TAXATION

The process whereby charges are imposed on individuals or property by the legislative branch of the federal government and by many state governments to raise funds for public purposes.

Boulware v. United States

Federal tax law makes it a felony to willfully attempt “in any manner to evade or defeat any tax” imposed by the Internal Revenue Code. A key element of tax evasion is the “existence of a tax deficiency,” which the government must prove beyond a reasonable doubt . A question arose, however, as to whether a person charged with tax evasion who claimed he did not have a deficiency needed to prove that the funds he received from a corporation were nontaxable at the time the distribution occurred. The Supreme Court resolved this issue in Boulware v. United States,—U.S.—,—S.Ct.—,—L.Ed.2d—2008 WL 552880 (2008), ruling that the defendant did not have to make such a showing. It was permissible for the defendant to introduce evidence that the income was nontaxable.

Michael Boulware was charged with tax evasion and filing a false income return, based on his diversion of funds from Hawaiian Isles Enterprises (HIE), a closely held corporation that he controlled as president, founder, and primary, but not sole, shareholder. The government claimed that Boulware had received taxable income by systematically diverting funds from HIE. At his trial the government showed that Boulware had given millions of dollars to his wife and to his girlfriend without reporting any of this money on his personal income tax returns. He diverted corporate funds by writing checks to employees and friends, who then returned the cash to him, by diverting payments by HIE customers, by submitting fraudulent invoices to HIE, and by laundering money through companies in Hong Kong and the Kingdom of Tonga.

Boulware fought these charges by seeking to introduce evidence that HIE had no retained or current earnings and profits in the taxable years in question. He contended that he had in effect received distributions of property that must have been returns of capital, up to his basis in his stock. In other words, he got back what he had put into the corporation, with no income derived from that original investment. The Internal Revenue Service Code states that the portion of any corporate distribution to a shareholder that is not earnings and profits is nontaxable. Boulware argued that because the return of capital was nontaxable, the government could not establish the tax deficiency required to convict him of tax evasion.

The government convinced the federal district court not to allow Boulware to introduce this line of argument, pointing to a 1976 Ninth Circuit Court of Appeals decision that held in a criminal tax evasion case, a diversion of funds may be considered a return of capital only after “some demonstration on the part of the taxpayer and/or the corporation that such [a distribution was] intended to be such a return.” Boulware had not offered to make such a demonstration. A jury convicted Boulware on four counts of tax evasion and five counts of filing a false return. The Ninth Circuit upheld the verdict and its 1976 precedent that imposed an intent requirement on Boulware. One judge concurred in the decision only because the court was required to follow precedent. He thought it illogical that a defendant “may be criminally sanctioned for tax evasion without owing a penny in taxes to the government.” The precedent also contradicted the tax evasion statute , which requires a tax deficiency.

The Supreme Court, in a unanimous decision, vacated the criminal verdict and reversed the Ninth Circuit. Justice David Souter, writing for the Court, found no merit in the 1976 Ninth Circuit case. There was no support for the view that a defendant had to show “contemporaneous intent” that the distribution was a return of capital. The tax consequences on such a distribution depend not on intent but on whether “the corporation had earnings and profits, and the amount of the taxpayer's basis for his stock.” Agreeing with the concurring Ninth Circuit judge, Souter stated that there is “no criminal tax evasion without a tax deficiency, and there is no deficiency owing to a distribution” if the corporation “has no earnings or profits and the value distributed does not exceed the taxpayer-shareholder's basis for his stock.” The Ninth Circuit precedent also failed to note that the contemporaneous intent requirement would be difficult to meet, as the corporation will not know until the end of its fiscal year whether there were earnings or profits. Therefore, Boulware had a right to make his defense based on the lack of a deficiency.

United States v. Clintwood Elkhorn Mining Company

On April 15, 2008, the U.S. Supreme Court issued a ruling where the Court held that coal exporters and producers were barred from recovering for past taxes beyond the period of time covered by the statute of limitations in the Internal Revenue Code (I.R.C.). The case of United States v. Clintwood Elkhorn Mining Co.,—U.S.—, 128 S. Ct. 1511,—L. Ed. 2d—(2008) resolved a potential conflict between the I.R.C. and the Tucker Act, which allows a private party to sue the government under some circumstances.

Congress first imposed the Coal Excise Tax in 1978 in order to finance the Black Lung Disability Trust Fund. The tax was rather unique in that it applied to all sales of coal, irrespective of whether the coal was sold domestically or was exported. Coal exporters brought suit against the United States, arguing that the tax violated the Constitution. More specifically, the companies pointed to the Export Clause of Article 1, Section 9 of the Constitution, which states that “[n]o Tax or Duty shall be laid on Articles exported from any State.” The U.S. District Court for the Eastern District of Virginia ruled that the Coal Excise Tax indeed violated the Export Clause, noting that the Supreme Court in the past had “broadly proscribed excise taxes levied on a variety of goods.” Ranger Fuel Corp. v. United States, 33 F. Supp. 2d 466 (E.D. Va. 1998). Two years later, the Internal Revenue Service (IRS) acquiesced in the decision in Ranger Fuel. IRS Notice 2000-28, 2000-1 Cumm. Bull. 1116.

Under the I.R.C., a taxpayer who seeks a refund of a tax that was erroneously or unlawfully assessed may file an action against the United States in either a U.S. district court or the U.S. Court of Federal Claims. Before filing such a suit, however, the taxpayer must comply with the I.R.C.'s tax refund scheme. I.R.C. 7422. The claim must also be brought in a timely manner. Under I.R.C. 6511, a taxpayer who seeks a “refund of an overpayment of any tax imposed by [the tax code] in respect of which tax the taxpayer is required to file a return” must file the return no later than three years from the time the return was filed, or two years from the time that the tax was paid (whichever is later). The section also states that “[n]o credit or refund shall be allowed or made” of the claim is not filed within the appropriate time limits.

Several coal producers and exporters, including Clintwood Elkhorn Mining Company, had paid excise taxes on their coal until the I.R.S. had acquiesced to the Ranger Fuel decision. In response to that decision, Clintwood Elkhorn and other companies in 2000 filed administrative claims with the I.R.S., requesting refunds for excise taxes. These claims could only cover the three-year period prior to this filing, due to the requirements of § 6511. The I.R.S. complied, refunding taxes for the years of 1997, 1998, and 1999.

In addition to the administrative claim filed with the I.R.S., the companies filed suit in the Court of Federal Claims, where they sought to recover a total of $1,065,936 for taxes paid in 1994, 1995, and 1996. The companies based their claim on the Tucker Act, which allows private citizens to sue the United States government. Under 28 U.S.C. § 1491, claims under the Tucker Act may be brought within six years of the time that the claim was filed.

The Court of Federal Claims relied on the Federal Circuit's decision in Cyprus Amax Coal Co. v. United States, 205 F.3d 1369 (Fed. Cir. 2000). In that case, the Federal Circuit held that the Excise Clause gave a party an independent cause of action under the Tucker Act, meaning that the party did not have to first file an administrative claim. The Court of Federal Claims allowed the companies to recover based on the Tucker Act, although the court would not allow recovery of interest. Andalex Resources, Inc. v. United States, 54 Fed. Cl. 563 (2002). On appeal, the Federal Circuit refused to revisit the holding of Cyprus Amax and held that the companies could bring their claims under the Tucker Act. Moreover, the appellate court reversed the Court of Federal Claims and held that the companies could recover interest. Clintwood Elkhorn Mining Co. v. United States, 473 F.3d 1373 (Fed. Cir. 2007).

The government sought an appeal from the Supreme Court, and the Court granted a writ of certiorari , and the Court agreed to hear the case. In a unanimous decision, the Court sided with the government, holding that the companies were barred from bringing suit for the taxes covering the period of 1994 to 1996. Writing for the Court, Chief Justice John Roberts focused primarily on the statutory language of I.R.C. 7422, which states that “[n]o suit … shall be maintained in any court for the recovery of any internal revenue tax alleged to have been erroneously or illegally assessed or collected, or of any penalty claimed to have been collected without authority, or of any sum alleged to have been excessive or in any manner wrongfully collected, until a claim for refund … has been duly filed with” the IRS. Commented Roberts, “Five ‘any's’ in one sentence and it begins to seem that Congress meant the statute to have expansive reach.”

The companies tried to argue that the language regarding the I.R.C.'s requirements is ambiguous. The Court, however, flatly rejected this premise. “The companies argue that these statutory provisions are ambiguous …, but we cannot imagine what language could more clearly state that taxpayers seeking refunds of unlawfully assessed taxes much comply with the Code's refund scheme before bringing suit, including the requirement to file a timely administrative claim.”

The companies focused much of their attention on their argument that the Tucker Act establishes an independent cause of action against the government. The Court refused to decide whether this was true, because the Court determined that it did not matter to the outcome of the case. The Court likewise rejected the companies' arguments that claims for refunds of taxes paid in violation of the Export Clause should be treated any differently than other types of refund cases. Accordingly, the Court reversed the Federal Circuit's opinion.

Knight v. Commissioner of Internal Revenue

The intricacies and ambiguities of the Internal Revenue Code keep legions of accountants and financial planners well-employed. The U.S. Supreme Court infrequently wades into tax law to settle disputes within the circuit courts of appeals on how to interpret a particular code provision. Such was the case in Knight v. Commissioner of Internal Revenue,—U.S.—, 128 S.Ct.782,—L.Ed.2d—(2008), where the legal debate was focused on the deductibility of certain trust expenses. The Internal Revenue Service (IRS) ruled that the trust expenses were limited to an amount that exceeds 2 percent of gross adjusted income. The trust administrator argued that the trust was entitled to deduct the entire amount of the expense. The Court, in a case of statutory construction, ruled that the law clearly meant to limit the deductible amount.

Michael Knight was the trustee of the William Rudkin trust, which was established in Connecticut in 1967. In 2000, Knight hired a financial advising firm to provide its expertise on management of the trust. The trust paid the firm over $22,000 that year and its fiduciary income tax return for 2000 reported total income of $624,000. It deducted the entire $22,000 on the return but a later IRS audit found that these fees were miscellaneous itemized deductions subject to the 2 percent floor. The IRS allowed the trust to deduct the investment advising fees only to the extent that they exceeded 2 percent of adjusted gross income . This resulted in a tax deficiency of $4,448. Knight filed a petition in the U.S. Tax Court seeking review of this decision. He contended that under Connecticut state law he was required to obtain investment advisory services and therefore had to pay the associated fees. These fees, he argued, were unique to trusts and therefore were fully deductible under 26 U.S.C. 67(e)(1). The Tax Court disagreed, ruling that this statute only applied to expenses that are not commonly incurred outside the trust setting. Investment advice is purchased by many individuals, so the trust expenses were subject to the 2 percent floor. The Circuit Court for the Second Circuit upheld the Tax Court decision.

The Supreme Court, in a unanimous decision, agreed that the fees were not fully deductible. Chief Justice John Robert, writing for the Court, noted that before 1986 itemized deductions were deductible in full. However, this system was complex and could be used, requiring extensive taxpayer record-keeping for small expenditures. Enforcing this part of the tax code was also taking a toll on IRS resources. The Tax Reform Actof 1986, 100 Stat. 2085, changed this policy, placing the 2 percent floor on miscellaneous itemized deductions for any taxable year to the extent that aggregate of these deductions exceeds 2 percent of adjusted gross income . Investment advisory fees are deductible as miscellaneous itemized deductions, as the Code does note this as of one the categories that is fully deductible. Under § 67(e), trust expenses can be fully deductible if they “would not have been incurred if the property were not held in such trust or estate.”

Knight had argued that this exception established a “straightforward causation test.” The proper inquiry was whether a trust expense “was caused by the fact that the property was held in trust or estate.” In this case the investment fees met the test because the costs were caused by the trustee's obligation to obtain financial advice in compliance with the trustee's fiduciary duties. Chief Justice Roberts was not persuaded. He pointed out that all or nearly all of a trust's expenses were incurred because the trustee has a duty to incur them: “otherwise, there would be no reason for the trust to incur the expense in the first place.” The argument offered by Knight was circular: “Trust investment advice fees are caused by the fact the property is held in trust.” If Knight's position was correct there would have been no need for Congress to insert the exception clause.

The Court ruled that the test adopted by Fourth and Federal Circuit Courts of Appeals was correct. Under this test costs incurred by trusts that escape the 2 percent floor are those that would not “commonly” or “customarily” be incurred by individuals. In this case Chief Justice Roberts noted that it was “not uncommon or unusual for individuals to hire an investment adviser.” Therefore, the trust's financial advisory expenses were not fully tax-deductible.

MeadWestvaco v. Illinois Department of Revenue

The question before the U.S. Supreme Court in MeadWestvaco Corp. v. Illinois Department of Revenue No. 06-1413, 553 U.S.—(2008), was whether and under what circumstances a parent company may use a division as a non-taxable “investment” and thus avoid state tax consequences when the division is sold. An unanimous Supreme Court remanded the case to the Illinois Appellate Court for renewed analysis and determination under U.S. Supreme Court precedent.

MeadWestvaco, the petitioner, was the successor in interest to its wholly owned subsidiary known as the Mead Corporation (Mead), an Ohio company. In 1968, Mead bought Data Corporation. At that time, Mead dealt mainly in paper products and school supplies, and made the purchase because Data Corporation owned ink-jet printing technology that Mead was interested in acquiring. Data Corporation's business at that time also included an information technology component that ultimately developed into Lexis/Nexis, a leader in the field of electronic legal, business, and news research software tools.

In 1994, Mead sold Lexis/Nexis for approximately $1.5 billion and realized just over $1 billion in gain. However, it did not report any of this gain as business income on its Illinois tax return for 1994. Instead, it took the position that the gain qualified as non-business income that should be allocated to Mead's domiciliary state of Ohio, under Illinois's Income Tax Act (ITA)[Ill. Comp. Stat. Ch. 35, § 5/303(a)]. But according to the State of Illinois, after auditing Mead's return, the ITA required Mead to treat the capital gain from the sale as taxable business income. Mead paid the tax, then filed suit in state court.

The relevant provision in the ITA allows the state to tax a non-domiciliary corporation that conducts business in Illinois on business income that is derived from, or “apportioned to,” its business in Illinois. Under the ITA, taxable business income includes income from intangible property, such as a corporation's subsidiaries. However, the “apportionment” referenced in the ITA is subject to constitutional limits of the Due Process and Commerce clauses. Accordingly, income from intangible property is only apportionable if the business and the intangible property are so closely related that they can be considered a singular entity (a “unitary business”). In the alternative, the intangible property must be necessary to the operation of the business (an “operational function”).

The state trial court rejected Illinois' argument that Mead and Lexis/Nexis were a unitary business, but it found that, in the alternative, the gain was apportionable business income, because Lexis/Nexis served an operational function. Mead appealed to the Appellate Court of Illinois. That court upheld the apportionment tax and affirmed the judgment in the state's favor.

But the U.S. Supreme Court concluded that the state courts had “misapprehended the principles that we have developed for determining whether a multistate business is unitary …” The high court vacated the decision of the Appellate Court of Illinois and remanded for further proceedings consistent with prior Supreme Court precedent.

To wit, the Supreme Court had previously held that the Due Process and Commerce Clauses prohibited states to tax “extraterritorial values.” Container Corp. Of America v. Franchise Tax Bd., 463 U.S. 159 (1983). The “unitary business” language came from Hunt-Wesson, Inc. v. Franchise Tax Bd. Of Cal., 528 U.S. 458 (2000), in which the Court held that a state may tax an apportioned share of the value generated by intrastate and extrastate activities of a multistate enterprise, if those activities form part of a unitary business.

Justice Alito delivered the opinion for an unanimous Supreme Court. Because in this case, Mead did business in Illinois, the inquiry shifted from whether Illinois may tax Mead, to what it may tax, wrote Alito. Under the unitary business principle, a state need not “isolate the intrastate income-producing activities from the rest of the business.” Instead, it may “tax an apportioned sum of the corporation's multistate business if the business is unitary.” (quoting from Allied-Signal, Inc. v. Director, Div. Of Taxation, 504 U.S. 768.

Justice Alito concluded that the Appellate Court of Illinois was misguided in applying an “operational function” test. Instead, said Alito, because in this case the “asset” was another business, the state appellate court should have looked for the existence of “functional integration, centralized management, and economies of scale.” Mobil Oil Corp. v. Commissioner of Taxes of Vt., 445 U.S. 425. This would be the proper examination to determine whether or not the two were a unitary business for tax purposes. Because the appellate court had relied on its operational function test instead, on remand, it should re-examine under the unitary business question, the Court concluded.

Justice Thomas wrote a separate opinion in which he concurred in the results but opined that the Court should refrain from jurisdiction over state tax cases.