By Ryan C. Wood
Generally speaking taxes are dischargeable depending upon when the taxes were due and a number of other factors. There are also a number of exceptions to a bankruptcy discharge that must be raised by filing an adversary lawsuit and proving why the debt to be discharged should not be. Section 523(a)(1)(C) provides tax debts may not discharged, “. . . with respect to which the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat such tax.” What mental state is required to find a debtor willfully attempted to evade or defeat a tax? The Ninth Circuit Court of Appeals held that specific intent is required for the discharge exception to apply to Section 523(a)(1)(C)exception to discharge.
William Hawkins, III vs. Franchise Tax Board, Internal Revenue Service et. al., Case No. 11-16276, Sept. 15, 2014 (9th Cir. 2014)
The Ninth Circuit Court of Appeals in the Hawkins case discusses the required mental state to find a tax debt excepted from discharge pursuant to Section 523(a)(1)(C). This case is about a very rich person trying to lawfully or unlawfully avoid paying taxes on capital gains resulting from the sale of Electronic Arts, Inc. stock. The debtor in this case, William “Trip” Hawkins, was one of the first employees of Apple Computer and later co-founded Electronic Arts, Inc. For many Electronic Arts, Inc. is a household name due to the numerous successful games the company has created over the years. Mr. Hawkins left Electronic Arts, Inc. to head 3DO, a wholly owned subsidiary of Electronic Arts, Inc. Mr. Hawkins eventually sold millions in Electronic Arts, Inc. stock to invest in 3DO and racked up a capital gains bill of approximately $66.8 million. Accountants at KPMG advised Mr. Hawkins to shelter the gains in a Foreign Leveraged Investment Portfolio (“FLIP”) and an Offshore Portfolio Investment Strategy (“OPIS”). Long story short Mr. Hawkins put millions into 3DO, Inc. and his finances took a turn for the worse. Mr. Hawkins chose to file Chapter 11 bankruptcy in 2006. Mr. Hawkins confirmed a Chapter 11 plan of liquidation, but the plan also provided that the FTB and IRS could bring suit to determine if the taxes are dischargeable or not.
Mr. Hawkins Files Adversary Proceeding to Determine Taxes Are Discharged
Not believing in the theory of wait and see Mr. Hawkins preemptively filed an adversary proceeding (lawsuit within a main bankruptcy case) to obtain a ruling that the taxes were discharged in the Chapter 11 liquidation. The FTB and IRS counterclaimed alleging the taxes are not discharged and excepted pursuant to 11 U.S.C. §523(a)(1)(C). This is a case of statutory interpretation. What does the word “willful” mean in Section 523(a)(1)(C)? The language of Section 523(a)(1)(C) apparently was a compromise between the House and Senate according to the legislative history. The House wanted to use “willfully” and the Senate wanted to use “fraudulently attempted to evade” the tax. In support of using specific intent, the 9th Circuit Court of Appeals further explained that the Internal Revenue Code also uses almost exact language of Section 523(a)(1)(C). It is a felony to “willfully attempt in any manner to evade or defeat any tax.” 26 U.S.C. §7201. The specific intent required for felonious tax evasion requires the government to prove that the law imposed a duty on the defendant and the defendant knew of this duty and the defendant voluntarily and intentionally violated that duty. In the Hawkins case a mere showing that Mr. Hawkins spent far more than what he earned leading up to the bankruptcy case is not enough for the required intent to evade paying taxes. The government must prove the bankruptcy petitioner took some action with the specific intent of evading taxes.
Intent is a difficult thing to prove and the Hawkins case seemingly helps to define what actions make taxes excepted from discharge pursuant to Section 523(a)(1)(C). At the same time it seemingly gives Mr. Hawkins a pass. In the Hawkins case Mr. Hawkins used the FLIP and OPIS shelters knowing that it would reduce his tax burden to the IRS and FTB. Did Mr. Hawkins believe his actions were wrong at the time? He received advice from his accountants at KPMG that were paid a lot of money to be right.
Judge Rawlinson strongly dissented and pointed out that there is no question Hawkins spent lavishly even though he absolutely knew of is large tax burden to the IRS and FTB. Hawkins now seeks to have the taxes he willfully did not pay discharged in bankruptcy. I Judge Rawlinson gets it right by looking at a recent 10th Circuit Court decision. The Tenth Circuit held in Vaughn v.IRS (In re Vaughn), No. 13-1189, 2014 WL4197347 (10th Cir. Aug. 26, 2014) that the determination of whether or not a debtor willfully attempted to evade or defeat a tax under Section 523(a)(1)(C) is a question of fact reviewable for clear error. The following elements were listed to satisfy the mental state requirement: (1) the debtor had a duty under the law; (2) the debtor new he had the duty; (3) the debtor intentionally and voluntarily violated the duty.
