Tax Litigation Update: Ninth Circuit Decision Provides Significant Support for Taxpayers Seeking to Discharge Tax Debt in Bankruptcy
October 20th, 2014
On September 15, 2014, the United States Court of Appeals for the Ninth Circuit issued a landmark decision strongly favoring debtors seeking to discharge tax debt in bankruptcy.
The case, Hawkins v. Franchise Tax Board (In Re Hawkins), involved a taxpayer, Trip Hawkins, seeking to discharge roughly 19 million dollars in a Chapter 11 bankruptcy. The Government objected to the discharge under 11 U.S.C. § 523(a)(1)(C), which precludes the discharge of a tax debt “with respect to which the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat such tax.” The Government, which prevailed at the bankruptcy court and district court levels, argued that Hawkins’ level of spending while his tax debt remained outstanding constituted a willful attempt to evade or defeat his tax liability.
Overruling the bankruptcy court and district court decisions below, the Ninth Circuit held that in order for a tax debt to be precluded from discharge due to a willful attempt to evade or defeat the tax, the Government must establish that the debtor had the specific intent to evade payment of tax; mere overspending on other items while the tax debt remained outstanding, if the overspending did not occur with the specific intent of avoiding payment of tax, is insufficient to rise to requisite level of willfulness.
Hawkins’ background created a less than sympathetic picture, which may have had some effect on the lower courts’ decisions to bar discharge. Hawkins was a graduate of Harvard and Stanford who had been among the first employees of Apple Computers and later served as CEO (and significant stockholder) of Electronic Arts (EA), the noted video game manufacturer. Hawkins’ wealth grew to about $100 million. In 1990, EA created a wholly owned subsidiary called 3DO for the purpose of developing and marketing video games and game consoles, and Hawkins was put in charge of 3DO. Thereafter, Hawkins sold a large amount of his EA stock and used the proceeds to invest in 3DO. By selling his EA stock, Hawkins generated significant capital gains. In order to offset his capital gains liability, Hawkins invested in several tax shelters offered by KPMG. The IRS challenged the tax shelters in 2001 and disallowed the losses Hawkins had taken to offset his capital gains, resulting in millions of dollars of liability for Hawkins. At the same time, 3DO’s business was stuttering, further compounding Hawkins’ financial situation. In a 2003 state court filing seeking to reduce his child support obligations, Hawkins acknowledged that he owed $25 million to the United States in back federal income taxes. All the while, even after recognizing the severity of his tax debt, Hawkins had enjoyed an expensive lifestyle, spending somewhere between $500,000 and $2.5 million more than what he earned on personal expenses in the 33 months between January 2004 and September 2006 when the bankruptcy petition was filed.
Hawkins did make some efforts to reduce his tax liability; he sold his house in July 2006 and paid all of the net proceeds, $6.5 million, toward his tax debt. Hawkins also proposed an Offer in Compromise of $8 million in an effort settle the liability, but the IRS rejected the offer. In September 2006, Hawkins filed for Chapter 11 protection, primarily in an attempt to rid himself of his tax debt. Shortly after filing, Hawkins sold a vacation house for $3.5 million and paid the proceeds to the IRS. The IRS also received a distribution of $3.4 million in Hawkins’ Chapter 11 plan. Nevertheless, millions of dollars of tax debt remained outstanding and the United States objected to the discharge of the tax debt on the basis that Hawkins willfully attempted to evade or defeat his tax liability, again arguing that Hawkins’ extravagant spending evidenced his willfulness.
The United States prevailed on this argument at both the Bankruptcy Court and District Court levels, and Hawkins appealed to the Ninth Circuit.
The Bankruptcy Code generally permits a discharge of all pre-petition liabilities of a debtor, unless discharge is specifically precluded by the Bankruptcy Code. Discharging income tax debt is possible, but doing so requires the debtor to overcome several hurdles. In addition to meeting several timing requirements contained in § 523(a)(1)(A)-(B) (for instance, the tax at issue must have been based on a return due at least three years before the petition date and the return must have been timely filed and filed more than two years prior to the petition date), the debtor’s return must not be fraudulent and the debtor must not have willfully attempted to evade or defeat the tax at issue.
In many cases, the timing and non-fraudulent return requirements are clearly satisfied, and the outcome of the dischargeability determination hinges solely on whether the debtor willfully attempted to evade or defeat the tax at issue. Courts are in near universal agreement that the phrase “willfully attempted in any manner to evade or defeat such tax” contains two elements the Government must prove: a conduct requirement and a mental state requirement. The conduct requirement means that the Government must prove that the debtor engaged in some act or omission in an attempt to evade or defeat the tax. The Government must also prove that the debtor committed the act or omission willfully.
The Hawkins case dealt solely with the mental state requirement, more specifically the mental state required by the statute’s use of the word “willfull” in order to preclude discharge. A majority of Courts, including the Eleventh Circuit, have adopted a test which requires the Government to show that the debtor (1) had a duty to pay taxes under the law; (2) knew that he had such a duty; and (3) voluntarily and intentionally violated that duty. These courts have not expressly required the Government to establish that a debtor had a specific, fraudulent intent to evade or defeat the tax.
In reversing the bankruptcy court and district court in Hawkins, the Ninth Circuit set forth a more restrictive, debtor-friendly interpretation of willfulness. Specifically, the Court held that “we conclude that declaring a tax debt dischargeable under 11 U.S.C. § 523(a)(1)(C) on the basis that the debtor ‘willfully attempted in any manner to evade or defeat such tax’ requires showing of a 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 action the actions with the specific intent of evading taxes.” In other words, to the Ninth Circuit, overspending alone will not rise to willfulness unless the debtor overspent with the specific intent of avoiding payment of his tax liability.
In reaching this conclusion, the Ninth Circuit focused on purpose of the Bankruptcy Code and the textual structure of § 523(a)(1)(C). First, the Ninth Circuit emphasized the fact that federal bankruptcy law was designed to provide debtors with a fresh start, which in turn compels a strict, rather than expansive, interpretation of “willfulness.” For support, the Ninth Circuit cited Kawaauhau v. Geiger, 523 U.S. 57 (1998), in which the Supreme Court held that, under § 523(a)(6) of the Bankruptcy Code, which precludes discharge of debts arising out of a willful and malicious injury, the party seeking to preclude discharge must establish an intent to injure, not just an intentional act that leads to injury.
The Ninth Circuit also relied on the text of § 523(a)(1)(C) in requiring a higher standard of willfulness. The Ninth Circuit held that by grouping willfulness with the filing of a fraudulent return in a separate subsection, rather than the more banal timing requirements of § 523(a)(1)(A)-(B), Congress had evidenced its intent to require a showing of bad purpose on the part of the debtor for the Government to establish willfulness.
The Court also found support for its ruling in the Internal Revenue Code. Specifically, the Court highlighted the fact that the language of § 523(a)(1)(C) is nearly identical to that found in IRC § 7201, which makes it a felony to “willfully attempt in any manner to evade or defeat any tax.” Courts interpreting § 7201 have required the Government to prove that the taxpayer voluntarily and intentionally violated a known legal duty. See Cheek v. United States, 498 U.S. 201 (1992). This, “almost invariably,” will “involve deceit or fraud upon the Government, achieved by concealing tax liability or misleading the Government as to the extent of the liability.” Kawashima v. Holder, 132 S. Ct. 1166, 1175, 1177 (2012). In following this rationale, the Ninth Circuit rejected reasoning of other Circuit Courts facing this question which have relied upon portions of the Internal Revenue Code dealing with civil willfulness (such as IRC § 6672). Generally speaking, civil willfulness requires the Government to establish intentional conduct, but not a bad faith purpose, while criminal willfulness requires a bad faith purpose.
The Ninth Circuit also focused on the consequences of imposing a rule providing that living beyond one’s means would lead to the preclusion of tax debt dischargeability. “Indeed, 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. Such a rule could create a large ripple effect throughout the bankruptcy system.”
In sum, the Ninth Circuit held that acts that detract from a debtor’s ability to pay the outstanding tax debt will not preclude discharge unless those acts are made with the specific intent of evading tax. Intending to commit the act (or omission) that detracts from payment of the outstanding tax is not by itself sufficient.
Conflict with Other Circuits?
As stated above, several Circuit Courts of Appeal have read § 523(a)(1)(C) to require the Government to prove that the debtor (1) had a duty to pay taxes under the law; (2) knew he had that duty; and (3) voluntarily and intentionally violated that duty. Under a broad interpretation, those elements are arguably satisfied if the act of overspending was committed intentionally, but without the specific purpose of avoiding taxation.
From a surface level it appears that the Ninth Circuit’s Hawkins decision creates a Circuit split, because the Ninth Circuit now requires the Government to prove specific intent to establish willfulness while a number of other Circuits have not expressly made that a requirement. However, as the Court points out in Hawkins, in those other Circuits, living a lifestyle beyond one’s means has always been coupled with some other act or omission designed to evade taxes, such concealing assets, a failure to file returns and pay taxes, and structuring financial transactions to avoid currency reporting requirements. Prior to Hawkins, no Circuit Court had directly answered the question of whether a taxpayer that files timely, accurate returns and does not engage in acts of deceit but spends beyond his means is willful under § 523(a)(1). In that regard,Hawkins can be seen as a case of first impression and its reasoning is applicable across the country.
Moreover, it can be argued that the Ninth Circuit’s Hawkins decision expressly said what other Courts have said implicitly, or at least in a less forthright manner: where a bankruptcy debtor has lived beyond his means in the face of an existing tax debt, in order for discharge of the tax debt to be precluded, the Government cannot rely on overspending itself and must establish by a preponderance of the evidence some other act designed to evade taxes.
Effect on Eleventh Circuit Cases
The Eleventh Circuit is among the Circuit Courts that applies the three part test set forth above (the debtor had a legal duty to pay tax, knew of the legal duty, and voluntarily and intentionally violated that duty) in determining whether the mental state requirement of § 523(a)(1) has been satisfied. Put more succinctly, “a debtor’s tax debts are non-dischargeable if the debtor acted knowingly and deliberately in his efforts to evade his tax liabilities.” In Re Mitchell, 633 F.3d 1319 (11th Cir. 2011). Additionally, the Court has stated that “fraudulent intent is not required” in determining willfulness. In Re Fretz, 244 F.3d 1323 (11th Cir. 2001).
However, the Eleventh Circuit has never held that mere lavish spending in the face of a tax debt is sufficient to bar discharge. Some evidence of a debtor’s deceit has always been present. In both Mitchell (failure to file, titling assets in nominee names, reincorporating to avoid garnishment) and Fretz (failure to file), other factors contributed to the determination that the debtor satisfied the willfulness requirement. Overspending alone was not determinative. Therefore, Hawkins does not serve as directly contrary authority to the Eleventh Circuit’s approach to determining willfulness, but it does lend significant support to combat any argument the Government may raise in an attempt to establish willfulness based solely on overspending.
The attorneys at Fuerst Ittleman David & Joseph, PL have extensive experience in the areas of tax and tax litigation in the Tax Court, the Federal District Courts, and Bankruptcy Courts. They will continue to monitor developments in the Hawkins case and this area of the law generally. If you have any questions, an attorney can be reached by emailing us at firstname.lastname@example.org or by calling 305.350.5690.