WHAT DOES IT TAKE TO “WILLFULLY. . . EVADE OR DEFEAT” AN INCOME TAX?
A couple months ago the Ninth Circuit Court of Appeals (which serves all of California and much of the West) ruled that it takes quite a lot for a taxpayer to “willfully. . . evade or defeat” an income tax for bankruptcy purposes. In Hawkins v. Franchise Tax Board of California and IRS the court ruled that a formerly very wealthy executive was NOT “willfully” evading $29 million in income taxes during a period of two and a half years that he knew that he and his spouse owed that tax debt and yet during every consecutive month of that time they spent tens of thousands of dollars in expenses in excess of their income, instead of paying anything towards the taxes. To “willfully . . . evade” a tax “requires that the acts be taken with the specific intent to evade the tax.” “Living beyond one’s means alone [does not constitute] willful tax evasion.”
WHY IS THIS COURT RULING SO IMPORTANT?
It’s important because it changed the law on what income taxes can be discharged (permanently written off) in bankruptcy. The ruling made it easier to do so.
To discharge an income tax it must meet a number of conditions. See my earlier blog post called “Discharge Taxes in Bankruptcy” in which I outlined the 5 required conditions. One of these conditions is that you can’t get a discharge of a tax if, as stated in the Bankruptcy Code, you “made a fraudulent [tax] return or willfully attempted in any manner to evade or defeat such tax.”
Here is what I said in my earlier blog post about this required condition for discharge:
There was no willful intent to evade taxes or fraud involved -The taxes that you owe must have not resulted from an intent to evade taxes such as filing inaccurate tax returns in which you count additional dependents that you know you cannot count as dependents or underreporting your income.
Interestingly, I then gave the following example of willful evasion of taxes:
Failing to pay taxes while engaging in "unnecessary and unreasonable expenditures" evidences an intent to evade taxes. Engaging in lavish purchases or transferring of assets while failing to pay your tax obligations indicates an intent to evade taxes.
This new ruling by the Ninth Circuit Court of Appeals has turned this prior understanding of the law upside down.
SOME MORE FACTS ABOUT THIS COURT DECISION
In the Hawkins case the debtors were Trip Hawkins and his wife Lisa. He had been an early top manager at Apple Computer, and then became one of the founders of Electronic Arts, at the time the world’s biggest computer entertainment provider. His net worth had been $100 million about ten years before he and his wife filed bankruptcy.
The Hawkinses got into deep tax problems because of what turned out to be bad tax advice (from KPMG, one of the biggest accounting firms). Trip Hawkins sold huge amounts of his stock in Electronic Arts in order to raise money to invest in a new company. The capital gain (profit) from those sales was nearly $70 million over the course of three years. These gains were sheltered through a complicated set of transactions. The IRS eventually disallowed the tax shelters, resulting in a multi-million dollar tax bill. The new company in which Trip Hawkins invested all his tens of millions of dollars itself eventually filed bankruptcy.
Trip Hawkins knew by 2003 that he was insolvent, and that he owed tens of millions of dollars to the IRS and the California Franchise Tax Board. And yet he and his wife “did very little to alter their lavish lifestyle.” Their personal living expenses during the two and a half years at issue were “truly exceptional,” spending “between $16,750 and $78,000 more” each month during that period than they had earned income to spend.
SO WHAT’S THE PRECISE LEGAL ISSUE HERE?
The legal issue is easy to express: what does a single word in the Bankruptcy Code mean: “willfully.” For a person filing bankruptcy to have “willfully attempted in any manner to evade or defeat” a tax, does the IRS/California have to establish that the taxpayer specifically intended to evade or defeat the tax? Or is it enough simply to establish merely that the taxpayer
intentionally committed acts or omissions which indicated that they were committed for the purpose of evading the tax? Is it necessary to establish that the Hawkinses specifically intended to evade taxes, or is it enough to establish that they intentionally spent lavishly when they should have instead been paying the income taxes?
WHAT DID THE LOWER COURTS DECIDE ON THIS?
The bankruptcy judge decided that there was plenty of evidence of “willful tax evasion.” The judge focused on the business executive’s “exceptional business sophistication,” his “open acknowledgment” of his huge tax debt and his insolvency, and the long period of extravagant spending in spite of the known tax debt. The judge decided that this degree of “profligate spending indicated willful evasion of tax payments,” and did not allow the discharge of the tax as to the husband.
Trip Hawkins appealed this decision to the U. S. District Court, but that court also agreed that there was sufficient evidence of “willful tax evasion,” and decided the tax should not be discharged. So Hawkins appealed again, to the Ninth Circuit Court of Appeals.
HOW DID THE NINTH CIRCUIT FLIP THE LAW IN FAVOR OF HAWKINS?
The Ninth Circuit Court of Appeals, in a split 2-1 decision by the assigned 3-judge panel, overruled these two lower courts, saying:
[W]e conclude that declaring a tax debt nondischargeable . . . 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. Therefore, 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.
The Court of Appeals determined that a “stricter interpretation of ‘willfully’ than an expansive definition” is called for because of 1) “the ‘fresh start’ philosophy of the Bankruptcy Code,” 2) “the structure of the statute,” 3) its legislative history, 4) the cases that have interpreted the statute so far, and 5) the language of the Internal Revenue Code.
The court further made the practical argument that
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.
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.
HOW DID THE DISSENTING JUDGE ARGUE TO THE CONTRARY?
The dissenting judge on the Ninth Circuit panel thought that the bankruptcy judge and the first appellate judge got it right by finding “willful” tax evasion.
The dissenting judge approvingly citing a decision by another Court of Appeals, for the Tenth Circuit, in a case out of Colorado, which had been published less than a month earlier. That court’s decision also involved “a wealthy taxpayer [who] sought to discharge through bankruptcy a substantial amount of taxes owed.” The court ruled that what was required for willful tax evasion was that “1) the debtor had a duty under the law; 2) the debtor knew he had that duty; and 3) the debtor voluntarily and intentionally violated the duty.”
That is very different from the “specific intent” required by the Ninth Circuit majority opinion. Under this Tenth Circuit standard, the dissenting judge would “affirm the bankruptcy court ruling denying discharge of Hawkins’ substantial tax liability due to his willful attempt to avoid payment of those taxes through profligate spending.”
SO DID HAWKINS GET TO DISCHARGE THE $29 MILLION IN INCOME TAXES?
Not necessarily. The Court of Appeals majority opinion didn’t cleanly state that he got to discharge these taxes. Instead the case was “remanded” back to the bankruptcy court to decide the case again, now under the “specific intent” standard that the Court of Appeals established here.