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Bankruptcy Debtor's Lavish Lifestyle Doesn't Preclude a Discharge of Taxes.
(Parker Tax Publishing September 30, 2014)
Generally, a debtor in bankruptcy can discharge all debts that arose before the filing of his or her bankruptcy petition. However, a debtor cannot discharge any tax debts with respect to which the debtor made a fraudulent return or willfully attempted to evade or defeat. Late last month, the Tenth Circuit in In re Vaughn, 2014 PTC 436 (10th Cir. 8/26/14) relied on this provision when it held that a cable TV executive, who purchased expensive homes, automobiles, and jewelry that significantly depleted his assets so he could not pay his taxes, did not meet the criteria for having his taxes discharged in bankruptcy. One of the factors cited by the court was the debtor's luxurious lifestyle. However, dealing with a similar situation in Hawins v. Franchise Tax Board of California, 2014 PTC 477 (9th Cir. 9/15/14), the Ninth Circuit took a different approach and concluded that a lavish lifestyle before filing for bankruptcy did not necessarily preclude a debtor's taxes from being discharged; instead taxes are nondischargeable if the debtor had a specific intent to evade the taxes. The court remanded the case to the lower court to determine if the debtor had "specific intent" to evade his tax liability at the time he was living large.
Background
William "Trip" Hawkins designed and received an undergraduate degree in Strategy and Applied Game Theory from Harvard University, and an M.B.A. from Stanford University. After college, he became one of the earliest employees at Apple Computer, where he ultimately became Director of Marketing. He left Apple to co-found Electronic Arts, Inc. (EA), which became the world's largest supplier of computer entertainment software. Trip owned 20 percent of EA and served as its Chief Executive Officer. By 1996, his net worth had risen to $100 million. That year, he divorced his first wife, Diana, and married his second wife, Lisa. Tripp and Lisa bought a $3.5 million home, where she cared for their two children and Tripp's two children from his first marriage. They flew in a private jet, their children attended expensive private schools, they bought an ocean-side condo in La Jolla, and employed a large private staff.
Beginning in 1994, Trip began selling his EA stock to invest in a new company, 3DO. His accountants at KPMG advised him to shelter the gains in a foreign leveraged investment portfolio (FLIP) and an offshore portfolio investment strategy (OPIS). Both strategies were designed to generate large paper losses to shield the capital gains from the sale of EA stock from tax.
Over the next several years, Trip used the strategies recommended by KPMG and claimed losses of approximately $6 million on his 1996 federal tax return, $23.4 million on his 1997 return, $20.5 million on his 1998 return, $3.5 million on his 1999 return, and $8.2 million on his 2000 return. In 2001, the IRS challenged the validity of the tax shelters and began an audit of Trip's 1997 return, which later expanded to include the 19982000 tax years. In 2002, the IRS sent Trip's attorney a letter stating that the losses from the FLIP and OPIS transactions would be disallowed. The subsequent audit report indicated that Trip owed additional taxes and penalties of $16 million for tax years 19972000.
During this period, the financial fortunes of 3DO deteriorated to the point where it needed a large capital infusion. Trip loaned 3DO approximately $12 million, to no avail, and 3DO filed for bankruptcy in 2003. Trip never received a significant distribution from the bankruptcy estate. Faced with these losses, Trip filed a motion in family court in 2003 to reduce the child support payments he was required to make to his first wife. He acknowledged that he owed $25 million to the IRS, had limited income, and was insolvent. The family court granted his request in part. During the family court proceedings, Trip's attorney testified that Trip intended to discharge the tax debt in bankruptcy proceedings.
In 2005, the IRS made an aggregate assessment of taxes, penalties, and interest for tax years 19972000 that totaled $21 million. The California Franchise Tax Board (FTB) assessed $15.3 million in additional taxes, penalties, and interest for the same tax years. Trip made an offer in compromise to the IRS of $8 million, which was rejected. The bankruptcy court found that Trip and his wife did very little to alter their lavish lifestyle after it became apparent in 2003 that they were insolvent and that their personal living expenses exceeded their earned income.
In July 2006, Trip sold his primary residence and paid the entire $6.5 million net proceeds to the IRS. A month later, the FTB seized $6 million from various financial accounts. In September of that year, the Hawkins filed a Chapter 11 bankruptcy petition, which the bankruptcy court found was for the primary purpose of dealing with their tax obligations. Shortly after filing, Trip sold the La Jolla condominium for $3.5 million and paid the proceeds to the IRS. Even after these payments and the seizure by the FTB, the IRS filed a proof of claim for $19 million and the FTB filed a claim for $10.4 million.
Trip proposed a liquidating plan of reorganization, which was confirmed by the bankruptcy court. The IRS received a distribution of $3.4 million from the estate. The confirmed plan discharged the Hawkins from any debts that arose before the date of plan confirmation, but provided that the Hawkins, IRS, or FTB could bring suit to determine whether the tax debts should be excepted from discharge.
The Hawkins filed an action against the IRS and FTB seeking a determination that the unpaid taxes were covered by the discharge. The IRS and FTB counterclaimed, alleging that the tax debts were excepted from discharge pursuant to Bankruptcy Code Section 523(a)(1)(C), which excepts from discharge any debt with respect to which the debtor willfully attempted in any manner to evade or defeat such tax. The primary, but not exclusive, theory of the IRS and FTB was that the Hawkins' maintenance of a rich lifestyle after their living expenses exceeded their income constituted a willful attempt to evade taxes.
The bankruptcy court rejected most of the other government theories, but found that the Hawkins' personal living expenses from January 2004 to September 2006 were "truly exceptional." The court estimated that the couples' personal expenses exceeded their earned income by $516,000 to $2.35 million during that period. Given these facts, the bankruptcy court concluded that, as to Trip, the tax debts were excepted from discharge. However, as to Lisa Hawkins, the court held that the tax debts were discharged. A district court affirmed and the Hawkins filed an appeal.
Discharging a Debt in Bankruptcy
Generally, under Bankruptcy Code Section 727(b), a debtor can discharge all debts that arose before the filing of his bankruptcy petition. However, there are certain exceptions to the general rule. One of the exceptions is Bankruptcy Code Section 523(a)(1)(C), which provides that a debtor cannot discharge any tax debts with respect to which the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat such tax.
OBSERVATION: The Ninth Circuit noted that it had yet to interpret Bankruptcy Code Section 523(a)(1)(C), and the mental state that was required under the provision to qualify as a "willful" attempt to evade taxes.
Ninth Circuit's Opinion
The Ninth Circuit held that, given the structure of the statute as a whole, declaring a tax debt nondischargeable under Bankruptcy Code Section 523(a)(1)(C) on the basis that the debtor willfully attempted in any manner to evade or defeat such tax requires a showing of specific intent to evade the tax. Therefore, a mere showing of spending in excess of income is not sufficient to establish the required intent to evade tax; the IRS must establish that the debtor took the actions with the specific intent of evading taxes. The Ninth Circuit remanded the case back to the district court and bankruptcy court to reanalyze the case using the specific intent standard.
In reaching its conclusion, the Ninth Circuit began by noting that the key question in this case revolved around the meaning of the word "willful" in Bankruptcy Code Section 523(a)(1)(C). The Ninth Circuit noted that "willful" is a word of many meanings and its construction is often influenced by its context. Because the Bankruptcy Code is designed to provide a "fresh start" to the discharged debtor, the court observed, the Supreme Court has interpreted exceptions to the broad presumption of discharge narrowly. Exceptions to the discharge of taxes in bankruptcy, the Ninth Circuit said, should be limited to dishonest debtors seeking to abuse the bankruptcy system in order to evade the consequences of their misconduct.
For guidance on what constitutes "willful" behavior, the Ninth Circuit looked to the Supreme Court's decision in Kawaauhau v. Geiger, 523 U.S. 57 (1998). In Kawaauhau, the creditors asked a bankruptcy court to hold a medical malpractice claim to be non-dischargeable under Bankruptcy Code Section 523(a)(6). That section provides that a discharge in bankruptcy does not discharge an individual debtor from any debt for willful and malicious injury to another. The Supreme Court noted that, because the word "willful" modified the word "injury" in Bankruptcy Code Section 523(a)(6), a deliberate or intentional injury, not merely a deliberate or intentional act that leads to injury, was required to establish non-dischargeability. The Supreme Court analogized "willful" as the mental state required for intentional torts, not for negligent acts.
The structure of Bankruptcy Code Section 523(a)(1)(C), the Ninth Circuit said, also supports a narrow construction of "willfully." Bankruptcy Code Section 523(a)(1) lists tax and customs debts warranting exception from discharge in three categories. Under Bankruptcy Code Section 523(a)(1)(A), numerous types of debts are excepted from discharge on a strict liability basis. Under Bankruptcy Code Section 523(a)(1)(B), tax debts for which a return was not filed or was filed late cannot be discharged. Finally, under Bankruptcy Code Section 523(a)(1)(C), no discharge is allowed for tax debts with respect to which the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat such tax. The grouping of the fraudulent return offense with the evasion offense in subsection (C) rather than with the other offenses involving tax returns in subsection (B) suggested to the court that the offense was more akin to attempted tax evasion than to failing to file a timely return. If a willful attempt to evade tax requires mere knowledge of the tax consequences of an act, and no bad purpose, then it was difficult for the court to see how such acts resemble the filing of a fraudulent return. By contrast, if a willful attempt requires bad purpose, then such acts are naturally grouped with other acts requiring bad purpose, such as filing a fraudulently false return.
OBSERVATION: One judge dissented, saying that she was persuaded by the Tenth Circuit's decision in In re Vaughn, which ironically cited to the lower court decisions in Hawkins as support for not allowing a debtor, who also spent money lavishly, to discharge his tax liability. The judge said that the majority opinion gave the debtor a pass by focusing on the Bankruptcy Code's purpose of providing a "fresh start" to debtors. She noted that an overly expansive interpretation of the "fresh start" policy could easily eclipse all discharge exceptions. The majority's conclusion, she said, created a circuit split and turned a blind eye to the shenanigans of the rich. (Staff Editor Parker Tax Publishing)
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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