Fred Witt PLC, Phoenix Federal Tax Attorney
   

Bankruptcy Tax Alert — September 2014

Ninth Circuit Holds Nonpayment of Taxes Is Not a Bar to Discharge

Fred Witt

 

Fred Witt

 

If a wealthy person can’t pay back taxes, but continues to live a lavish lifestyle beyond his means, does the payment of personal expenses at a time when taxes are due bar the discharge of these taxes in a subsequent personal bankruptcy because nonpayment constitutes a prohibited “willful attempt” to evade taxes?

In an important case of first impression, the Ninth Circuit answered "no" — the mere nonpayment does not make a tax debt nondischargeable.

The facts of Hawkins v. FTB, __ F.3d __ (9th Cir. Sept. 15, 2014), read like a novel of America's rich and famous. Or possibly, borrowing from Greek mythology, the modern version of the story of Icarus.

Between 1996 and 2000, Mr. Hawkins:

  • sold company stock for substantial tax gains;

  • entered into tax sheltered transactions designed to create substantial, offsetting, tax losses;

  • got divorced and remarried;

  • lived a lavish lifestyle, owned multiple homes and traveled by private jet; and

  • invested in a new "dot bomb" company that later failed and proved worthless.

On audit, the IRS disallowed the tax shelter losses, resulting in over $30 million in federal and state taxes due. Mr. Hawkins reversal of fortune was breathtaking. In 1996, his net worth approached $100 million, but by 2003, he was financially insolvent with over $30 million in back taxes due. However, until filing a personal chapter 11 bankruptcy in 2006, he continued to live a rich lifestyle, with personal expenses substantially exceeding his income by estimated amounts ranging from $500,000 to $2 million.

In order to deal with his back taxes, he filed a personal chapter 11 bankruptcy petition in 2006. After the sale of his personal assets and confirmation of a liquidating plan of reorganization, he was entitled to a discharge of all debts, including $25 million in tax debts. The IRS subsequently challenged, arguing that the tax debts were excepted from discharge under Bankruptcy Code Section 523(a)(1)(C), because the debtor "willfully attempted in any manner to evade or defeat such tax." 11 U.S.C. § 523(a)(1)(C). The IRS argued that spending beyond his income amounted to a "willful attempt" to evade taxes.

First, some background. The right of debtors to restructure their financial affairs and obtain a fresh-start discharge of prior obligations is so fundamental that it is found in the bankruptcy clause of the U.S. Constitution. U.S. Const., art. I, section 8, cl. 4. In furtherance of this broad policy, a debtor is permitted to discharge all debts that arose before filing a bankruptcy petition. 11 U.S.C. § 727. However, there are specific exceptions to discharge, including any tax debts "with respect to which the debtor ... willfully attempted in any manner to evade or defeat such tax." 11 U.S.C. § 523(a)(1(C).

The Ninth Circuit held the "fresh start" policy of discharge should be interpreted broadly, and the exceptions interpreted narrowly. Mere nonpayment is not sufficient. A "willful attempt" requires the government to show that "the debtor took the actions with the specific intent of evading taxes." Spending beyond your income, without more, does not qualify as a "willful attempt."

Given the importance of the question, and a different conclusion reached by the Tenth Circuit, expect this issue to one day be decided by the U.S. Supreme Court.