A taxpayer does not “willfully . . . evade or defeat” a tax by merely “spending in excess of income” and so not paying the tax.
The Law of Discharging (Permanently Writing Off) Income Taxes
Income taxes can, under the right conditions, be discharged in bankruptcy. See our blog post of earlier this year called “Discharging Income Taxes through Chapter 7 Bankruptcy.”
We refer there to four conditions that have to be met in order to discharge taxes, and describe the fourth one as one that is “very seldom a problem” to meet. That’s because most people do not intentionally cheat on their taxes and then file bankruptcy to discharge their debts.
This fourth condition is stated in the Bankruptcy Code as follows: you can’t get a discharge of a tax if you “made a fraudulent [tax] return or willfully attempted in any manner to evade or defeat such tax.” Even if meet the other three conditions, you must meet this one as well or your tax will not get discharged.
The Issue in the Recent Ninth Circuit Decision
It is this fourth condition that was the subject of a decision a few weeks ago in the federal Ninth Circuit Court of Appeals (which governs Oregon) called Hawkins v. Franchise Tax Board of California and IRS. The specific question was an interesting one, with unusual facts that made it all the more interesting. The debtors were Trip Hawkins and his wife Lisa. He had been a top manager at Apple Computer and then 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 legal question sounds quite dry, but its practical impact is huge.
The court focused on a single word in the Bankruptcy Code quoted above: “willfully.” For a person filing bankruptcy to have “willfully attempted in any manner to evade or defeat” a tax, does the IRS/state really have to show that the person specifically intended to evade or defeat the tax? Or is it enough to show merely that the person intentionally committed acts or omissions which may or may not have been committed for the purpose of evading the tax? Which mental state does the person need to have had to “willfully” evade a tax?
This seemingly hair-splitting distinction makes much more sense when applied to the practical question of this case: is it “willful” evasion of taxes simply to spend in excess of one’s income instead of paying taxes owed? In this case, was it willful tax evasion for the debtors’ family to be spending between $16,750 and $78,000 per month in excess of their income for a period of more than two and a half years while the debtor was aware that he owed tens of millions of dollars in income taxes? Specifically do the IRS and other taxing entities have to prove that the debtor spent this money with the specific intent to evade taxes, or is it enough for them just to prove that he intended to spend the money while owing the taxes, regardless whether or not he actually did so in order to evade taxes?
The Decisions of the Lower Courts
The bankruptcy judge on the case focused on the long-time business executive’s “exceptional business sophistication,” his full knowledge of his huge tax debt and insolvency, and the long period of extravagant spending which persisted at such a wasteful rate in spite of that knowledge. 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. When he appealed this decision, the U. S. District Court judge agreed with the bankruptcy judge that the tax should not be discharged. So Hawkins took the appeal one step higher, to the Ninth Circuit Court of Appeals.
The Decision of the Ninth Circuit
The Ninth Circuit Court of Appeals (as pronounced by the 3-judge panel that decided the case) overturned these two lower courts and decided in favor of Hawkins on the “willful evasion” issue. The court said:
[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 argued that “[a]s to the 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.’ ”
The court pointed out 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.
The Dissenting Opinion
Rulings by the federal Court of Appeal 3-judge panels are often unanimous. But not this one. One of the three judges wrote a dissenting opinion approvingly citing a contrary decision that had been issued less than a month earlier by another Court of Appeals, of the Tenth Circuit, in a case out of Colorado. 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 all that 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.”
The dissenting judge concluded by agreeing with the original bankruptcy court’s decision “denying discharge of Hawkins’ substantial tax liability due to his willful attempt to avoid payment of those taxes through profligate spending.” “Providing a fresh start under the Bankruptcy Code should not extend to aiding and abetting wealthy tax dodgers.”