Taxpayers will be denied a discharge if they willfully attempt to evade the payment of taxes or the government’s collection of the tax debt.
Section 727(b) of the Bankruptcy Code provides for the discharge of an individual chapter 7 debtor’s prepetition debts unless such debts are excepted from discharge pursuant to 11 U.S.C. §523. Section 1328(a)(2) of the Code similarly provides for the discharge of an individual chapter 13 debtor’s prepetition debts unless excepted from discharge pursuant to the same §523. Section 523(a)(1)(C) excepts from discharge any debt “with respect to which the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat such tax.”
The US Bankruptcy Code helps honest, but unfortunate taxpayers who cannot pay general unsecured income tax debt. Those taxpayers can discharge their tax debts. But, the Code excepts from discharge income tax debts relating to (1) taxpayers who willfully attempt to evade paying taxes, and (2) taxpayers who attempt to evade the government’s collection of the tax debt. See 11 U.S.C. §523(a)(1)(C).
The U.S. Court of Appeals for the Seventh Circuit set out the rules for non-dischargeability of tax liability in bankruptcy in In re Birkenstock, 87 F.3d 947 (7th Cir. 1996). There the court noted that a Chapter 7 debtor is typically granted a general discharge of all debts owed as of the bankruptcy filing date. However, 11 U.S.C. §523(a)(1)(C) creates an exception to the dischargeability of income taxes when the taxpayer makes “a fraudulent return or willfully attempts in any manner to evade or defeat” the tax.
So the question in the Birkenstock case was what constitutes “willfully attempts … to evade or defeat” the payment of taxes. The 7th Circuit held that §523(a)(1)(C)’s exception comprises both a conduct requirement (that the taxpayer sought in any manner to evade or defeat his tax liability) and a mental state requirement (that the taxpayer did so willfully). The court found that a “willful” determination requires a taxpayer’s attempt to avoid tax liability to be voluntary, conscious, and intentional. In other words, the taxpayer must both (1) know that she has a tax duty under the law, and (2) voluntarily and intentionally attempt to violate that duty. The willfulness requirement prevents the application of the bankruptcy discharge exception to taxpayers who make inadvertent mistakes, reserving nondischargeability for those whose efforts to evade tax liability are knowing and deliberate.
Collier’s Bankruptcy Manual states that the act of willful tax evasion “consists of a conduct element (an attempt to evade or defeat taxes) and a mens rea requirement (willfulness). Tax evasion, [the conduct element] may be proven by a course of conduct revealing the willful concealing of assets, dealing in cash, shielding income and otherwise frustrating various tax collection efforts when the [taxpayer] clearly knows that attempts to collect the tax are being made. Nonpayment of taxes coupled with affirmative acts to avoid payment or collection of taxes can be sufficient to render the tax debt nondischargeable.” Collier Bankruptcy Manual, Section 523.06(4).
The “mens rea” component requires a showing that debtor voluntarily and intentionally violated the taxpayer’s legal duties. The taxpayer needs to provide a sound rationale explaining why the taxpayer failed to pay the income taxes. The taxpayer’s inability to pay the tax obligations because of financial hardship is a significant factor in evaluating whether the taxpayer’s conduct was willful.
The 11th Circuit in Zimmerman v. IRS (In re Zimmerman), 262 Fed. Appx. 943, 946 (11th Cir. 2008) reviewed factors that could support a finding of nondischargeability: (1) failure to timely-file tax returns: (2) failure to pay taxes; (2) intra-family transfers for little or no consideration; (3) titling a house solely in the spouse’s name while the debtor remains on the mortgage and makes all the payments; (4) characterizing earnings so they are not subject to tax withholding; (5) making large discretionary expenditures; (6) failure to file tax returns while maintaining a luxury lifestyle. Other issues to consider are: (6) use income to pay off other burdensome debts; (7) behavior intended to prevent IRS from reaching taxpayer’s assets; (8) under-withholding of taxes from paychecks; (9) failure to pay estimated taxes; (10) failure to accrue assets by opting to lease assets instead; (11) dealing primarily in cash transactions; (12) excessive spending; or (13) discontinuance of direct deposit of wages into an account subject to a levy.
The 9th Circuit in Hawkins v. Franchise Tax Board of California, 769 F.3d 662 (9th Cir. 2014), found insufficient the mere intentional acts that lead to the failure to pay the taxes. Instead, the Hawkins court required a showing that the taxpayer “specifically intended” to evade paying the taxes.
Other circuits have found taxes nondischargeable if the case involved intentional acts or omissions designed to evade taxes, such as criminal structuring of financial transactions to avoid currency reporting requirements (Vaughn, 2014 WL 4197347 at 6; Coney, 689 F.3d at 369); concealing assets through nominee accounts (Gardner, 360 F.3d at 559; Birkenstock, 87 F.3d at 952); concealing ownership in assets (Dalton, 77 F.3d at 1302); and failing to file tax returns ad pay taxes (Fretz, 244 F.3d at 1329); Fegeley, 118 F.3d at 984).
The blog posts contain some interesting legal cases involving taxpayers attempts to discharge income tax debt by filing bankruptcy.