Category Archives: Evasion

What Mental State is Required to be Guilty of Tax Evasion?

Some taxpayers do not pay taxes because of poor cash flow.  Other taxpayers employ elaborate schemes to evade paying taxes. A third category of taxpayers show an indifference to tax obligations and continue to live their lives without paying taxes—some of the latter taxpayers are very rich people!

The U.S. Court of Appeals for the Ninth Circuit determined what mental state is required to find that a taxpayers’s federal tax liabilities should be excepted from discharge under 11 U.S.C. §523(a)(1)(C) for willfully attempting to evade paying the tax.  In Hawkins v. Franchise Tax Board of California, 769 F.3d 662 (9th Cir. 2014), the Ninth Circuit concluded that “specific intent” to evade is required for the discharge exception to apply.

In Hawkins, the taxpayer enjoyed the trappings of wealth, including a private jet, expensive private schooling for the children, an ocean-side condominium in La Jolla, CA, and a large private staff.  Taxpayer was a successful capitalist who invested in tax shelters upon the advice of tax counsel.  The IRS audited Hawkins and challenged the validity of the tax shelters.  The IRS then disallowed the tax shelters and assessed taxes and penalties of $16 million.

Hawkins did very little to alter his lavish lifestyle after it became apparent that Hawkins was insolvent and their personal living expenses exceeded their earned income.  Later, Hawkins filed Chapter 11 bankruptcy and confirmed a liquidating plan of reorganization.  The IRS received over $3 million from the bankruptcy estate.  The plan provided for a discharge of all preconfirmation debts, but provided that Hawkins and the IRS could bring suit to determine if the tax debt was dischargeable by the bankruptcy.  Such a suit was filed.

The IRS’ argued that the tax debt should not be discharged in bankruptcy because Hawkins’ maintenance of a rich lifestyle after their living expenses exceeded their income constituted a willful attempt to evade taxes.  The bankruptcy court agreed, but the Hawkins court reversed and rejected the IRS’ broad interpretation of the word “willful” and adopted a narrow interpretation of “willful.” More specifically, the Hawkins court concluded that declaring a tax debt nondischargeable under §523(a)(1)(C) on the basis that the taxpayer “willfully attempted in any manner to evade or defeat such tax” requires a showing of specific intent to evade the payment of taxes.  Id. at 669.

The Hawkins court distinguished its ruling from the ruling of other circuits that have found income taxes nondischargeable if the taxpayer merely committed the evasive acts intentionally—even if taxpayer’s evasive acts were committed for a purpose other than evading the payment of taxes (e.g. payment of money to doctors for cancer treatment instead of paying IRS).  While the Hawkins court noted that other circuits used different semantics, the court noted  that most of the cases in the other circuits resulting in nondischargeability actually involved intentional acts or omissions designed to evade taxes.  Id. at 669.

The Hawkins court reversed the bankruptcy court and remanded for consideration of the facts in light of the new “intent to evade” standard.  Apparently the Hawkins court wanted the bankruptcy court to determine if Hawkins continuation of a lavish lifestyle after IRS assessment of $16 million was (a) an indifference to taxpayer’s duty to pay taxes, or (b) an attempt to evade paying the taxes.

Practice Pointer:   Some red flags indicating intent to evade paying taxes include: keeping double books, making false bookkeeping entries, destroying records, transferring assets to a third-party, and concealing assets.

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Can a Bipolar Disorder Protect a Taxpayer from Being Accused of Willful Failure to Pay Taxes?

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.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.