Category Archives: Willfully Evade Paying

How Does “Innocent Spouse Relief” Protect Taxpayers From IRS Levies and Collections?

Taxpayers who file joint IRS 1040 tax returns are jointly and severally liable for the full tax liability no matter how much or how little they contribute to the total tax.  That liability is not affected by divorce.  Sure, a divorce court could order one party to pay all or part of the joint tax debt, but such an order does not change the fact that each spouse is jointly and severally liable to the IRS.  The IRS can pursue collections against either or both taxpayers no matter how the divorce court shifts responsibility between the joint filers.

What options are available to an ex-wife if the prior years’ joint tax liability really resulted from extraordinarily large income produced by the ex-husband and the ex-husband now refuses or is unable to pay the taxes? You should consider “innocent spouse relief” offered by the IRS pursuant to 26 U.S.C. §6015?

Tax professional must be able to distinguish between two separate scenarios that may offer “innocent spouse relief” to the ex-wife: one good, and one bad.

The good scenario relates to a situation where a tax return was never filed or the filed return understated the true tax liability.  That scenario causes the IRS to assess a tax for the never filed return or assess a tax deficiency for the understated portion of the tax liability.  Section 6015 of the Internal Revenue Code grants the IRS authority to eliminate the assessed tax deficiency under the “innocent spouse relief” program when the innocent spouse had no knowledge of the understatement and had no reason to know of the understatement.  A perfect example is a wife of a self-employed home-remodeler and the wife has no involvement with the business and no knowledge that the home-remodeler underestimated the tax liability on the joint tax return.

The bad scenario relates to a situation where a tax return was properly filed and did NOT understate the tax liability on the return; the tax liability exists because the taxpayers did not save sufficient funds to pay the tax liability.  That was the scenario in In re Mikels, 524 B.R. 805 (Bankr. S.D. IN 2015).  In Mikels, an ex-spouse applied to the IRS for innocent tax relief for several years.  Some of those years related to years no returns were ever filed, and other years related to years where the innocent spouse failed to pay the taxes that were properly reported on the returns.

The spouse in Mikels sought innocent spouse relief from the IRS before filing bankruptcy.  The IRS granted the innocent spouse relief as to the tax years when no tax return was filed and the IRS had assessed the tax deficiency. However, the IRS denied innocent spouse relief for the tax years that the tax return properly reported the tax liability.

The Mikels spouse filed bankruptcy and objected to the IRS’ proof of claim seeking payment for the properly reported tax liability.  The Mikels court overruled the spouse’s objection and allowed the IRS’ claim for the tax liability relating to the properly reported tax years.  The court ruled that “innocent spouse relief” is only available pursuant to 26 U.S.C. §6015 when the IRS assesses a tax deficiency and such relief is not available when the taxpayers merely fail to pay the tax.

PRACTICE POINTERS: Innocent spouse relief is a great tool for ex-spouses who were deceived by their self-employed ex-spouses who underreported net income and concomitantly underreported the total tax liability.  However, the tax professional must be able to spot when the IRS will grant such relief and when it won’t.  The simple rule is no relief when the tax was reported accurately, and relief may be available it the tax was underreported and the ex-spouse had no knowledge of the underreporting.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.
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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 Spouse Who Signs a Joint Tax Return Without Reviewing it be Denied a Bankruptcy Discharge?

Sometimes one spouse takes the financial reins and handles all the financial aspects of a marriage (like banking, buying cars, preparing tax returns, etc.) while the other spouse handles the day-to-day family issues (like cooking, cleaning, children, etc.).  It is not uncommon for the non-financial spouse to sign a tax return without reviewing it.  It is a matter of trust.  The non-financial spouse trusts the other spouse to prepare an accurate tax return.

In In re Birkenstock, 87 F.3d 947 (7th Cir. 1996), the court was confronted with the issue of whether a wife who signs a joint tax return without reviewing it can be denied a bankruptcy discharge of tax liability for “willful attempt to evade” taxes.  The Birkenstock court had no problem finding the husband to be a chronic tax evader who took extraordinary steps to willfully attempt to evade paying the taxes. The husband’s taxes were excepted from the bankruptcy discharge and survived intact at the conclusion of the bankruptcy.

The Birkenstock court had a more difficult time deciding whether the wife also willfully attempted to evade paying the taxes.  The court noted that the only relevant evidence upon which the bankruptcy court had determined that the wife had acted willfully was the fact that she had signed the joint tax return.

The Birkenstock court set out the rules for non-dischargeability of tax liability in bankruptcy. 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.

After reviewing the law and apply the law to the facts, the court ruled that the bankruptcy had erred in finding the spouse had willfully attempted to evade the tax liability.  The only evidence presented at trial regarding the wife’s willfulness was the fact that she had signed the tax returns.  Therefore, the bankruptcy court order was reversed and the wife was granted the bankruptcy discharge as to the tax liability.


Practice Pointers:  A spouse should consider not filing a joint tax return if the spouse has any reason to believe the other spouse may be filing a fraudulent return or may be willfully evading the tax liability.  Instead, a spouse should consider filing a separate tax return, especially if the spouse has little to no income as the spouse in Birkenstock.  The wife in Birkenstock would not have had any tax liability, because she did not work, had she filed separately.  The husband would have had all the tax liability and the wife would not have had to worry about any court ruling that her share of the tax liability was nondischargeable.  There are some tax disadvantages by filing separately, but none of the those disadvantages would compare to the disadvantage of the wife being held jointly and severally liable for the husband’s tax liability that could later be deemed nondischargeable in bankruptcy.

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

Did a Parent Willfully Evade Paying Taxes by Paying College Tuition Instead?

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 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 issue of willful evasion was addressed in In re Looft, 553 B.R. 910 (Bankr. N.D.GA 2015).  In Looft, an IRS audit resulted in the disallowance of partnership losses taken by an individual taxpayer on Form 1040. The IRS then assessed tax liability of approximately $319,000.  The taxpayer struck back by hiring attorneys to sue the tax professional who advised the taxpayer to include the partnership losses on the tax returns.  Taxpayer submitted a request for a collection due process hearing and filed a petition in the US Tax Court.  The IRS issued notice of intent to levy.  Taxpayer filed an offer in compromise to settle the tax liability.  Ultimately, taxpayer sought bankruptcy relief to discharge the tax liability.

The Looft court considered the taxpayer’s behavior after the IRS audit to determine if the taxpayer willfully attempted to evade paying the taxes.  On the negative side, and instead of paying the tax liability assessed, taxpayer paid more than $88,000 in college tuition so his child could attend the University of Virginia.  Taxpayer also purchased an $18,500 BMW for taxpayer’s daughter to use during college and another BMW for $9,800 when she graduated.  Taxpayer also gave cash gifts to his children and bought them cell phones and a laptop computer.  Taxpayer also spent $68,000 on his country club and more than $16,000 on trips and vacations.

On the positive side, the court noted the following about the taxpayer: (1) asserted he was victim of bad tax advice; (2) made voluntary payments towards the assessed taxes, including $2,500 obtained through a home equity loan; (3) took no action to stop the IRS from intercepting taxpayer’s refunds; (4) did not change tax withholdings to reduce future refunds; (5) withdrew money from a 401(k), paying tax penalties to do so, and paid $22,000; (6) took no effort to change bank accounts or withdraw money from bank accounts after receiving the IRS’ notice of intent to levy; (7) taxpayer continued to direct deposit his paychecks into the same bank account after the levy; (8) did not avoid keeping money in the bank account; and (9) timely-filed tax returns and timely-paid tax obligations relating to all tax years after the tax assessment resulting from the audit.

The Looft court noted that the IRS has the burden of proof and that exceptions to discharge are strictly construed in favor of the taxpayer. The Looft court identified IRS burden.  The IRS must show that taxpayer engaged in (1) evasive conduct with (2) a mental state consistent with willfulness.

Evasive conduct requires a showing that the taxpayer engaged in affirmative acts to avoid payment or collection of the taxes, either through commission or culpable omission.  The conduct requirement is not satisfied by mere nonpayment of taxes.

The 11th Circuit in Zimmerman v. IRS (In re Zimmerman), 262 Fed. Appx. 943, 946 (11th Cir. 2008) supported a finding of nondischargeability when the conduct included: (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; and (13) discontinuance of direct deposit of wages into an account subject to a levy.

The Looft court considered all these factors as they related to taxpayer and found that the tax payer did not willfully attempt to evade paying the taxes.  Important to the court was the fact that the only steps the taxpayer took to prevent the IRS from collecting the tax liability were through official channels (i.e. offer in compromise, tax court, collection due process hearing). The court found that taxpayer’s actions were not consistent with an intentional failure to pay.

Practice Pointers: Whether a taxpayer willfully evaded paying taxes is a fact intensive analysis.  If in doubt, a taxpayer should establish a pattern of action that would support a conclusion that the taxpayer has the desire to pay without the ability to pay.

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

Who Has the Burden of Proof in a Tax Dischargeability Dispute Relating to Fraudulent Returns or Willful Attempt to Evade Paying Taxes?

Certain tax liabilities can be discharged in bankruptcy provided they are not excepted from discharge pursuant to 11 U.S.C. §523.  Section 523(a)(1)(C) excepts from discharge any tax debt “with respect to which the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat such tax.”

Taxpayers or the IRS can file an adversary proceeding in bankruptcy court seeking an order determining whether the taxpayer’s tax obligations are discharged.  The factual question in these cases is whether  a taxpayer filed a fraudulent return or willfully attempted to evade or defeat a tax.

Who has the burden of proof: the taxpayer or IRS?  That issue was addressed in In re Looft, 553 B.R. 910 (Bankr. N.D.GA 2015), citing Griffith v. United States (In re Griffith), 206 F. 3d 1389, 1396 (11th Cir. 2000). The Looft court found that the burden of proof is on the government to prove nondischargeability by a preponderance of the evidence. Exceptions to discharge are strictly construed in favor of the debtor.  In determining whether the government has met its burden, the court considers the totality of the circumstances.

Practice Pointers: The taxing authority has the burden of proof, but the analysis is fact intensive.  The bankruptcy court would be given wide discretion in determining whether the government met its burden.

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

Can a Taxpayer Eliminate Tax Debt if He Failed to File a Return Until After the IRS Assessed the Tax?

An old case is instructive for taxpayers who live in Illinois, Indiana, and Wisconsin.  See In re Payne, 431 F.3d 1055 (7th Cir. 2005).  This case is more than 10 years old and applies pre-BAPCPA law, but it is the only case addressing the issue issued by the US Court of Appeals for the Seventh Circuit. Other circuit courts have ruled on the issue. SEE BLOGS. Again, the 7th Circuit has not yet ruled on the issue for taxes due after the 2005 BAPCPA law was enacted.

In Payne, the taxpayer failed to file the 1986 tax return until 1991, which was one year AFTER the IRS had assessed tax liability for income tax due.  Taxpayer offered to compromise his tax debt in 1992, but the IRS rejected the offer.  Five year later taxpayer filed for Chapter 7 bankruptcy relief in 1997.

The court correctly noted that Section 523(a)(1)(B)(i) of the Bankruptcy Code forbids the discharge of federal income tax liability with respect to which a “return” was required to be filed but “was not filed.”  The taxpayer argued that the return filed in 1992 was a “return” as used in the statute, albeit filed six years late and after the IRS had gone to the trouble of figuring out what the taxpayer owed.  The IRS argued that an untimely post-assessment return is not a “return” within the meaning of the statute and that therefore taxpayer never filed a 1986 “return” and so cannot be discharged from liability for the taxes that the taxpayer owes for that year.

The Payne court noted that the Bankruptcy Code had not defined the term “return” pre-BAPCPA.  However, cases held that to be deemed a return, a document filed with the IRS must (1) purport to be a “return,” (2) be signed under penalty of perjury, (3) contain enough information to enable the taxpayer’s tax liability to be calculated, and (4) “evince[] an honest and genuine endeavor to satisfy the law.  Id. at 1057, citing United States v. Moore, 627 F.2d 830, 834-35 (7th Cir. 1980). The Payne court further declared that a purported return that does not satisfy all four conditions does not play the role that a tax return is intended to play in a system of self-assessment.  So while a “return” that satisfies the first three conditions comports with the literal meaning of the word, it does not comport with the functional meaning.

The whole dispute in Payne was whether the taxpayer satisfied the fourth prong of the test and “endeavored to satisfy the law” by filing the 1986 tax return in 1992.  The court rejected a line of reasoning used by other courts that the a late-filed return after the IRS assessed the tax does not serve the purpose of the filing requirement.  The Payne court expressly stated that the legal test is not whether the filing of a purported return has some utility for the tax authorities, but whether it is a reasonable endeavor to satisfy the taxpayer’s obligations.  So the bankruptcy courts should not look through the eyes of the IRS to determine usefulness; rather, the court should look through taxpayer’s eyes to determine if the taxpayer’s efforts constituted a reasonable endeavor to satisfy the taxpayer’s obligations.

The majority of the Payne court reversed the lower court and found that the taxpayer had not reasonable endeavored to satisfy the taxpayer’s obligations.  Hence the tax debt was excepted from discharge.  However, a persuasive counter argument was asserted in a dissent by Circuit Judge Easterbrook, who argued that the return was a “return” for bankruptcy purposes.  The judge believed taxpayer’s failure to timely file the return was distinct from the definition of “return.”  Instead, the judge believed motive may affect the consequences of a late-filed return, but not the definition of “return.”  Motive was an issue relating to Section 523(a)(1)(C) and whether taxpayer “willfully attempted… to evade or defeat” the tax.  Remember, however, this case relates to pre-BAPCPA law established in 2005.  Judge Easterbrook, in dicta, suggested the result would be different if the BAPCPA law was applicable.

Practice Pointer:  This is an old case and several circuit courts have recently ruled that a late-filed return does NOT constitute a “return” for bankruptcy purposes.  So file those returns on time.  The Seventh Circuit has yet to issue a ruling, but a future circuit court panel could agree with Judge Easterbrook’s dissent.

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

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.