Taxpayers generally have the right to discharge certain income tax liability relating to old tax returns. For example, a taxpayer may have the right to discharge in bankruptcy income tax liability relating to tax returns due and filed more than three years before the bankruptcy case was filed. An exception to that rule exists when the taxpayer “willfully attempted in any manner to evade…” paying the taxes. See 11 U.S.C. §523(a)(1)(C).
That exception was explored in United States v. Stanley, 595 Fed App. 314 (5th Cir. 2014). In Stanley, an osteopathic doctor filed Chapter 7 bankruptcy in an effort to discharge income taxes due more than three years prior to the date the bankruptcy case was filed. The United States objected to the discharge alleging the tax liability was non-dischargeable because the doctor willfully attempted to evade paying the taxes.
The doctor argued that he suffered from Type II bipolar disorder and was thus incapable of forming the requisite “willful” mental state. At trial, the doctor called a psychologist as a witness to testify that the doctor suffered periods of depression and irresponsible conduct. However, the psychologist also stated that the doctor had other periods when the doctor was functioning normally.
Pursuant to 11 U.S.C. §523(a)(1)(C), a discharge in bankruptcy does not discharge tax liability where the debtor “willfully attempted in any manner to evade” the tax liability. This provision ensures that the Bankruptcy Code’s “fresh start” policy is only available to honest but unfortunate debtors.
The 5th Circuit employed a three-pronged test to determine willfulness in the tax evasion context, considering whether 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. The court held that the third prong could be satisfied by either an affirmative act or culpable omission that, under the totality of the circumstances, constituted an attempt to evade or defeat the assessment, collection, or payment of a tax.
The Stanley court noted that a mere failure to pay the tax did not automatically constitute “willfulness,” since a taxpayer may not have the financial wherewithal to pay the tax. However, the failure to pay combined with the ability to pay may constitute “willfulness.” The court reviewed many factors before determining that the doctor in the case at bar “willfully” attempted to evade paying the tax liability, including: ability to successfully carry out duties in a demanding profession, maintaining a lavish lifestyle, major purchases made by the doctor, payment of other long-term debts obligations, forming corporations, and transferring money to the doctor’s spouse who did not share the tax liability. Consequently, the court found the tax liability non-dischargeable because the doctor willfully attempted to evade paying the taxes.
Practice Pointers: Before filing bankruptcy, a practitioner should identify a taxpayer’s job status, disposable monthly income, major purchases since the tax liability was incurred, history of paying other long-term obligations, ability to pay the tax liability since the tax liability was incurred, and choices made to utilize net income in manners other than paying tax liability. If factors weigh against a taxpayer, then the practitioner should consider an installment agreement to demonstrate a taxpayer’s desire to repay the tax liability. Then installment payments should continue until a pattern is shown demonstrating a desire to pay taxes.
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