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If the Court Thinks You Preferred a “Lavish Lifestyle” Over Paying Taxes, You May Find the Tax Not Dischargeable in Bankruptcy (Unless You Live in the Ninth Circuit) by ROBERT S. HORWITZ

I recently blogged on the Eleventh Circuit’s decision in In re Shek rejecting First, Fifth and Tenth Circuit precedent that a late return filed two years or more before bankruptcy is not discharged.  Today I am blogging on another recent bankruptcy case, In re Harold, 2020 WL 709866 (B. Ct. M.D. Mich. 2/12/2020), which addressed whether the debtor, Patricia Harold, attempted to evade or defeat tax, thus making otherwise dischargeable taxes not dischargeable under Bankruptcy Code §523(a)(1)(C).

The debtor was a successful obstetrician-gynecologist in Detroit.  She had a professional corporation that was a member of an LLC with another obstetrician-gynecologist.  She owed taxes for 2004-2012 and 2014.  The taxes for 2012 and 2014 were not dischargeable as priority taxes and the taxes for 2008 and 2010 were not dischargeable because the returns were filed late and less than two years before she filed for bankruptcy.  The question before the bankruptcy court was whether the taxes for the remaining years were not dischargeable under Bankruptcy Code 523(a)(1)(C).  That section provides that a tax is not discharged “with respect to which the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat such tax.”

The case was complicated by its procedural posture: the IRS was the debtor’s largest creditor.  It had obtained orders that the Estate had no interest in the debtor’s residence and lifting the stay to allow it to bring a district court action to foreclose its tax liens.

The debtor’s husband had been convicted of bank and tax fraud and lost his CPA license.  They had a son and a daughter.  Her husband to handle all tax matters.  The debtor was the main income earner in the family.  During the years for which she did not pay tax her average gross receipts from her practice were more than $500,000 and her net income ranged between $170,000 and over $350,000.  Their returns for the years in issue were often filed late and the tax shown due was not paid.

The debtor and her husband entered into an installment agreement with the IRS that they defaulted on.  During this period the debtor and her husband maintained “a comfortable, even affluent, lifestyle.  They purchased a new home in 2005 under a land sale contract before they sold their existing home; they ended up making monthly mortgage payments on two homes until the bank foreclosed on the first home in 2009.  Devout Catholics, they sent their children to Catholic grade schools, high schools and universities and spent over $325,000 on their children’s private schooling while their tax obligations went unpaid.  They took a number of family vacations and personal trips, and leased “high-end” autos that cost between $600 and $800 a month, including Lexuses, Cadillacs and  Jaguar.

In 2016, the debtor filed a chapter 7 bankruptcy to deal with her tax debt.  While the bankruptcy and IRS foreclosure suit were pending, a client of the debtor’s husband “purchased” their home and purportedly leased it back to them.  The debtor admitted this was done to avoid foreclosure by the IRS. The debtor did not disclose this to her attorneys, the IRS, the district court or the bankruptcy court until after the IRS moved to appoint a receiver to sell the property.  At the trial in bankruptcy court, she could produce no lease agreements, rent checks or other documents supporting her claim that she and her husband were renting the property

The bankruptcy court was in the Sixth Circuit.  Beginning with In re Toti, 24 F. 3rd 806 (1994), the Sixth Circuit developed a two-part test to determine whether a debtor attempted to evade or defeat tax.  The first part focuses on the debtor’s conduct: did the debtor engage in affirmative acts to avoid assessment or payment of tax.  The second part focused on mental state: did the debtor know of the duty to pay tax and voluntarily and intentionally violate that duty.  The mere failure to pay tax for a number of years was not enough to prove an attempt to evade or defeat.

The bankruptcy court held that the debtor attempted to evade or defeat tax.  The bankruptcy court found that the IRS proved the taxpayer engaged in affirmative acts to avoid payment of tax: she had a substantial income, yet consistently failed to pay the tax, instead spending large sums on non-discretionary items, including vacations, cars and her private schools for her children.  The IRS also proved the taxpayer had the requisite mental state: she knew she owed the tax but voluntarily and intentionally decided to pay substantial sums for non-discretionary items, including her children’s private schooling, rather than pay the tax and let her husband handle tax matters even though he had been convicted of tax fraud.  Finally, after filing for bankruptcy, she entered into the purported sale and lease back of her home to keep the IRS from foreclosing.

The Sixth Circuit conduct test focuses on the taxpayer’s lifestyle.  The Ninth Circuit in Hawkins v. FTB, 769 F. 3rd 662 (9th Cir. 2014), rejected the test used by the Sixth Circuit and other circuits and held that to prove an attempt to evade or defeat the taxing agency must show that the debtor acted with the specific intent to evade or defeat the tax and that profligate spending while knowing tax wasn’t paid was insufficient.  The Ninth Circuit distinguished cases decided by other circuits, noting that in each one the taxpayer engaged in conduct, such as transferring assets to nominees, that could support a finding of specific intent.  So while Dr. Harold’s spending on her kids’ schooling would not have been relevant, the sale and lease back transaction may have been sufficient in the Ninth Circuit to support a finding of an attempt to evade or defeat.

Contact Robert S. Horwitz at horwitz@taxlitigator.com or 310.281.3200   Mr. Horwitz is a principal at Hochman Salkin Toscher Perez P.C., former Chair of the Taxation Section, California Lawyers’ Association, a Fellow of the American College of Tax Counsel, a former Assistant United States Attorney and a former Trial Attorney, United States Department of Justice Tax Division.  He represents clients throughout the United States and elsewhere involving federal and state administrative civil tax disputes and tax litigation as well as defending criminal tax investigations and prosecutions.

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