U.S. Income Series

Procedure and Administration
Portfolio 636-2nd: Tax Crimes
II. Corporate Criminal Liability
D. The Nature of Corporate Tax Crimes
4. Diversion of Corporate Funds to...
4. Diversion of Corporate Funds to Personal Use

One of the more common corporate tax problems is the payment and deduction of personal expenses by a corporation. Individuals who are sole owners or principal stockholders of corporations sometimes attempt to evade both their own taxes and corporate taxes by altering corporate records or receipts. Such schemes might consist of an overstatement of purchases through the use of false invoices and checks, or claims of personal expenses on the books of the corporation. Thus, the diversion of corporate funds for individual use might result in charges of both corporate and personal tax evasion. 439

/Footnote/ 439 See, e.g., U.S. v. Schenck, 126 F.2d 702 (2d Cir. 1942), cert. denied, 316 U.S. 705 (1942).

In light of the Supreme Court holding in James v. U.S. 440 that embezzled funds are taxable, taxpayers may no longer argue that diverted corporate income is nontaxable to the individual. With regard to the corporation's taxes, the argument is occasionally made that the evasion charge cannot be sustained because there would be an offsetting "embezzlement" loss and, therefore, no tax deficiency. Under §165(e), embezzlement losses are deductible in the year of discovery. Thus, an officer-stockholder may contend that his own knowledge at the time of the taking of the corporate funds constitutes "discovery" for purposes of §165(e). This argument is unsound in two respects. First, the typical defendant usually has such ownership and control of the corporation that he cannot be held to "embezzle" from his own corporation. Second, as long as the defendant has signed the corporate returns "under the penalty of perjury," the understatement of receipts or the overstatement of purchases would be false as to a material matter and, therefore, in violation of §7206(1). 441

/Footnote/ 440 366 U.S. 213 (1961).

/Footnote/ 441 See U.S. v. Jernigan, 411 F.2d 471 (5th Cir. 1969), cert. denied, 396 U.S. 927 (1969); U.S. v. Rayor, 204 F. Supp. 486 (S.D. Cal. 1962), reh'g denied, 323 F.2d 519 (9th Cir. 1963), cert. denied, 375 U.S. 993 (1963).

When funds are diverted by a defendant-shareholder, the payment is usually treated as a "constructive" dividend to the shareholder. According to §316, a "dividend" is a distribution made by a corporation to its shareholders out of its accumulated earnings and profits, or out of its earnings and profits for the taxable year. Thus, proof in this type of criminal case would necessarily include an analysis of the corporate surplus as well as a computation of the "constructive" dividend out of this surplus. 442 The court in Davis v. U.S., 443 however, held that where the taxpayer diverted the income of a wholly owned corporation for his own use, such income was taxable to him regardless of whether the corporation had sufficient surplus to make the distribution in the form of a dividend or whether the corporate creditors might challenge the transaction. 444

/Footnote/ 442 Bernstein v. U.S., 234 F.2d 475 (5th Cir. 1956), cert. denied, 352 U.S. 915 (1957), reh'g denied, 352 U.S. 977 (1957). See U.S. v. D'Agostino, 145 F.3d 69 (2d Cir. 1998) (sole shareholder who diverted fans from firm which had no earnings and profits is not a tax evader). See also U.S. v. Bok, 156 F.3d 157 (2d Cir. 1998) (defendant accused of using corporate funds to pay personal expenses must establish some foundation in the record to justify a jury instruction on a return of capital theory).

/Footnote/ 443 226 F.2d 331 (6th Cir. 1955), cert. denied, 50 U.S. 965 (1955), reh'g denied, 351 U.S. 915 (1956).

/Footnote/ 444 Accord Hartman v. U.S., 245 F.2d 349 (8th Cir. 1957).

See also U.S. v. Miller, 545 F.2d 1204 (9th Cir. 1976), cert. denied, 430 U.S. 930 (1977).

Since the prosecution in constructive dividend cases will attempt to prove that sufficient corporate earnings were available, some defendants have argued that any fraud penalty imposed 445 should be deducted from corporate earnings, leaving the constructive dividends to be computed from whatever earned surplus remains. Although this argument has found support with respect to the assessment of tax deficiencies in civil cases, 446 it does not apply to criminal tax evasion cases. 447

/Footnote/ 445 See §6663(a) and Regs. Section 1.6664-1. For returns due before January 1, 1990, see former §6653(b), repealed by P.L. 101-239, §7721.

/Footnote/ 446 Drybrough v. Comr., 238 F.2d 735 (6th Cir. 1956).

/Footnote/ 447 See Bernstein v. U.S., above, 234 F.2d at 482.

Comment: Many taxpayers believe that "living" out of the corporate pocketbook is simply not a criminal violation. The view adopted reflects a benign attitude, i.e., the discovery of such irregularities will merely result in civil tax deficiencies plus penalties. U.S. v. Helmsley 448 teaches us that this benign attitude is not justified. There is a danger, however, that many taxpayers will not relate to the Helmsley case and its consequences because of the large amounts of money that were involved. In fact, criminal cases have been pursued for such diversions even when the amounts were much lower. There is no general rule that can be enunciated.

/Footnote/ 448 941 F.2d 71 (2d Cir. 1991), cert. denied, 112 S. Ct. 1162 (1992).