Posted by: Taxlitigator | September 15, 2014

Bankruptcy (Tax) Law Must Apply Equally to the Rich and Poor Alike . . .

Generally, subject to certain statutory exceptions, a debtor is permitted to discharge all debts that arose before the filing of his bankruptcy petition.[1] With respect to tax debts, the Bankruptcy Code provides that a debtor may not 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.” [2]

Today, the Ninth Circuit Court of Appeals “reversed and remanded” a district court’s earlier affirmance of the bankruptcy court’s judgment that a chapter 11 debtor’s tax debts should not be discharged on the basis of his alleged “willful attempt to evade or defeat taxes” under 11 U.S.C. § 523(a)(1)(C).[3]

The Rich Are Different . . . They Have More Money. In a somewhat colorful opinion, the Ninth Circuit Majority stated “F. Scott Fitzgerald observed early in his career that the very rich ‘are different from you and me,’[4] to which Ernest Hemingway later rejoined, ‘Yes, they have more money.’[5] As with many bankruptcy cases involving the wealthy, our saga reads like a Fitzgerald novel, telling the story of acquisition and loss of the American dream, and the consequences that follow.”

In association with various “tax shelter” transactions, the IRS made aggregate assessments against the underlying taxpayer for tax years 1997–2000 totaling $21 million and the California Franchise Tax Board also made assessments which totaled $15.3 million. With overall limited financial resources, the taxpayer ultimately found himself attempting to resolve these debts in a bankruptcy proceeding. The bankruptcy court opinion determined that the taxpayer (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.”

Changing direction, the Ninth Circuit noted that the taxpayer “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 [taxpayer] 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, the [taxpayer] 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.”[6] To settle the remaining IRS liability, the taxpayer submitted an offer in compromise of $8 million, which was rejected.

The Ninth Circuit deemed it important that most of the expenditures by the taxpayer along the way “were made consistent with [taxpayer’s] past spending practices, and investments were made in property that would be subject to tax liens. As far as the record discloses thus far, there were no financial transfers into nominee accounts or concealment of assets, although the government claims that some funds ordered paid into trust by the family court were done so with the intent of tax evasion.” It also appears the taxpayer was investing funds improving or preserving property encumbered with tax liens that would ultimately accrue in a benefit to be received by the government when the property was sold.

The IRS and FTB alleged that the assessed liabilities could not be discharged in bankruptcy pursuant to 11 U.S.C. § 523(a) (1) (c), which excludes from discharge any debt “with respect to which the debtor . . .  willfully attempted in any manner to evade or defeat such tax.” (Emphasis added).  The primary, but not exclusive, theory of the IRS and FTB was that the [taxpayers] maintenance of a rich lifestyle constituted a “willful attempt to evade taxes.”

The bankruptcy court rejected most of the other government theories, but stated that the [taxpayer’s] personal living expenses from January 2004 to September 2006 were “truly exceptional.” The bankruptcy court estimated that the couples’ personal expenses exceeded their earned income by $516,000 to $2.35 million during the years at issue. Given these facts, the bankruptcy court concluded that, as to the Taxpayer-Husband, the tax debts were excluded from discharge; the district court affirmed and the appeal to the Ninth Circuit followed.

Specific Intent Required? The Ninth Circuit noted that “The key question in this case is the meaning of the word ‘willful’ in the statute. Unfortunately, the plain words of the text do not answer that question because, as the Supreme Court has observed, ‘willful . . . is a word of many meanings, its construction often being influenced by its context.’ Spies v. United States, 317 U.S. 492, 497 (1943). Context matters in this case. The Bankruptcy Code is designed to provide a “fresh start” to the discharged debtor. [Citation omitted]. As a result, the Supreme Court has interpreted exceptions to the broad presumption of discharge narrowly. See Kawaauhau v. Geiger, 523 U.S. 57, 62 (1998). As we have observed ‘exceptions to discharge should be limited to dishonest debtors seeking to abuse the bankruptcy system in order to evade the consequences of their misconduct.’ [Citation omitted].”

Further, “[t]hus, the ‘fresh start’ philosophy of the Bankruptcy Code argues for a stricter interpretation of ‘willfully’ than an expansive definition. . . . The structure of the statute also supports a narrow construction of ‘willfully.’ The discharge exception at issue, § 523(a) (1), lists tax and customs debts warranting exception in three categories. Under § 523(a) (1) (A), numerous types of debts are excepted from discharge on a strict liability basis. Under § 523(a) (1) (B), tax debts for which a return was not filed or was filed late may not be discharged. Section 523(a) (1) (C) is the grouping at issue here: no discharge is permitted 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.” 11 U.S.C. § 523(a) (1) (C). 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)—suggests that it is more akin to attempted tax evasion than to failing to file a timely return. If a willful attempt to evade taxation requires mere knowledge of the tax consequences of an act, and no bad purpose, then it is difficult 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.” (Emphasis added).       

The Ninth Circuit Majority. Given the structure of § 523(a)(1) as a whole, the Ninth Circuit Majority concluded that declaring a tax debt nondischargeable under 11 U.S.C. § 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. Specifically, “[t]herefore, a mere showing of spending in excess of income is not sufficient to establish the required intent to evade tax; the government must establish that the debtor took the actions with the specific intent of evading taxes. Indeed, if simply living beyond one’s means, or paying bills to other creditors prior to bankruptcy, were sufficient to establish a willful attempt to evade taxes, there would be few personal bankruptcies in which taxes would be dischargeable. Such a rule could create a large ripple effect throughout the bankruptcy system. As to discharge of debts, bankruptcy law must apply equally to the rich and poor alike, fulfilling the Constitution’s requirement that Congress establish ‘uniform laws on the subject of bankruptcies throughout the United States.’ U.S. Const., art. I, § 8, cl. 4.”

The Dissent. With obvious passion, the dissent noted, in part,: “I respectfully dissent. I agree with the majority that the rich are different in many ways, but that difference should not include an unfettered ability to dodge taxes with impunity. . . . The majority’s conclusion, in my view, creates a circuit split and turns a blind eye to the shenanigans of the rich. . . . . Providing a fresh start under the Bankruptcy Code should not extend to aiding and abetting wealthy tax dodgers. I respectfully dissent.”

Conclusion. What mental state is required in order to find that a bankruptcy debtor’s federal tax liabilities should be excluded from a bankruptcy discharge under 11 U.S.C. § 523(a)(1)(c) because he “willfully attempted in any manner to evade or defeat such tax”? Consistent with similar provisions in the Internal Revenue Code, the Ninth Circuit Majority concluded that “specific intent . . . to evade or defeat such tax” is required for the tax debt to not be discharged in a bankruptcy proceeding and remanded the underlying case to the district for a re-evaluation under that standard.

The result in this case might seem obvious to most – to “willfully evade tax” it should be clear that the debtor took some actions with the specific intent of evading taxes, i.e., financial transfers into nominee accounts or concealment of assets, etc. Continuing to mostly live life as they had before the underlying debts accrued, selling assets such that all proceeds are distributed to the government, making investments in assets already subjected to the tax liens, etc. would not seem to support the requisite “specific intent . . . to evade or defeat such tax.

In tax nothing is obvious until various levels of courts and sometimes even the U.S. Supreme Court have had a chance to evaluate and re-evaluate potentially relevant events. Rich or poor, the tax code (and the bankruptcy code) apply to the taxpayer (debtor) and, at least in this situation (although the dissenting opinion certainly disagrees) the Ninth Circuit seems to have gotten it exactly right.


[1] 11 U.S.C. § 727(b) and 11 U.S.C. § 523

[2] 11 U.S.C. § 523(a)(1)(C) (emphasis added).

[3] See William M. Hawkins, III, aka Trip Hawkins, Appellant, v. The Franchise Tax Board of California; United States of America, Internal Revenue Service, Appellees (9th Circuit No. 11-16276; September 15, 2014).

[4] F. Scott Fitzgerald, The Rich Boy, in The Short Stories of F. Scott Fitzgerald: A New Collection 317  Matthew J. Bruccoli ed., Scribner 1989) (1926).

[5] Ernest Hemingway, The Snows of Kilimanjaro, in The Snows of Kilimanjaro and Other Stories 23 (Scribner 1961) (1936). (Hemingway, quoting the critic Mary Colum without attribution, used Fitzgerald’s name in the original magazine version of the short story, but altered the name to “Julian” in the later published book. See Eddy Dow, Letter to the Editor, The Rich Are Different, N.Y. Times, November 13, 1988, available at different-907188.html.)

[6] The Ninth Circuit also noted that the IRS received a $3.4 million distribution pursuant to a  liquidating plan of reorganization, which was confirmed by the bankruptcy court.


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