Lavish Lifestyle Alone Does Not Equate to Tax Evasion

Lavish Lifestyle Alone Does Not Equate to Tax Evasion

By:  Michael R. Blaskowsky  – Columbia River Law Group

 

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In one of my prior articles, I outlined the four factors which must be met in order to discharge tax debt in bankruptcy:

1.  The tax must be more than three years old prior to the filing of the bankruptcy petition;

2.  The return for the tax year sought to be discharged must have been filed more than two years prior to the filing of the bankruptcy petition;

3.  The tax must be assessed more than 240 days prior to the filing of the bankruptcy petition; and

4.  The taxpayer cannot have willfully attempted in any manner to evade or defeat the tax.

It is this fourth point, the willful attempt to evade or defeat the tax, which was the subject of a recent case before the Ninth Circuit Court of Appeals.  Hawkins v. Franchise Tax Board involved William “Trip” Hawkins, one of the earliest employees of Apple Computer, and a co-founder of Electronic Arts, one of the world’s largest video game distributors. From 1994 through 1998, Mr. Hawkins sold large amounts of his EA stock to invest in 3DO, a subsidiary of EA, created for the purpose of developing and marketing video games and game consoles.

Mr. Hawkins’ sales of those shares created a capital gain of almost $67 million.  In an attempt to generate large paper losses to shield the EA capital gain from taxation, his accountants advised him to shelter the gains in a Foreign Leveraged Investment Portfolio (“FLIP”) and an Offshore Portfolio Investment Strategy (“OPIS”).  Unfortunately for Mr. Hawkins, the IRS disallowed those losses, ultimately resulting in tax bills to the IRS and California Franchise Tax Board of over $36 million for the 1997 – 2000 tax years.

Mr. Hawkins filed for Chapter 11 protection in 2003, but that case was later converted to Chapter 7.  After filing for bankruptcy, he sold a residence and had other assets seized by the taxing authorities, but $29 million remained owing.  At that point, Mr. Hawkins filed suit against the IRS and California Franchise Tax Board seeking a declaration that the remaining debt was a dischargeable debt in bankruptcy.

The IRS and California Franchise Tax Board took the position that Mr. Hawkins had willfully attempted to evade or defeat the tax.  Their primary argument was that he was living a lavish lifestyle, enjoying the trappings of wealth, such as a private jet, expensive private schooling for his children, an ocean-side condominium in La Jolla, California, and a large private staff.  In essence, the argument was that the failure to pay taxes was a willful evasion when such large sums were spent on luxuries which could have otherwise been used to pay down the tax debt.

The Bankruptcy Court agreed, finding that Mr. Hawkins did little to alter his lavish lifestyle after his financial difficulties became apparent, and held that the remaining tax owing was non-dischargeable.  On appeal, the District Court affirmed.  The Ninth Circuit Court of Appeals, however, in a 2 – 1 decision, reversed, holding that a lavish lifestyle alone does not support a finding of a “willful” attempt to evade or defeat the tax.

“Given the structure of the statute as a whole, including its object and policy, legislative history, case precedent, and analogous statutes, we conclude that declaring a tax debt non-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 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. 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.”

In holding that a “specific intent” to evade or defeat the tax must be found before holding a tax debt non-dischargeable on this basis, the Ninth Circuit noted that such an intent can be inferred from acts such as failing to file tax returns, keeping double books, making false bookkeeping entries, destroying records, shifting assets to another person or a false bank account, concealing assets, or switching all financial dealings to cash.  Though the taxing authorities did make other claims in this case aside from the lavish lifestyle argument, in light of the heavy reliance on that argument, the Ninth Circuit remanded the case to the Bankruptcy Court for further consideration, instructing it to reanalyze the case using the “specific intent” standard.

This post is intended to be purely informational in nature, and cannot be considered legal advice.  If you have questions related to bankruptcy, please call our office at (503) 545-1061 (Oregon cases) or (360) 836-4238 (Washington cases) to schedule a free initial consultation.