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Evidence of Extravagant Spending Not Enough to Prevent Discharge of Tax Debt, Ninth Circuit Holds

Microsome at the German language Wikipedia [GFDL (http://www.gnu.org/copyleft/fdl.html) or CC-BY-SA-3.0 (http://creativecommons.org/licenses/by-sa/3.0/)], via Wikimedia CommonsAn extravagant lifestyle was not enough to overcome the presumption that debts incurred prior to filing for bankruptcy, including tax debts, are dischargeable, according to the Ninth Circuit. Hawkins v. Franchise Tax Bd. of California, No. 11-16276, slip op. (9th Cir., Sept. 15, 2014). The court considered whether the debtor’s tax debt was not subject to discharge under the exception for “willful[] attempt[s]…to evade such tax.” 11 U.S.C. § 523(a)(1)(C). After noting that the question of the mental state required to prove a “willful attempt to evade tax” was a matter of first impression, it held that the statute requires proof that a debtor specifically intended to evade tax liability. The debtor’s spending prior to filing bankruptcy, while “lavish,” was not out of the ordinary for him, and the tax debt was therefore dischargeable in bankruptcy.

The debtor made a substantial amount of money in the technology industry. He was an early employee of Apple, which he left to found the software and video game company Electronic Arts (EA). In 1990, he left EA to run a newly-created EA subsidiary called 3DO, which was entering into the video game and console market. By 1996, his net worth was around $100 million. He sold much of his EA stock and invested in 3DO. The Ninth Circuit’s opinion describes a series of accounting techniques using offshore corporations in order to claim losses on the sales of EA stock.

3DO filed for Chapter 11 bankruptcy in 2003 and later converted the case to a Chapter 7 liquidation. The debtor never received any substantial payouts from the liquidation of the business. The IRS began challenging his tax shelters in the late 1990s, and in 2005 it and the California Franchise Tax Board (FTB) assessed a total balance of over $36 million in unpaid taxes, penalties, and interest. The debtor sold some real property and applied all of the proceeds to the IRS balance in 2006, and the FTB also seized some financial accounts. In September 2006, the debtor and his wife filed for bankruptcy. The IRS and FTB filed proofs of claim for $19 million and $10.4 million, respectively.

Both the IRS and the FTB objected to the discharge of the tax debts based on the exception for willful tax evasion. They cited the fact that the debtor and his wife had done “very little to alter their lavish lifestyle after it became apparent in 2003 that they were insolvent.” Hawkins, slip op. at 7. The bankruptcy court ruled that the tax debt was excepted from discharge, and the district court affirmed.

The debtor appealed to the Ninth Circuit, which looked to see if the words of the statute, specifically the word “willful,” had a plain meaning based on prior cases. It looked at the interpretation of the exception to discharge for “willful and malicious injury…to another,” 11 U.S.C. § 523(a)(6), and the Supreme Court’s holding that “willful” modified “injury,” meaning that the statute applied to “a deliberate or intentional injury, not merely a deliberate or intentional act that leads to injury.” Hawkins, slip op. at 10, quoting Kawaauhau v. Geiger, 523 U.S. 57, 61 (1998). The court applied the same reason to “willful tax evasion,” holding that the exception only applied if the debtor showed a specific intent to evade taxes. Since the debtor’s lavish spending was only a continuation of his pre-bankruptcy lifestyle, the court held, the exception did not apply.

Personal bankruptcy attorney Devin Sawdayi has represented clients in Chapter 7 and Chapter 13 bankruptcy cases in the Los Angeles area since 1997. To schedule a free and confidential consultation to see how we can help you, please contact us today online or at (310) 475-9399.

More Blog Posts:

Discharging Tax Debts in Chapter 7 or Chapter 13 Bankruptcy, Los Angeles Bankruptcy Lawyer Blawg, August 4, 2014

Court Does Not Allow Chapter 13 Debtor to Strip Unsecured Amount of IRS Tax Lien, Los Angeles Bankruptcy Lawyer Blawg, May 19, 2014

Discharge of Federal Tax Debt in Bankruptcy, feat. Willie Nelson, Los Angeles Bankruptcy Lawyer Blawg, June 10, 2013

Photo credit: Microsome at the German language Wikipedia [GFDL or CC-BY-SA-3.0], via Wikimedia Commons.