviction, concluding that diversion of funds cannot constitute a criminal offense, despite criminal intent, if no personal tax deficiency exists. The court explained that a conviction under §7201 requires in part that the government prove beyond a reasonable doubt the existence of a tax deficiency. Citing to DiZenzo v. Comr., 348 F.2d 122 (2d Cir. 1965), the court declared that corporate funds lawfully diverted by a shareholder constitute taxable income, and are treated as a constructive dividend to the shareholder, only to the extent that the corporation had earnings and profits during the tax year in which the diversion occurred - the "no earnings and profits, no income" rule.

U.S. v. D'Agostino, No. 97-1336, 2d Cir. (4/30/98).