In yesterday’s post A. Lavar Taylor discussed the case law in other circuits and the bankruptcy opinion in Hawkins v Franchise Tax Board. Today’s post turns to the Ninth Circuit and its decision to part ways with the other circuits. Lavar explains why he believes for both legal and practical reasons the Ninth Circuit’s view is correct. Les
Now I turn to why the Ninth Circuit reached the correct result in Hawkins by concluding that “improper” expenditures, by themselves, do not constitute an attempt to evade or defeat a tax liability. There are both legal and practical reasons why the Ninth Circuit’s holding in Hawkins is the correct one. I first discuss the legal reasons.
The Legal Reasons Why the Ninth Circuit Is Correct
The Ninth Circuit noted that the purpose of a bankruptcy discharge is to give an individual debtor a “fresh start.” It noted that this “fresh start” philosophy argues for a more narrow interpretation of the “attempt to evade or defeat” exception from discharge. The Ninth Circuit also concluded that both the structure of section 523(a) of the Bankruptcy Code and its legislative history support a narrow reading of the “attempt to evade or defeat” exception to discharge.
The Ninth Circuit also took note of the Supreme Court’s holding in Kawaauhau v. Geiger, 523 U.S. 57 (1998), in which the Supreme Court narrowly construed the term “willfully” for purposes of section 523(a)(6) of the Bankruptcy Code.
But the key to the Ninth Circuit’s ruling is the fact that the Supreme Court, in Spies v. United States, 317 U.S. 492 (1943), held that a mere willful failure to file a return, coupled with a mere willful failure to pay the tax, does not constitute a willful attempt to evade or defeat the tax for purposes of section 7201 of the Internal Revenue Code. Section 7201 uses language almost identical to the language in section 523(a)(1)(C) of the Bankruptcy Code. The Supreme Court held in Spies that the taxpayer must take some sort of “willful commission” (in addition to the willful omissions), or engage in an “affirmative act,” in an effort to evade the tax, in order to commit tax evasion under section 7201. Whether a particular act taken by a taxpayer is an affirmative act taken in an effort to evade the tax is to be decided by the trier of fact.
Because the language in section 523(a)(1)(C) of the Bankruptcy is virtually identical to the language in section 7201 of the Internal Revenue Code, it makes sense to construe section 523(a)(1)(C) in the same manner in which the Supreme Court construed section 7201 of the Internal Revenue Code in Spies. The elements discussed above in in the Fretz case, which were used by Judge Carlson in the Hawkins case and were used by all other Courts of Appeal to consider this issue, are elements required to convict a taxpayer of a willful failure to file or a willful failure to pay under IRC section 7203. See, e.g., United States v. Tucker, 686 F.2d 230 (5th Cir. 1982).
Section 7203 uses very different language than the “willful attempt in any manner to evade or defeat” language contained in IRC §7201 and Bankruptcy Code section 523(a)(1)(C). The failure by Congress to incorporate the language of IRC §7203 into section 523(a)(1)(C) of the Bankruptcy Code, coupled with the incorporation into section 523(a)(1)(C) of the language contained in section 7201, indicates that the holdings of the other Courts of Appeal were in error.
The Practical Reasons Why the Ninth Circuit is Preferable
The Ninth Circuit’s approach is also preferable for practical reasons. The most obvious practical problem for courts relying on the standard used in other Circuits is determining in a principled manner what expenditures by the debtor are “unnecessary” once the duty to pay the taxes arises. Only a principled approach can provide future guidance to courts, future litigants, debtors who wish to avoid a fight over whether they attempted to evade or defeat the taxes that they owed, and professionals who advise debtors who wish to avoid this fight.
Judge Carlson offered precious little principled guidance on how to decide what expenditures are “unnecessary” in other factual contexts. We know that a “nuanced approach” should be used, depending on the debtor’s pre-existing income and lifestyle, but we know very little about how to define those “nuances” or about how to apply those “nuances” in future cases where the taxpayer’s circumstances differ from those of Mr. Hawkins.
Can a debtor pay for extraordinary medical expenses for a parent or for a beloved pet, at the expense of not paying their taxes? What about paying modest private school tuition for their children? What about paying tuition for the debtor to obtain an advanced degree in the hopes that the debtor will obtain a much higher paying job? Does the potential level of earnings once the degree is earned make a difference? Can the debtor pay to go on any vacations at all? What if the debtor’s therapist recommends that the debtor take a vacation because of stress related to a difficult marriage or related to financial difficulties?
What about debtors who owe business debts? Will some of these debts be deemed “necessary” and other “unnecessary?” Will it matter if payment of the business debt will give rise to a tax deduction which would reduce the amount of taxes owed? If a debtor pays state taxes without paying federal taxes, is that an attempt to evade or defeat the federal taxes? If the debtor pays federal taxes without paying state taxes, is that an attempt to evade or defeat the state taxes? What about payment of alimony and child support?
For those debtors who are living a good lifestyle but are greeted by an overwhelmingly large tax liability, how long do they have to reduce their expenditures before their pre-existing level of expenditures becomes “unnecessary?” Six months? A year? If they attempt to sell their expensive house and find no buyers at a reasonable price after a year, are debtors required to sell at a fire sale or to stop paying their mortgage?
If the debtor reasonably believes that he owns property that will appreciate enough for him to fully pay his taxes within several years, must the debtor lower his or her level of living expenses while waiting for the property to appreciate? Will the expenses paid while waiting for the property to appreciate be deemed to be “excessive” through hindsight if property values suddenly and unexpectedly decline?
The number of questions regarding “necessary” and “unnecessary” expenses which could arise under the standard employed by Judge Carlson and other Circuits is virtually limitless. Under this standard, courts, debtors and their counsel can look forward to innumerable Circuit splits on all of the exciting issues mentioned immediately above, among many others.
Simply put, if the standard for determining whether a taxpayer/debtor has attempted to evade or defeat the tax is whether the taxpayer/debtor made “inappropriate” expenditures, there is no principled way for courts to draw the line between what expenditures are “appropriate” and what expenditures are “inappropriate.” Cases will be decided based on the whims and fancies of individual judges, each of whom will have their own sense of what expenses are “appropriate” and what expenses are “inappropriate.” One judge may conclude that it was entirely proper for a taxpayer to spend $25,000 furthering their education in an effort to significantly increase their earnings capacity instead of paying the money over to the IRS, while another judge may conclude that the taxpayer attempted to evade or defeat the tax by spending $25,000 on educational expenses instead of paying the $25,000 over to the IRS.
In addition, IRS and other tax agencies could invoke the “attempt to evade or defeat” exception merely because they do not like the way the debtor/taxpayer spent their money. Such a standard carries with it a significant potential for abuse of taxpayers by tax agencies. The potential for abuse drastically decreases if tax agencies are required to prove the traditional elements of tax evasion in order to invoke the “attempt to evade or defeat” exception in section 523(a)(1)(C).
Under the standard used by Judge Carlson, it is impossible for tax professionals to advise their clients on whether the clients can make certain expenditures, assuming that the use of bankruptcy to discharge tax liabilities is a possibility at the time the advice is solicited. If the standard used by Judge Carlson applies, no competent professional will ever offer meaningful advice on this subject out of fear of the potential consequences of giving incorrect advice.
As a final note, I have several comments about the dissenting opinion in Hawkins. First, this dissent makes a statement that is downright scary. At page 17 of the Slip Opinion, the dissent states:
At the family court hearing, Hawkins’ bankruptcy attorney “testified that Hawkins’ intent was not to pay the tax debt, but to discharge it in bankruptcy. . . .” Id., p. 19. This testimony is a strong indication of a willful intent to avoid the payment of taxes by hook or by crook.
I am troubled by the dissent’s language, given that, at the time the statement was made by the attorney, Hawkins was insolvent and lacked the ability to pay the taxes in full. (I will ignore the fact that this statement regarding Hawkins’ intent was not made by Hawkins himself.) In addition, 3DO was in financial difficulties and headed for chapter 7. Planning to discharge taxes in bankruptcy at a time when you are insolvent and lack the ability to pay the taxes in full is not an attempt to evade or defeat a tax liability. And Hawkins paid to the IRS and the FTB many millions of dollars between the date of that statement and the date of the bankruptcy petition.
I am also troubled by the dissent’s conclusion that the majority opinion “gives Hawkins a pass.” The majority opinion does no such thing. The majority remands the case so that the trial court can apply the correct legal standard. The trial court may now have to decide the issue previously ducked by Judge Carlson (who has now retired from the bench), namely, whether Hawkins acted with intent to defraud in filing the tax returns in question. At a minimum, the trial court will have to decide whether the actions taken by Hawkins leading up to his chapter 11 bankruptcy were taken with Spies-type intent to evade the tax liability. Hawkins has not been given a “pass.” Rather, his conduct is going to be judged under the appropriate legal standard, rather than under a standard that is no standard at all.
For those of you who disagree with my statement that the standard relied upon by Judge Carlson (and by the dissent and by other Circuits) is no standard at all, I invite you to carefully review Judge Carlson’s opinion and tell me how you would apply the “standard” set forth in that opinion to the vast majority of taxpayers whose financial circumstances are much more modest than those of Mr. Hawkins. I’ve read and re-read Judge Carlson’s opinion. All I can take away from that opinion is that some expenditures are “appropriate,” some expenditure are “inappropriate,” that Bankruptcy Judges must take a “nuanced approach” in deciding which expenditures are “appropriate” and “inappropriate” for purposes of determining whether the debtor “attempted to evade or defeat” a tax liability, and that, if you continue spending “too much” money in the face of known tax liabilities for “too long,” you will have engaged in an “attempt to evade or defeat” the tax liabilities, regardless of your motives for spending that money.
How you apply that standard to all other taxpayers other than Mr. Hawkins in a principled manner I haven’t a clue. Which is why I believe the Ninth Circuit got it right in Hawkins.