Bankruptcy Debtor Did Not Fraudulently Evade Paying Tax Debts

(Parker Tax Publishing March 2019)

A bankruptcy court held that a Chapter 7 debtor's tax debts were dischargeable because he did not make a fraudulent return or willfully attempt to evade or defeat the taxes. The court found that, given the debtor's irregular employment and his wife's decision to reduce the family's income while increasing its expenses by moving out of state for graduate school, the debtor did not affirmatively avoid collection of the taxes. Clark v. U.S., 2019 PTC 60 (Bankr. N.D. Ga. 2019).

Background

Dr. Steven Clark, a radiologist, was married in Georgia in 1994. In 2009, Dr. Clark's wife moved to Virginia for schooling and never returned to live with him. After receiving her degree in 2012, she continued living in Virginia and working, and eventually she moved to Tennessee. While she was living in Virginia, both as a student and as an employee, Dr. Clark contributed toward her living expenses, in some years paying as much as three quarters of her rent ($900 per month).

In 2017, Dr. Clark and his wife began divorce proceedings. The divorce court ordered Dr. Clark to pay $2,000 per month in spousal support and a $15,000 one-time payment to Mrs. Clark for certain issues. He also incurred attorney's fees in connection with the divorce.

Dr. Clark has four children. In 2006, his two younger children were aged 7 and 8 and his two older children were in their early 20s. The two younger children initially stayed with Dr. Clark when their mother moved to Virginia, but they later moved to Virginia to join her. Dr. Clark's expenses during 2006 through 2011 included expenses for the children's school, cars, and extracurricular activities. For the two younger children, Dr. Clark paid total tuition of approximately $50,000.

Dr. Clark had an irregular employment history that he attributed to medical conditions including ADHD, anxiety, and depression. During 2006 through 2016, Dr. Clark was completely unemployed for around 26 months, and for much of the remaining time he worked part-time. However, beginning in 2016, Dr. Clark was employed full time, working a night shift of around nine to ten hours at a hospital in Illinois.

Dr. Clark and his wife bought a home in Georgia in 2001 for approximately $562,000. The home has around 4,000 square feet with five bedrooms and a pool. The pool and other areas of the home were in need of repairs. Dr. Clark was in default on his mortgage since 2011 and the home was scheduled for foreclosure. Dr. Clark obtained two loan modifications in 2011 and 2012 which reduced the deferred principal to $210,200. Dr. Clark never attempted to sell the house, even after his wife and children moved out.

In addition to the home, Dr. Clark's assets included two older BMWs with estimated values of $1,100 and $5,000 respectively. Dr. Clark had minimal money in checking accounts and only about $2,400 of other personal property. He had no retirement fund or significant savings. His money was used primarily for ordinary living expenses and upkeep on the house, with infrequent vacations to Florida or South Carolina.

Dr. Clark borrowed a total of around $72,000 from his parents beginning in 2011, which he did not repay. Each time he borrowed from his parents he created a list of expenses that needed to be paid. The expenses included home-related expenses and around $250 a month for food, gas and other expenses, but no entertainment expenses. Some of these lists included income taxes but many did not. During this time period, Dr. Clark also obtained title pawns on several of his cars and used a check cashing service. Dr. Clark used the loans from his parents to pay off the title pawns.

Most of Dr. Clark's employment was not as a W-2 employee, and Dr. Clark did not make any arrangements for setting aside money to pay his taxes or estimated taxes. The total amount the IRS claimed to be due for 2006 through 2011 for unpaid taxes plus interest was approximately $408,200. Dr. Clark also did not file tax returns for 2012 through 2017. He personally prepared at least the 2014, 2015 and 2016 returns but did not file them. Instead, he prepared these returns in connection with his loan modification requests. Dr. Clark claimed that filing returns was not a priority because he expected a refund. He also said he could not afford to pay an accountant to prepare the other returns.

In 2011, Dr. Clark hired attorney, Lance Einstein, to assist him with his tax issues. Dr. Clark estimated that he paid Einstein around $10,000. But Dr. Clark did not know if Einstein had ever met with the IRS or had made any settlement offers. The IRS sent Dr. Clark numerous notices of delinquency, which Dr. Clark never opened because he assumed Einstein was receiving the communications. Dr. Clark did not remember discussing the notices with Einstein. Dr. Clark filed a petition under Chapter 7 of the Bankruptcy Code in 2016.

Analysis

Under 11 U.S.C. Sec. 523(a)(1)(C), a tax debt is not dischargeable in a bankruptcy if the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat the tax. In the Eleventh Circuit, the court to which this case would be appealable, courts consider the facts and circumstances to determine whether the debtor willfully engaged in evasive conduct. Evasive conduct requires a showing that the debtor engaged in affirmative acts to avoid paying taxes, either through commission or culpable omission. Courts also consider whether the debtor characterized earnings so as not to be subject to withholding, made large discretionary expenditures, or maintained a lavish lifestyle. The mere nonpayment of taxes does not satisfy the conduct requirement, but nonpayment may be relevant when considering the totality of the circumstances.

The IRS contended that Dr. Clark's lifestyle was lavish and that his discretionary spending was evidence that he willfully evaded paying his taxes. The IRS suggested that Dr. Clark should not have paid for any of his wife's living expenses in Virginia and emphasized that he negotiated a mortgage loan modification and a hardship student loan deferral but did not resolve his tax debt. The IRS pointed out that Dr. Clark had a large house which he never attempted to sell, bought cars for his children, took at least two vacations with his family, and paid around $50,000 for his children's college tuition, all of which the IRS said was evidence of a lavish lifestyle.

The bankruptcy court disagreed with the IRS and held that Dr. Clark's taxes were dischargeable. The court found no factors indicating evasive conduct other than some late filed returns and a failure to pay taxes. The court noted that Dr. Clark was frequently unemployed or underemployed and found that his work history was not intentional or voluntary but rather due to poor performance. The court also noted that Mrs. Clark's decision to quit her job and move to Virginia reduced the family's income and increased expenses. Mrs. Clark did not live lavishly in Virginia, in the court's view, and Dr. Clark remained obligated to support her and their children during this time.

The court reasoned that Dr. Clark's negotiations with lenders were different from resolving his tax debt because they decreased his expenses, while an IRS resolution required an increase in his expenditures. The court also noted that Dr. Clark could not maintain his medical license if he was in default on his student loans. The court agreed that buying cars and taking vacations were not necessary expenses, but it found that the cars were used cars and the vacations were modest, and there was no evidence of sums spent on clothes or entertainment.

The court also found that Dr. Clark's expenses were not incurred in lieu of payment to the IRS. Dr. Clark borrowed $72,000 from his parents which he never repaid, and that amount was more than the college and other expenses. The court also found that while Dr. Clark's house was larger than he needed, he could not sell it due to the 2008 housing crisis. The fact that the loan modification reduced Dr. Clark's expenses almost in half showed, the court's view, that he did not live a lavish lifestyle.

The court found that Dr. Clark never had a lump sum of cash or stock which could have been liquidated to pay his debts in full. Given the irregularity of his employment and income, Dr. Clark never had the ability to make a substantial payment on the tax debt, in the court's view. The court also found that Dr. Clark never transferred property to avoid paying taxes and was not a 1099 employee by choice.

For a discussion of the discharge of taxes 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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