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
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
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.
Article © Fred Witt 2014. All Rights Reserved.
Disclaimer: This alert is
provided for general information purposes and is not intended to constitute
legal or tax advice. Please consult with your own legal or tax advisor before making
any decisions concerning your financial or business matters.