Couple's Lavish Spending Prevents Discharge of Taxes in Bankruptcy

(Parker Tax Publishing October 2020)

The Eleventh Circuit affirmed a bankruptcy court's judgment that a couple's tax debt was non-dischargeable under 11 U.S.C. Sec. 523(a)(1)(c) because the couple willfully evaded payment of the taxes. The court held that, while making an offer in compromise (OIC) to the IRS is not, by itself, an act to evade taxes, the couple's OICs were inadequate and unrealistic offers considering their income and discretionary spending as well as the fact that they were submitted to the IRS at conveniently low points in the couple's highly profitable business venture. Feshbach v. IRS, 2020 PTC 286 (11th Cir. 2020).

Background

Matthew Feshbach is an investment professional and former hedge-fund manager. Mr. Feshbach used an investment strategy that allowed him to delay the recognition of his taxable income from investments. He and his wife, Kathleen, built a $14 million home in Monte Sereno, California, in the 1990s. But events in the late 1990s forced him to close out his investment positions and incur a tax liability of $1.9 million in 1999. The Feshbachs made some payments to the IRS and received other credits during the 1999 tax year but did not submit a payment with their tax return.

In 2001, the Feshbachs made an offer in compromise (OIC) to the IRS to settle their 1999 tax debt for $1 million - about half what they owed. They made an immediate payment of $200,000 and said they would make another payment after they sold their house in Bellaire, Florida, where they were living by the time. Considering the Feshbachs' high income and allowable expenses, the IRS called the offer a "nonstarter." The Feshbachs paid the $200,000 but withdrew the offer before the IRS could reject it and opted instead for a temporary agreement in which they would make monthly payments of $1,000 while the IRS suspended its collection efforts.

The Feshbachs dug a deeper hole by liquidating securities in order to make the $200,000 payment to the IRS and by the end of 2001 they owed the IRS around $5.1 million. However, the debt did not seem insurmountable, as Mr. Feshbach founded a highly profitable hedge fund in 2001 that earned more than $13 million over the next nine years. However, the Feshbachs would also spend about $8.5 million on personal expenses and charitable contributions in that same period, leaving a balance of more than $3.8 million on their tax debt. In 2002, the Feshbachs had $764,000 in expenses, including a domestic payroll of over $58,000 and personal expenses of $383,000.

The Feshbachs made a second OIC in 2002, which was a higher dollar value than the first offer but a lower percentage of their total liability. The IRS determined that the Feshbachs were earning much more income than they had reported. The Feshbachs represented on a Form 433-A financial disclosure that they were earning about $15,000 per month, or $180,000 annually, yet they reported income of over $611,000 on their 2002 tax return. For the next three years after submitting their second OIC, the Feshbachs reported more than $10 million in income.

In 2008, the Feshbachs made a third OIC of $120,000 on a $3.6 million balance for the 2001 tax debt. They proposed monthly payments of $2,500 over 48 months. Along with this offer they submitted another Form 433-A in which they claimed a monthly income of $833, or $9,996 annually. At that time, they were incurring monthly household expenses of over $12,000. An IRS officer later testified that he knew either that the Feshbachs' income was understated or their expenses overstated or a combination of the both. On their 2008 tax return, the Feshbachs claimed an income of $193,205 (19 times what they reported on the Form 433-A). After a lengthy review process, the IRS concluded in 2010 that the Feshbachs had the means to pay $15,000 per month. The Feshbachs made four payments of $15,000 but ceased payments altogether in 2011, when they filed for Chapter 7 bankruptcy.

In the bankruptcy court, the Feshbachs initiated an adversary proceeding seeking a determination that their 2001 tax liability either partially or fully dischargeable. The bankruptcy court held that the taxes were non-dischargeable under 11 U.S.C. Sec. 523(a)(1)(C) because the Feshbachs willfully attempted to evade or defeat the taxes. The bankruptcy court relied primarily on the Feshbachs' total income and spending over the previous nine years. It found that they earned over $13 million during that time period and therefore had the capacity to pay the taxes in full, yet they chose to spend more than $8.5 million on personal expenses and charitable contributions. The bankruptcy court also held that, although the issue of a partial discharge had not been resolved in the Eleventh Circuit, most courts had concluded that a partial discharge is not permitted under 11 U.S.C. Sec. 523(a)(1)(C). The Feshbachs appealed, and a district court affirmed. The Feshbachs appealed to the Eleventh Circuit.

In In re Jacobs, 490 F.3d 913 (11th Cir. 2007), the Eleventh Circuit set forth a two-prong test for determining whether a tax debt is non-dischargeable due to willful evasion under 11 U.S.C. Sec. 523(a)(1)(C). Under the conduct prong, the government must prove that the debtor attempted to evade or defeat a tax, and under the mental state prong, the government must prove that the attempt was done willfully. The Feshbachs argued that both of the lower courts erred in holding that their personal spending alone could satisfy the conduct prong for willful evasion. As to their mental state, the Feshbachs asserted that the government was required to prove that their overspending was undertaken with the specific intent to evade taxes. They also asserted that even under the lower civil willfulness standard, their efforts to compromise with the IRS yielded substantial penalties and interest, which suggested a lack of willful evasion.

Analysis

The Eleventh Circuit affirmed the bankruptcy court's holding that the Feshbachs willfully evaded the payment of their 2001 tax liability. The court found no error in the bankruptcy court's determination that the Feshbachs' lavish spending on personal luxuries instead of paying their taxes met the conduct requirement. The court also found that the bankruptcy applied the correct legal standard in its mental state determination and correctly determined that the Feshbachs' conduct was willful under that standard.

The court found that a finding of willful evasion under 11 U.S.C. Sec. 523(a)(1)(C) was supported by the Feshbachs' personal spending habits and also in their conduct related to the OIC process. In the court's view, there was ample evidence that the Feshbachs approached the IRS with inadequate and unrealistic OICs given their income and spending and that they used the OIC process to delay the payment of their taxes. The court found that Mr. Feshbach was more sophisticated than the average taxpayer and knew that a pending offer would halt IRS collection efforts. The court said that the Feshbachs took advantage of the offer process by continuing to maintain an extravagant lifestyle, and the court rejected their assertion that the expenses were for a business purpose of cultivating an appearance of wealth in order to attract clients. The court also noted the vast disparities between the income the Feshbachs reported to the IRS during the settlement process and the income they actually earned. According to the court, the inference that the Feshbachs clouded their income and spending bolstered the finding that the Feshbachs used the OIC process as a delay tactic. The court found that the Feshbachs submitted meager offers to the IRS at conveniently low points in their highly profitable business venture.

Regarding the Feshbachs' mental state, the court found that the bankruptcy court applied the correct standard, which requires only a voluntary, conscious, and intentional attempt to violate a known duty to pay taxes, rather than specific intent as the Feshbachs argued. Applying that standard, the court found that the Feshbachs' excessive discretionary spending was evidence of willfulness. The court also noted that the bankruptcy court relied on contemporaneous notes by IRS officers that the Feshbachs' offers were intended to delay collection in reaching its conclusion that the Feshbachs acted willfully. The court rejected the Feshbachs' argument that the substantial penalties and interest the Feshbachs incurred negated their willfulness; the court said this argument was probative at best, and did not show that the bankruptcy court committed clear error.

The Eleventh Circuit also upheld the bankruptcy court's denial of a partial discharge. The court agreed that partial discharge would have been relevant only if the Feshbachs were unable to pay the entire debt, and the court found nothing in the record to suggest as much, particularly given that the Feshbachs earned $13 million over nine years and their tax debt was less than half that amount.

For a discussion of the dischargeability of tax debts in bankruptcy, see Parker Tax ¶16,160.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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