UNITED STATES of America, Plaintiff-Appellee, v. Michael KAYSER, Defendant-Appellant, 488 F.3d 1070

Opinion by Judge IKUTA; Dissent by Judge KOZINSKI. IKUTA, Circuit Judge. Michael Kayser appeals from his conviction for tax evasion in violation of 26 U.S.C. § 7201 for the year 2000. He alleges, among other things, that the district court erred in failing to instruct the jury in accordance with his theory of defense. We have jurisdiction under 28 U.S.C. § 1291 and we reverse and remand. BACKGROUND From November 1998 to May 2000, A2Z USA, Inc. (“A2Z”) employed Kayser first as a salesperson and later as a vice president for its Internet-based shopping mall.

A2Z compensated Kayser as an independent contractor and paid him a commission by checks made out to his name. In July 1999, Kayser incorporated Aspen Ventures Inc. (“Aspen Ventures”) to receive A2Z income and take business deductions related to that income. After failing to file timely tax returns for 1998 through 2000, Kayser ultimately filed his delinquent individual and corporate tax returns for those years in August 2001. Kayser was subsequently indicted on two counts of attempted income tax evasion (for 1999 and 2000) in violation of 26 U.S.C. § 7201.

At trial, the government alleged that Kayser had improperly structured his individual and Aspen Ventures’ corporate returns for 1999 and 2000 to evade the payment of taxes on his A2Z activities. For the year 1999 (count 1), the government contended that Kayser received $104,000 of A2Z income that should have been reported on his individual return, but Kayser improperly reported this income on Aspen Ventures’ corporate return. For the year 2000 (count 2), the government showed that Kayser failed to report his A2Z income on either his individual or Aspen Ventures’ corporate return.

However, Kayser did report $49,026 in deductible business expenses on Aspen Ventures’ 2000 return. These deductions were composed of automobile expenses, office expenses, utilities, travel and entertainment expenses, and rents. Kayser’s accountant testified that the deductions were calculated from receipts and records maintained by Kayser. As reported, the expenses generated a net operating loss of $49,026 on Aspen Ventures’ 2000 return, which Kayser then carried back to eliminate the corporate taxes owed by Aspen Ventures on the income it reported for 1999.

The government alleged that Kayser willfully structured his individual and corporate returns in the manner described above to evade taxes, and that as a result of this improper reporting, Kayser was able to declare virtually no tax due on the $145,000 or more he received from A2Z as income in 1999 and 2000. At trial, Kayser’s primary theory of defense was that he had not willfully evaded paying taxes.

During the course of the trial, Kayser raised a second theory, namely, that the A2Z income he failed to report on his individual return in 2000 should be offset by the $49,026 in business deductions he improperly reported on Aspen Ventures’ corporate returns in 2000 and carried back to 1999. This theory was supported by two principal pieces of evidence. First, Kayser testified that he incurred the entire $49,026 in business deductions in connection with the production of the individual A2Z income he received in 2000.

In addition, Kayser’s accountant and the government’s expert both testified that an independent contractor’s legitimate and allowable business deductions could generally be used to reduce business income on an individual return.

On the last day of trial, Kayser asked the district court to approve the following jury instruction: “If the defendant had unclaimed deductions which would have offset his tax liability such that there was no tax due and owing, then there is no tax deficiency.” The government argued that this instruction was unwarranted because Kayser had introduced no evidence of previously “unclaimed” deductions. The government also argued that Kayser’s theory of defense was improper under United States v.

Miller, 545 F.2d 1204 (9th Cir. 1976), which the government read as precluding Kayser from arguing that the business deductions he reported on Aspen Ventures’ returns could be used to negate his individual tax deficiency. The district court agreed with the government and declined to give the requested instruction. The district court noted that the evidence did not support the instruction and also implicitly agreed with the government’s argument that Miller precluded the theory of defense in this case.

Following trial, the jury found Kayser guilty of tax evasion for the year 2000, but failed to reach a unanimous verdict on the count concerning tax evasion in 1999. On appeal, Kayser argues that the district court erred by rejecting his proposed jury instruction. DISCUSSION Kayser contends he was entitled to a jury instruction on his theory that the government could not prove there was a tax deficiency in 2000 if Kayser had sufficient allowable business expenses to offset his unreported A2Z income for that year.

Our cases hold that “[a] defendant is entitled to have the judge instruct the jury on his theory of defense, provided that it is supported by law and has some foundation in the evidence.” United States v. Fejes, 232 F.3d 696, 702 (9th Cir.2000) (internal quotations omitted). Here, the district court declined to give Kayser’s proposed instruction on two grounds, namely, that the instruction was erroneous as a matter of law under United States v. Miller, 545 F.2d 1204 (9th Cir.1976) and that the evidence was insufficient to support the instruction. We examine both of these determinations in turn. A.

We first consider whether Kay-ser’s proposed instruction was erroneous as a matter of law. The elements of attempted income tax evasion under 26 U.S.C. § 7201 are: (1) willfulness; (2) the existence of a tax deficiency; and (3) an affirmative act constituting an evasion or attempted evasion of the tax. Sansone v. United States, 380 U.S. 343, 351, 85 S.Ct. 1004, 13 L.Ed.2d 882 (1965); see also United States v. Marashi, 913 F.2d 724, 735 (9th Cir.1990). A tax deficiency occurs when a defendant owes more federal income tax for the applicable tax year than was declared due on the defendant’s income tax return.

See 9th Cir. Crim. Jury Instr. 9.35 (2005). A defendant may negate the element of tax deficiency in a tax evasion case with evidence of unreported deductions. See United States v. Marabelles, 724 F.2d 1374, 1378-79 (9th Cir.1984); Elwert v. United States, 231 F.2d 928, 933 (9th Cir.1956). Both Marabelles and Elwert involved small business owners who (among other things) under-reported their income for one or more years. Marabelles, 724 F.2d at 1378-79; Elwert, 231 F.2d at 933-34.

At trial for criminal tax evasion, the defendants introduced evidence of deductions for labor costs that had not been claimed on their returns in order to disprove the element of tax deficiency. Marabelles, 724 F.2d at 1378-79; Elwert, 231 F.2d at 933-34.

In rejecting the defendants’ challenges to the sufficiency of the evidence supporting their respective convictions, we held that “the burden is on the defendant to prove that he had allowable deductions that were not shown in his return, once the Government establishes unreported income and allows the deductions claimed by the defendant in [his] return and others that it can calculate without his assistance.” Marabelles, 724 F.2d at 1379 n. 3; Elwert, 231 F.2d at 933. Notwithstanding the greater sophistication of Kayser’s alleged tax evasion scheme, Marabelles and ElweH are controlling in Kayser’s case.

Like the defendants in those cases, Kayser failed to report income on his individual return and was entitled to demonstrate at trial that he had deductions that could offset this previously unreported income. See Marabelles, 724 F.2d at 1379 n. 3; Elwert, 231 F.2d at 933. The government, however, argues that United States v. Miller prohibits a defendant who reports his income and deductions in one manner from arguing for an alternative characterization at trial.

See Miller, 545 F.2d at 1215 (rejecting defendant’s “return-of-capital” defense because the defendant “presented no concrete proof that the amounts were considered, intended, or recorded on the corporate records as a return of capital at the time they were made”); see also United States v. Boulware (Boulware II), 470 F.3d 931, 935 (9th Cir.2006) (same).

The government thus contends that Kayser’s decision to report the $49,026 in business expenses on Aspen Ventures’ returns prevents Kay-ser from now arguing that these expenses were actually incurred by him individually in relation to his A2Z activities as an independent contractor. Contrary to the government’s argument, Miller does not preclude a defendant in a tax evasion case from asserting a defense that is inconsistent with information falsely reported on his challenged tax returns. Miller, 545 F.2d at 1215-16.

Rather, Miller allows a defendant to present evidence at trial regarding the facts of the transaction at issue, notwithstanding the defendant’s improper or “scrambled” reporting of those facts. Id. In Miller, the government alleged that the defendant had diverted substantial sums from his closely held corporation and failed to report the funds as income. Id. at 1209. The diverted funds had been recorded on the corporation’s books as “repayments of loans,” which were later shown to be non-existent or false. Id. at 1209, 1215-16.

Miller tried to convince the district court to apply certain technical tax rules to transform a taxable diversion of funds into a non-taxable return of capital. Id. at 1210-14. Miller argued that a court must automatically treat funds diverted by a shareholder from a closely held corporation as a constructive corporate distribution, pursuant to a rule established in civil tax decisions. Id. Under the facts of his case, Miller contended that such a distribution would be a non-taxable return of capital. Id. at 1211 & n. 9.

Therefore, the government could not prove a tax deficiency and Miller could not be convicted of tax evasion. Id. at 1211-12. We rejected Miller’s theory, holding that the civil constructive distribution rules did not automatically apply in a criminal tax evasion case. Id. at 1214-15. Instead, we held that a criminal defendant wishing to raise a “return-of-capital” defense had to introduce evidence that the diverted funds were, in fact, a return of capital. Id. at 1215.

For example, the defendant could demonstrate that the diverted funds were intended to be a return of capital by showing an adjustment in the corporate records indicating a reduction in his basis at the time of distribution. See id. at 1215. Consistent with this ruling, Miller was allowed to present evidence to establish his return-of-capital defense at trial. See id. at 1215-16. However, the record did not support his defense: among other things, there was a substantial question whether Miller was even a shareholder of the corporation who could receive payments as a return of capital. Id.

Based on the evidence, the district court concluded that the diverted funds constituted additional taxable salary, rather than a non-taxable return of capital. Id. at 1215. We held that the district court’s conclusion was not clearly erroneous. Id. at 1215-16. Neither we nor the district court suggested that Miller was bound by the original characterization of the diverted funds, i.e., the corporation’s characterization of the diverted funds as “repayments of loans” or Miller’s failure to report the diverted funds on his tax returns. Id. at 1214-16.

Rather, we concluded that “whether diverted funds constitute constructive corporate distributions depends on the factual circumstances involved in each case under consideration,” id. at 1214, and the demonstration made by the defendant at trial, id. at 1215. The import of our holding in Miller is that a defendant remains free to present evidence that funds diverted from a corporation are a non-taxable return of capital, regardless of the manner in which he or the corporation originally reported the transaction. See id. at 1214-16; see also Boulware II, 470 F.3d at 934-35.

Miller is thus consistent with Marabelles and El-wert, which provide the controlling authority in this case. Like Miller, Marabelles and Elwert permit defendants to present evidence at trial to establish the nature of their business transactions — including their actual business deductions — even when the position they take at trial is inconsistent with their original tax report-ings. Marabelles, 724 F.2d at 1379 n. 3; Elwert, 231 F.2d at 933.

Following Marabelles and Elwert, we hold that if Kayser had business expenses that were allowable offsets against his individual income, he had the right to show them and explain them as part of his defense for tax evasion. Marabelles, 724 F.2d at 1379 n. 3; Elwert, 231 F.2d at 933. The fact that Kayser improperly reported the deductions he now claims negate his individual deficiency, while the defendants in Marabelles and Elwert simply failed to report certain deductions, does not alter our conclusion.

Kayser’s improper report of deductions on his corporate return does not change the underlying nature of these expenses, although the filing of a false return itself may constitute a separate offense. See 26 U.S.C. § 7206(1). When the Supreme Court held that a tax deficiency is a necessary element of tax evasion under

section 7201, it made no exception for cases where the defendant owed no tax to the government but had improperly reported the underlying income and deductions that demonstrated this lack of a tax deficiency. See Lawn v. United States, 355 U.S. 339, 361, 78 S.Ct. 311, 2 L.Ed.2d 321 (1958); Sansone, 380 U.S. at 351, 354, 85 S.Ct. 1004.

Therefore, Kay-ser’s prior report of $49,026 in deductions on Aspen Ventures’ returns does not preclude him from now arguing that these deductions are offsets to his individual A2Z income, provided that he carries the burden of demonstrating the legitimacy and allowability of these deductions. See Marabelles, 724 F.2d at 1379 n. 3 (“the burden is on the defendant to prove that he had allowable deductions that were not shown in his return” (emphasis added) (citing Elwert, 231 F.2d at 933)). B.

Having concluded that Kayser’s theory of defense represents a correct application of Marabelles and Elwert, we next turn to the question whether Kayser established an adequate foundation in the record to warrant an instruction on this theory. The legal standard is generous: “a defendant is entitled to an instruction concerning his theory of the case if the theory is legally sound and evidence in the case makes it applicable, even if the evidence is weak, insufficient, inconsistent, or of doubtful credibility.” United States v. Washington, 819 F.2d 221, 225 (9th Cir.1987).

A defendant needs to show only that “there is evidence upon which the jury could rationally sustain the defense.” United States v. Jackson, 726 F.2d 1466, 1468 (9th Cir.1984) (per curiam); see also United States v. Johnson, 459 F.3d 990, 993 (9th Cir.2006). Where, as here, factual disputes are raised, this standard protects the defendant’s right to have questions of evidentiary weight and credibility resolved by the jury. Jackson, 726 F.2d at 1468; see also Johnson, 459 F.3d at 993.

We review the district court’s conclusion that Kayser’s proposed instruction was not supported by sufficient evidence for an abuse of discretion. Fejes, 232 F.3d at 702. Kayser’s theory of defense was that the jury should apply the $49,026 in deductions he initially reported on his corporate tax return in 2000 to eliminate the deficiency on his personal return for that year. Under Marabelles and Elwert, this theory required Kayser to establish two elements: First, Kayser had to show that the $49,026 represented legitimate business expenses actually incurred by him in an individual capacity.

Second, Kayser had to demonstrate that the $49,026 of business expenses represented “allowable” deductions on his individual return within the meaning of the Tax Code. Marabelles, 724 F.2d at 1379 n. 3 (citing Elwert, 231 F.2d at 933). We conclude that Kayser’s evidence was sufficient to warrant a jury instruction on this theory. Through his own testimony, and the testimony of his accountant, Kayser presented evidence that he maintained records and receipts of his business expenses and that from those records, his accountant calculated the $49,026 of business expenses reported on Kayser’s corporate return.

Kayser further testified that all of the $49,026 in business expenses was incurred in connection with his previously unreported individual A2Z income for 2000. On this record, a rational jury could have concluded that Kayser actually incurred $49,026 in business expenses and that these expenses were legitimate. We also conclude that there was sufficient evidence from which a rational jury could find that the $49,026 represented allowable business expenses with respect to Kayser’s personal return.

The record included Aspen Ventures’ 2000 tax return, which detailed that the business deductions in the amount of $49,026 were composed of automobile expenses, office expenses, utilities, travel and entertainment expenses, and rents. The government did not challenge either the character, amount, or validity of the expenses. At the same time, both the government’s expert and Kayser’s accountant testified that as a general matter, business expenses of the type reported on Aspen Ventures’ 2000 return could be used to reduce business income on an individual return.

This evidence, though arguably weak, was sufficient to allow a rational jury to sustain Kayser’s defense. The district court therefore abused its discretion in failing to instruct the jury on this theory. C. We thus conclude that the requested jury instruction was supported by law and had sufficient foundation in the evidence. Because the district court erred in declining to instruct the jury on Kayser’s theory of defense, we reverse Kayser’s conviction. REVERSED and REMANDED. .

Section 7201 provides: Any person who willfully attempts in any manner to evade or defeat any tax imposed by this title or the payment thereof shall, in addition to other penalties provided by law, be guilty of a felony and, upon conviction thereof, shall be fined not more than $100,000 ($500,000 in the case of a corporation), or imprisoned not more than 5 years, or both, together with the costs of prosecution. . Testimony at trial indicated that Kayser received either $41,765 or $53,445 in income from A2Z in 2000 and that this income should have been reported on Kayser’s individual return for 2000. .

Boulware II does not hold otherwise. In Boulware II, the government moved in limine to preclude the defendant from introducing expert testimony that the diverted funds could be deemed a constructive dividend constituting a return of capital. 470 F.3d at 933-34. The trial court granted the government’s motion, reasoning that the evidence proffered did not go to the question of whether the funds were, in fact, “considered, intended, or recorded on the corporate records as a return of capital” at the time of the distribution. Id. at 934-35 (internal quotation marks omitted). We affirmed the district court’s ruling.

Id. In so holding, we did not conclude that Boul-ware was bound by the manner in which he originally reported the transaction. See id. Nor did we hold that Boulware was precluded from introducing evidence to support his return-of-capital theory. See id. Rather, we held that under Miller, Boulware was required to show that the distribution was intended to be a return of capital. Id. at 933-35.

Because Boulware's proffered evidence did not go to the question whether the diverted funds " 'were considered, intended, or recorded on the corporate records as a return of capital at the time they were made,’ ” id. at 935 (quoting Miller, 545 F.2d at 1215), we held the district court properly concluded that Boulware failed to lay the requisite evidentia-ry foundation for a return-of-capital defense. Id. at 934-35. . Kayser did not argue that the $49,026 in business deductions he reported on Aspen Ventures' 2000 return "flowed through” Aspen Ventures to his individual return.

The government’s argument that Aspen Ventures is not a flow-through entity is therefore irrelevant. . The dissent contends that "Kayser made only very broad statements that the deductions relate to his personal income, and even then he hedged quite a bit.” Dissent at 1081. However, as the dissent acknowledges, on direct examination, Kayser specifically and unambiguously testified that "every deduction” reported on Aspen Ventures’ 2000 corporate return related directly to Kayser’s A2Z income.

The prosecution made effective use of its cross-examination to raise doubts about the assertions Kayser made on direct examination. While Kayser's stumbling answers on cross-examination may further weaken the evidence supporting his defense, under our case law, Kayser is entitled to his proposed instruction even if the evidence supporting his theory of defense "is weak, insufficient, inconsistent, or of doubtful credibility.” Washington, 819 F.2d at 225. . In discussing the weakness of Kayser’s evidence, the dissent merges the two separate counts of Kayser’s indictment by noting that "[t]o escape conviction, ...

Kayser had to show that he had enough deductions to shelter both his 1999 and 2000 income.” Dissent at 1080 (emphasis in original). There is no dispute that Kayser did not have sufficient deductions to offset both his 1999 and 2000 income. However, Kayser may still raise a deficiency defense with respect to the second count of his indictment (relating to the 2000 tax year) when a rational jury could conclude that Kayser had sufficient allowable deductions to negate the government’s proof of deficiency with respect to that year. . Kayser argues that any instructional error by the district court cannot be harmless.

See United States v. Escobar de Bright, 742 F.2d 1196, 1201-02 (9th Cir.1984) (holding that an erroneous refusal to give defendant’s proposed theory of defense instruction is reversible per se). We have not revisited Escobar de Bright in light of Neder v. United States, 527 U.S. 1, 119 S.Ct. 1827, 144 L.Ed.2d 35 (1999). Nor do we need to, because the district court’s failure to give Kayser's proposed instruction prevented him from making a significant challenge to the deficiency element of the tax evasion count for the year 2000, and thus cannot be harmless beyond a reasonable doubt. See Chapman v.

California, 386 U.S. 18, 87 S.Ct. 824, 17 L.Ed.2d 705 (1967). Kayser also argues that he was wrongfully prevented from introducing evidence to support his theory of defense and that the district court misapplied the Sentencing Guidelines in determining the total tax loss by refusing to reduce Kayser’s 2000 unreported income by the deductions he reported on Aspen Ventures’ 2000 return and carried back to 1999. Given our reversal and remand for a new trial, we do not reach these issues. Finally, Kayser asserts that his indictment should be dismissed because the grand jury was improperly instructed.

However, as Kay-ser acknowledges, our precedent has squarely rejected his position and we therefore affirm the district court’s denial of Kayser's motion to dismiss the indictment. See United States v. Navarro-Vargas, 408 F.3d 1184 (9th Cir.2005) (en banc); United States v. Cortez-Rivera, 454 F.3d 1038 (9th Cir.2006).