Taxpayer's Extravagant Lifestyle Prevents Tax Debts from Being Discharged

(Parker Tax Publishing March 2020)

A bankruptcy court held that a taxpayer's tax debts were not dischargeable in a Chapter 7 bankruptcy because the taxpayer willfully attempted to evade or defeat the tax under 11 U.S.C. Sec. 523(a)(1)(C). In reaching its conclusion, the court cited nonessential payments made by the taxpayer for private school tuition for her children, exotic vacations, expensive cars, and the taxpayer's transference of the title to her home in a transaction not at arm's length in order to prevent the IRS from foreclosing on its lien and selling the property. In re Harold, 2020 PTC 58 (Bankr. E.D. Mich. 2020).

Background

Patrice Harold is a practicing doctor who specializes in obstetrics and gynecology. Harold's husband, Thomas Barrow, is a former CPA who, before marrying Harold, lost his license after a conviction for tax evasion and filing a false tax return. Harold and Barrow have two children together, and Harold's medical practice is the family's primary source of income.

At all times during the couple's marriage, Barrow handled the family's tax matters. The couple filed joint tax returns for years 2004 through 2014, which Barrow prepared from information provided by Harold. For several of these years, Barrow requested extensions to file the couple's returns, and in others, returns were filed late. The couple eventually fell behind in their taxes. In 2009, they entered an installment agreement with the IRS, but they missed some payments.

While the couple struggled to deal with their tax problems, they maintained an affluent lifestyle. In 2005, the couple planned to sell their home on Newport Street in Detroit and move to a more expensive waterfront home on Dwight Street. They entered a land contract to purchase the Dwight Street home for $625,000. However, the couple was unable to sell their Newport Street home and were stuck with two house payments, which caused them to fall further behind on their tax debts. In 2009, they lost the Newport Street home to foreclosure. Despite these troubles, the couple paid more than $325,000 over a 13 year period to send their children to private schools. The couple lived well in other ways; they took multiple family vacations and personal trips to Mexico, Alaska, and Puerto Rico, among other destinations. They also drove expensive vehicles, including a Jaguar, two Cadillacs, a Lexus, and a Harley Davidson motorcycle.

After entering the installment agreement with the IRS, Harold made some tax payments but not enough to keep up with her current tax obligations or to keep up with repayment of her delinquent obligations under the installment agreement. The IRS continued sending notices and pursued collection actions. In January 2016, Harold filed for Chapter 7 bankruptcy and received a discharge. The IRS, which was by far the largest creditor, initiated an adversary proceeding seeking to have Harold's tax debts excepted from the discharge. The IRS abandoned any interest the bankruptcy estate had in the Dwight Street land contract, which meant that the automatic stay that went into effect when Harold filed Chapter 7 was no longer in effect. This allowed the IRS to enforce its lien against the Dwight Street home in a separate proceeding in a district court, which the IRS did in 2018. Harold and the IRS requested that the bankruptcy court stay the IRS's adversary proceeding pending the outcome of the IRS's lawsuit to enforce its lien.

In late 2018, Harold and Barrow came up with a plan to keep the IRS from enforcing its lien. Barrow approached his former client Sil Watkins, who bought and sold property through SWEWAT, LLC. An agreement was reached for SWEWAT to buy the Dwight Street property for $220,000. After the land contract was paid off, the remaining proceeds would go to Harold, and SWEWAT would rent the property back to Harold and Barrow so that they could continue living there without the IRS enforcing its lien on the home. SWEWAT wrote two checks to Harold totaling $42,397, which Harold paid to the IRS. Harold did not tell the IRS or the district court about the sale until July of 2019, when the IRS requested the appointment of a receiver to sell the property. Harold argued that the IRS's request was moot because she had already sold her interest in the property.

In November 2019, the bankruptcy court held a trial to determine whether Harold's tax debts were excepted from discharge under 11 U.S.C. Sec. 523(a)(1)(C). Under that provision, a tax debt cannot be discharged if the taxpayer made a fraudulent return or willfully attempted in any manner to evade or defeat the tax. In In re Gardner, 360 F.3d 551 (6th Cir. 2004), the Sixth Circuit held that Sec. 523(a)(1)(C) has a conduct requirement and a mental state requirement. According to the Sixth Circuit, the conduct requirement is met if the government can prove that the debtor engaged in affirmative acts to avoid payment or collection of the taxes. Under the mental state requirement, the government must prove that the debtor voluntarily, consciously, and knowingly evaded payments. The mental state requirement is proven when the debtor (1) had a duty to pay taxes, (2) knew he or she had such duty, and (3) voluntarily and intentionally violated that duty.

Analysis

The bankruptcy court held that Harold's tax debts were nondischargeable under Sec. 523(a)(1)(C) based on overwhelming evidence of Harold's conduct to evade or defeat the payment of her tax liabilities. The court found that while Harold obtained extensions for some returns and filed others late, she did not pay her tax liabilities. In the court's view, Harold's payment of over $325,000 for private schooling for her children while not paying taxes despite having substantial income was sufficient conduct to meet the conduct requirement under Gardner. But the court found that Harold engaged in even more overt, affirmative conduct after filing bankruptcy, when she sold the Dwight Street property to SWEWAT in order to prevent the IRS from enforcing its lien and in order to continue living there.

The bankruptcy court also found that the mental state requirement was met due to Harold's voluntary, conscious, and intentional choices to spend substantial amounts for personal, nonessential expenses rather than pay her taxes. The court noted that Harold delegated tax matters to her husband fully aware of his history of tax problems. The court said that if anything, it seemed that Harold's knowledge of her husband's past difficulties with the IRS reinforced her decision to delegate her tax matters to him. In the court's view, this was not a case of blind, uninformed trust in her husband, but an informed, conscious and intentional choice. Further, while Harold chose to let Barrow handle her taxes, the court found that she was fully aware that her taxes were delinquent. According to the court, Harold stressed over her tax problems yet continued to choose to pay personal expenses for nonessential items in order to maintain the same comfortable lifestyle, with private schools, multiple vacations and trips, and expensive cars.

In the court's view, the sale of the Dwight Street property to SWEWAT was even more compelling evidence of Harold's willfulness. The court noted that the sale, which it said was not a sale at arm's length, was at a price high enough to enable Harold to make some payment to the IRS but low enough for SWEWAT to make a profit. The court found the sale was not intended to generate the highest value in order to pay Harold's taxes but to prevent the IRS from taking control over the sale of the property. The court did not view the sale any differently after considering the fact that Harold used part of the proceeds to pay the IRS. Rather, the court concluded that Harold had attempted to unilaterally dictate the amount of proceeds to be paid to the IRS by blocking enforcement of its lien, which in the court's view was no less an evasion than withdrawing some but not all the money from a bank account to limit the amount the IRS can garnish from that account.

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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