A. Lavar Taylor of the Law Offices of A. Lavar Taylor discusses this week’s important Hawkins v Franchise Tax Board decision in the Ninth Circuit. In the first post, Lavar discusses how other courts have approached the issue. In tomorrow’s post, Lavar discusses the Ninth Circuit opinion and describes why he believes its approach is correct.
In Hawkins v. Franchise Tax Board, — F.3d – (9th Cir. No. 11-16276, Sept. 15, 2014), an opinion released on Monday that can be found here, the Ninth Circuit addressed the question of what the IRS and other taxing agencies must prove to establish that a tax liability cannot be discharged by an individual in a chapter 11 or chapter 7 bankruptcy because the debtor/taxpayer “willfully attempted in any manner to evade or defeat” a tax liability for purposes of section 523(a)(1)(C) of the Bankruptcy Code. Breaking ranks with the other Courts of Appeal which have addressed this issue, the Ninth Circuit construed this language in pari materia with the nearly identical language contained in section 7201 of the Internal Revenue Code, as interpreted by the U.S. Supreme Court in the case of Spies v. United States, 317 U.S. 492 (1943).
The Ninth Circuit’s holding in Hawkins departs from the holdings of virtually every other Court of Appeals to consider this issue. Before discussing prior case law and why I believe that the Ninth Circuit reached the right result, I want to warn readers that I am no innocent bystander on this issue. I authored a brief as amicus curiae filed in the Hawkins case, and the Hawkins majority opinion’s discussion of the Spies case and its applicability to cases involving section 523(a)(1)(C) adopts the position I advocated in the brief as amicus curiae. For those interested in reading that amicus brief, it can be found here. The amicus brief includes a detailed discussion of the differences between sections 7201 and 7203 and the case law construing those two provisions.
Case Law in Other Circuits
Now to the case law in the other Circuits construing section 523(a)(1)(C) which preceded the Ninth Circuit’s holding in Hawkins. In Toti v. United States (In re Toti), 24 F.3d 806 (6th Cir. 1994), the Court was faced with a situation where the debtor had failed to timely file returns and had failed to pay the taxes owed, but, per the trial court, had not committed an “affirmative act” of evasion. The trial court held that the taxes were discharged because there was no willful attempt to evade or defeat the taxes in that situation. The Sixth Circuit on appeal, however, reversed the trial court and held that Toti had “willfully attempted to evade or defeat the taxes” within the meaning of §523(a)(1)(C).
The Court attempted to justify its outright reversal of the finder of fact (as opposed to a remand to apply the legal standard adopted by the Sixth Circuit) by stating that the standard of “willfulness” under section523(a)(1)(C) should be the same standard of “willfulness” used by the courts in imposing criminal liability under section 7203 of the Internal Revenue Code, as opposed to section 7201 of the Code. The District Court’s ruling, which was affirmed by the Sixth Circuit, explicitly approved of the standard of “willfulness” used in imposing liability under section 6672 of the Internal Revenue Code. 141 B.R. 126 (E.D. Mich. 1993).
Other Courts of Appeal followed the rationale of Toti. The Eleventh Circuit, in Fretz v. United States (In re Fretz), 244 F.3d 1323 (11th Cir. 2001), reversed a finding by the trial court that the debtor had not attempted to evade or defeat the taxes in question. The debtor had failed to file his returns and had failed to pay the taxes owed. The Eleventh Circuit held that this was sufficient to render the taxes non-dischargeable under §523(a)(1)(C) and that this section does not contain a requirement that the debtor engage in an affirmative act of evasion to render the taxes non-dischargeable. The Court stated as follows:
Thus, all the government must prove is that Dr. Fretz (1) had a duty to file income tax returns and pay taxes; (2) knew he had such a duty; and (3) voluntarily and intentionally violated that duty. 244 F.3d at 1330.
The Seventh Circuit has ruled in a similar manner. See United States v. Fegley (In re Fegeley), 118 F.3d 979, 984 (3d Cir. 1997). Most recently, the Tenth Circuit followed this logic in holding that taxes were not dischargeable. Vaughn v. Comm’r (In re Vaughn), – F.3d – 2014 WL 4197347 (10th Cir. 2014). [Ed note: Keith discussed Vaughn here] Additional opinions on this issue from other Courts of Appeal are discussed in the Ninth Circuit’s opinion.
The Bankruptcy Opinion
Before discussing why the Ninth Circuit reached the correct result in Hawkins, it is useful to review the opinion of Bankruptcy Judge Carlson. Judge Carlson’ opinion can be read here. Judge Carlson wrote in part as follows:
William M. “Trip” Hawkins (Trip) is a very sophisticated businessman. He received an undergraduate degree in Strategy and Applied Game Theory from Harvard College, and an M.B.A. from Stanford University. He was an early employee of Apple Computer, where he rose to director of marketing. In 1982, he left Apple and became one of the founders of Electronic Arts, Inc. (EA), which became the largest supplier of computer entertainment software in the world. By 1996, Trip had a net worth of approximately $100 million, primarily from his holdings of EA shares.
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In 1990, EA created a wholly owned subsidiary, 3DO, for the purpose of developing and marketing the devices on which computer games are played. Trip Hawkins left EA to run 3DO. 3DO went public in 1993. In 1994, Trip began to sell large amounts of his EA common stock to invest heavily in 3DO.
The story from that point forward is not unfamiliar to practitioners who have represented those taxpayers who “invested” in various “products” hawked by certain tax professionals. Hawkins invested in the FLIP and OPIS tax shelter products and claimed losses from these “investments.” These losses were used to offset large gains generated from the sale of EA stock. The IRS then audited the income tax returns of Hawkins for the years 1996 through 2000, and Hawkins retained highly respected counsel to represent him in the audit. Hawkins attempted to participate in the settlement program announced in IRS Announcement 2002-97, but he was told that he was not eligible for that program.
In the meantime, Hawkins’ investment in 3DO was going south. He loaned over $12 million to this company. The net result was that 3DO filed a chapter 11 bankruptcy in May of 2003, and the bankruptcy was converted to a chapter 7 (liquidation) later that year.
There was more bad news for Hawkins. In July of 2003, he received a revenue agent’s report from IRS asserting that he owed roughly $16 million of taxes and penalties for the years covered by the audit. Hawkins had previously divorced his first wife. Trying to make lemonade out of lemons, in July of 2003 Hawkins filed a motion in the family law court to reduce child support payments due under the existing order, citing the fact that he owed the IRS and FTB over $25 million combined and his mounting losses associated with 3DO. The family law court granted Hawkins partial relief but required him to place certain assets in trust for his children and imposed a judicial lien on those assets in an effort to protect them from seizure by IRS and FTB.
Hawkins consented to the assessment of the IRS tax deficiencies in December, 2004, and the IRS assessed the deficiencies in March, 2005. The California FTB assessed their “piggyback” audit deficiencies in September of 2005. In October of 2005, Hawkins submitted an Offer in Compromise to the IRS. This OIC was ultimately rejected. In July of 2006, Hawkins sold a residence, and the IRS received $6.5 million from this sale. The FTB received $6 million as the result of levies on financial accounts in August of 2006.
In September of 2006, Hawkins filed a chapter 11 bankruptcy petition. He confirmed a plan of reorganization in July, 2007. The IRS received roughly $3.4 million under the plan. But substantial amounts remained due and owing to both the IRS and the FTB after consummation of the chapter 11 plan. Hawkins then filed suit to determine whether the unpaid taxes owed to IRS and FTB were discharged in the Chapter 11 bankruptcy.
In the litigation, the IRS made two arguments in support of its position that the unpaid tax liabilities had not been discharged. First, they argued that Hawkins had filed fraudulent returns by claiming the tax shelter losses on those returns. Those of you who are familiar with Jack Townsend’s excellent blog Federal Tax Crimes know that Jack has wondered for quite some time why the IRS has not asserted the civil fraud penalty more frequently against taxpayers who “invested” in tax shelters. In this particular case, the IRS argued that Hawkins filed a fraudulent return. So there you go, Jack. They finally claimed that a taxpayer acted fraudulently in claiming losses from a tax shelter on their income tax return, albeit in the context of bankruptcy dischargeability litigation, where the standard of proof for proving fraud is only a preponderance of the evidence.
Judge Carlson, however, explicitly refused to decide whether Hawkins acted with intent to defraud in filing the tax returns in question. Instead, Judge Carlson held that Hawkins had attempted to evade or defeat the taxes in question. Judge Carlson made it very clear that the basis for his holding that Hawkins had attempted to evade or defeat the taxes in question was that Hawkins had done nothing more than engage in “unnecessary” expenditures. Here is what Judge Carlson had to say:
The Government has met the required burden with respect to Trip Hawkins by establishing that for more than two and one-half years before filing for bankruptcy protection, he caused Debtors to make unnecessary expenditures in excess of Debtors’ earned income, while he acknowledged that Debtors had a tax liability of $25 million, while he relied upon that tax liability in seeking a reduction of child support payments, while he knew Debtors were insolvent, while Debtors paid other creditors, and while Debtors planned to file bankruptcy to discharge their tax obligations.
Judge Carlson then commented extensively on Hawkins’ lifestyle, stating as follows:
From the time of their 1996 marriage onward, Debtors maintained a lifestyle that was commensurate with the great wealth they enjoyed at the time they were first married. In 1996, Debtors purchased a home in Atherton, California for $3.5 million. In 2000, Debtors purchased an $11.8 million private jet that they used for family vacations as well as for business trips. In 2002, Debtors purchased an ocean-view condominium in La Jolla, California for $2.6 million. From the date of their marriage to the date of their bankruptcy petition, Debtors employed various gardeners and household attendants.
Debtors altered this lifestyle very little after it became apparent in late 2003 that they were insolvent. Although they sold the private jet in 2003, they continued to maintain both the Atherton house and the La Jolla condominium until July 2006. In October 2004, Debtors purchased a fourth vehicle costing $70,000.
Debtors’ personal living expenses exceeded their earned income long after Trip had acknowledged that Debtors were insolvent. In the Collection Information Statement accompanying their October 2005 Offer in Compromise, Debtors disclosed annual after-tax earned income of $150,000 and annual living expenses of more than $1.0 million. In the schedules filed in their bankruptcy case in September 2006, Debtors disclosed annual after-tax earned income of $272,000 and annual living expenses of $277,000. The components of Debtors’ living expenses are discussed in more detail below.
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Before examining Hawkins’ expenditures, it is appropriate to examine Hawkins’ earned income. For the purpose of this decision, this court assumes that it should take some account of a debtor’s earned income in determining what expenditures are culpable under section 523(a)(1)(C) as unduly lavish. It may not be appropriate to require a CEO earning hundreds of thousands of dollars per year to live in an apartment suitable for a clerical employee, even if that CEO is insolvent. The effort and skill required to earn such sums require a nuanced approach in determining what living expenses are necessary. Even the most nuanced approach, however, does not excuse living expenses greatly in excess of earned income over an extended period of time.
Debtors provided two snapshots of their income and expenses between January 2004 and September 2006. In October 2005, Debtors submitted a Collection Information Statement, signed under penalty of perjury, in support of their Office in Compromise. In September 2006, Debtors filed schedules in their chapter 11 case, also signed under penalty of perjury. The October 2005 Collection Information Statement indicated monthly after-tax earned income of $12,500. Bankruptcy Schedule I indicated monthly after-tax earned income of $22,180. All of this income was earned by Trip; Lisa was not employed outside the home at any time during this period.
Against this backdrop, the Debtors’ personal living expenses from January 2004 to September 2006 are truly exceptional. After Trip represented to the family court that he was liable for $25 million in federal and state taxes and that he was insolvent as a result, Debtors spent between $16,750 and $78,000 more than their after-tax earned income each month.
In the Collection Information Statement submitted in October 2005, Debtors stated that their personal living expenses were more than seven times their after-tax earned income, and exceeded that income by more than $78,000 per month.
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Several aspects of this Statement are worthy of note. The $33,600 housing expense included expenses for a 5-bedroom, 5.5 bath house in Atherton (later sold for $10.5 million), and a 4-bedroom, 3.5 bath condominium in La Jolla (later sold for $3.5 million). The transportation expense covers four vehicles for a family with only two drivers, and includes a $70,000 Cadillac SUV purchased ten months after Trip Hawkins had acknowledged Debtors’ tax liability and insolvency in the family court proceeding.
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The schedules filed in Debtors’ bankruptcy case indicate that Debtors’ personal living expenses greatly exceeded their after-tax earned income until just before they filed their bankruptcy petition in September 2006. Debtors sold the Atherton house just before the bankruptcy petition was filed. Debtors sold the La Jolla condominium after the bankruptcy petition was filed. If one adds the minimum amount they could have been spending for housing before the July 2006 sale of the Atherton house, together with the income and living expenses that Debtors reported in their bankruptcy schedules, Debtors’ living expenses greatly exceeded their after-tax earned income through July 2006.
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Debtors made expenditures in excess of earned income for more than two-and-one-half years after Trip Hawkins acknowledged in January 2004 that Debtors were insolvent and would not pay their tax debt in full. Debtors did not sell the Atherton home until July 2006. They did not sell the La Jolla condominium until after filing for bankruptcy protection in September 2006. 24 They reported in their bankruptcy schedules that on the petition date they were still making the expenditures for the Cadillac SUV, child care, and recreation noted above. Debtors’ high level of expenditure also continued well after they consented to assessment of tax by the IRS in the amount of $21 million in December of 2004, and well after the assessments were recorded in March 2005. The Collection Information Statement indicates that Debtors’ monthly living expenses were seven times their earned income ten months after they consented to assessment and seven months after the IRS formally assessed the additional tax. This is not a case where the taxpayers acted appropriately once the tax was formally assessed, perhaps suggesting that their earlier failure to pay was based on some innocent misconception of their duty.
There is one point not focused on by Judge Carlson but of potential relevance to the resolution of the case under the standard relied on by him. The IRS taxes were not assessed until March of 2005, some 18 months after the family court hearing. Assuming that Hawkins did not knowingly sign fraudulent tax returns when he claimed the tax shelter losses on those returns, his duty to pay the audit deficiency assessments did not arise until after the taxes were assessed and notice and demand for payment was sent in 2005. See, e.g., §6651(a)(3) of the Internal Revenue Code, which imposes a penalty for the taxpayer’s failure to pay a deficiency in income taxes only after the taxpayer has received notice and demand for payment after the tax deficiency has been assessed.
Based on the premise that Hawkins had no duty to pay the additional taxes until they were properly assessed, I have difficulty with Judge Carlson’s reliance on the pre-assessment conduct of Hawkins to determine that he attempted to evade or defeat the taxes in question. Pre-assessment conduct of a taxpayer is certainly relevant for purposes of determining whether a taxpayer engaged in Spies-type evasion of taxes under section 7201. See, e.g., United States v. Voorhies, 658 F.2d 710 (9th Cir. 1981). But I am unaware of any case in which the IRS has ever charged or convicted a taxpayer for a failure to pay a tax under section 7203 based on the taxpayer’s conduct prior to the tax being assessed and billed to the taxpayer.