No Discharge of Tax Debts in Bankruptcy for Couple with High Income, Extravagant Lifestyle

(Parker Tax Publishing November 2017)

A bankruptcy court held that a married couple's tax debts were not dischargeable because the couple had intentionally failed to pay their tax debt while realizing millions in income and sustaining high levels of spending on personal items. The bankruptcy court was not persuaded that the couple's spending was necessary to earn income and found that they had intentionally made offers in compromise to delay collection on the debt. Feshbach v. U.S., 2017 PTC 482 (Bankr. M.D. Fla. 2017).

Facts

Matthew and Kathleen Feshbach entered Chapter 7 bankruptcy in 2011. Mr. Feshbach had worked as a money manager and private investor since the 1980s. For years, he used an investment strategy known as selling short against the box to defer the recognition of taxable income. A failed investment in a home improvement company in 1999, structured as a short sale against the box, triggered significant income recognition and a tax bill of almost $2 million. At the time, the Feshbachs lacked the money to pay the taxes, so in 2001 they liquidated other investments, resulting in a gain of over $8 million and a tax liability of $3.2 million.

In June 2001, the Feshbachs approached the IRS with an offer in compromise (OIC) to settle their 1999 and 2001 tax debts. The Feshbachs offered to pay $1 million over five years to settle their 1999 taxes. With penalties and interest, the offer equaled roughly half of what they owed. They sent the IRS a check for $200,000 two months later. The IRS rejected the Feshbachs' offer because it determined that their collection potential exceeded their entire tax debt. The Feshbachs submitted a temporary agreement to make monthly payments of $1,000, which the IRS accepted on the condition that they sell their house in Belleair, Florida, and reduce their standard of living. Around 2002, Mr. Feshbach created an investment fund in order to trade on behalf of high net worth clients. He said the purpose of the fund was to increase the Feshbachs' income and thereby contribute more to their tax payments.

The Feshbachs proposed another OIC in 2002, when they owed the IRS more than $6 million. Their second OIC was $1.25 million. At this time, the Feshbachs had not yet sold their house or lowered their living expenses. The IRS responded that the excessive spending could perhaps be justified if it was necessary for the production of income, but warned that their expenses could also be considered egregious, especially when compared to the small payments they were making toward their tax debt under the temporary agreement. The IRS rejected the second OIC, concluding that there was no basis for a compromise because the Feshbachs had the ability to pay their debt in full.

In 2005, the Feshbachs approached the IRS about entering an installment plan. The IRS approved the plan but only for the 2001 debt, and on the condition that they pay their 1999 taxes in full. The Feshbachs paid off their 1999 tax debt, in part through a loan of $2.7 million. The IRS then accepted the installment plan proposal and the Feshbachs agreed make quarterly payments of $120,000 until the full 2001 debt was satisfied. From 2005 to 2008, the Feshbachs paid the IRS $1.2 million. In 2008, they sold their house. The economic downturn of that year and Mr. Feshbach's declining health led to the demise of Feshbach's investment fund.

In September 2008, the Feshbachs tendered a third OIC at a time when their remaining tax debt was $3.6 million. This time, they offered to settle the debt for $120,000. The IRS rejected that offer. The Feshbachs eventually defaulted on their installment agreement.

From 2001 to 2010, the Feshbachs had $13 million in income and spent over $8.5 million on personal and household expenses and charitable contributions. They lived in a multimillion dollar house on which they paid over $500,000 in mortgage interest, property taxes and association dues. Their household costs totaled more than $574,000. Personal travel expenses came to over $720,000, not including another $233,000 for a rented house in Aspen. They spent $500,000 on clothing and paid a person to come to their home to iron Mr. Feshbach's business clothes. They paid more than $610,000 over this period for a full time chef and other household employees. They spent $170,000 on two Mercedes-Benzes, a BMW, and a Lexus. Their monthly grocery bill averaged over $4,400, which did not include over $78,000 the Feshbachs spent on dining out.

The Feshbachs filed for chapter 7 bankruptcy in 2011 while still in debt to the IRS for over $3.8 million. In the bankruptcy, the Feshbachs filed an adversary proceeding against the IRS seeking a determination that the balance of their tax debt was dischargeable.

Analysis

Generally, a debtor in bankruptcy can discharge all debts that arose before the filing of the bankruptcy petition. However, under 11 U.S.C. Section 523(a)(1)(C), tax debts are not dischargeable if the debtor willfully attempted to evade or defeat a tax. This determination focuses on the debtor's conduct and mental state. The conduct requirement is met if the debtor has attempted in any manner to evade or defeat a tax. The mental state element requires a showing that the debtor has voluntarily and intentionally violated a known duty to pay taxes.

According to the IRS, the Feshbachs' excessive spending between 2002 and 2010 established the evasive behavior required under Section 523(a)(1)(C). The IRS argued that their excessive spending greatly reduced the Feshbachs' available assets and represented imprudent transfers made in the face of serious financial difficulties. The Feshbachs countered by arguing that their spending was necessary to generate income to pay their debts. The Feshbachs said they needed to live in a multimillion dollar house in an exclusive area to impress Mr. Feshbach's clients and convey an image of success. Moreover, even if their spending was excessive, the Feshbachs claimed that no one at the IRS ever told them to lower their expenses. The Feshbachs said their repeated efforts to settle with the IRS showed they did not voluntarily and intentionally fail to pay their tax debts. They also said that they had relied on their advisers when making their OICs. Finally, the Feshbachs argued that, if the court found that Section 523(a)(1)(C) applied, they should be entitled to at least a partial discharge.

The bankruptcy court held that the Feshbachs' tax debts were not dischargeable because they willfully attempted to evade their tax debt. The court recognized that a debtor may be justified in spending money in order to generate income to pay the taxes owed. However, the court found that none of the cases cited by the Feshbachs involved the type or magnitude of spending present in the Feshbachs' case. The court also reasoned that many of the Feshbachs' personal expenses, such as their personal travel and dining expenses, their Aspen vacation house rental, and their charitable giving, had nothing to do with Mr. Feshbach's business. The court concluded that the Feshbachs had failed to prove a correlation between a money manager's spending on household and personal items and the confidence in which his or her clients place him. It also rejected the argument that the IRS never told the Feshbachs to lower their expenses, finding that IRS officers directly confronted the Feshbachs' excessive spending on multiple occasions. The court concluded that the Feshbachs preferred their lofty lifestyle over reducing their tax debt at nearly every turn; although they made some payments toward their tax debt, these payments were dwarfed by the $8.5 million they spent on personal expenses and charitable giving.

The court also found that the willfulness element was satisfied by the Feshbachs using the OIC process to delay IRS collection efforts. The court reasoned that the Feshbachs' conduct did not show a dedicated, good faith effort to reach a settlement with the IRS but rather a cat and mouse game to delay the inevitable. The court was not persuaded by the Feshbachs' claim that they merely relied on their advisers when making their OICs because Mr. Feshbach was a financial professional who understood the tax laws. The Feshbachs should have realized that the IRS would not accept their meager offers, especially after the IRS had directly condemned their level of spending, according to the court. The Feshbachs' argument that they lacked the ability to pay the tax in full was also rejected because it was clear to the court that the IRS was open to a repayment plan. The court pointed out that the Feshbachs could have immediately reduced their tax debt by more than $1 million simply by canceling their vacations and giving up their house in Aspen. The Feshbachs' failure to sell their Belleair house until nine years after listing it in 1999 was further evidence of willful conduct by the Feshbachs and a lack of good faith.

Finally, the court determined that it did not have the power under Section 523(a)(1)(C) to grant a partial discharge, although the court observed that the rule's inflexibility could potentially conflict with the overall goal of giving debtors a fresh start in some cases.

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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