Exception to Bankruptcy Discharges for Fraudulent Returns or Willful Attempts to Evade or Defeat Tax (12/16/11)

A new case, United States v. Clayton, 2011 U.S. Dist. LEXIS 144031 (MD NC 2011), just in time for the Christmas season, offers a reminder about the confluence of tax and the bankruptcy discharges.  Generally, debtors are entitled to take bankruptcy and be discharged from their debts.  The operative word here, of course, is generally.  And, specifically with regard to tax debts, debtors may often be discharged from their tax debts.  The operative word here is often.

In my Tax Procedure book, I summarize the rules of discharge for individuals as follows:

Income taxes of individuals are not discharged for taxes in the following categories:  (i) taxes where the due date for the return is within three years of the date the bankruptcy petition was filed; (ii) taxes due for a year for which no return was filed; (iii)  taxes for a year for which a delinquent return was filed within 2 years of the bankruptcy petition date; and (iv) taxes (but not penalties) attributable to a fraudulent return or an attempt to evade or defeat the tax; and (v) taxes assessed within 240 days of the date of filing the bankruptcy petition, plus any time plus thirty days during which an offer in compromise was made within 240 days after the assessment was pending. 

Clayton focuses on the procedure for the discharge in the context of the Government's claim that Section 523(a)(1) exempted the tax in question from discharge.  That section exempts tax where "the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat such tax."  (The disjunctive "or" describes arguably different culpable acts, and that disjunctive is relevant to one argument made in Clayton.).

The Claytons had reported the taxes in question, some $1.8 million, on their 2002-2007 returns, but had paid only a small fraction.  Thus, for the taxes in issue, there appeared to be no fraudulent return and the dischargeability issue ultimately revolves around whether Clayton willfully attempted in any manner to evade or defeat such tax.

Prior to the bankruptcy proceedings at a time when dischargeability was not in issue, the Government sued to obtain judgment and collection against the Claytons.  The Claytons moved into bankruptcy, whereupon the Government's civil suit was stayed.  In the bankruptcy proceeding, the Claytons were discharged without any specific discharge of the federal taxes.  The Government moved to proceed in the civil suit, relying on Section 523(a)(1)(C).  Clayton objected, arguing that they had been discharged of the taxes in question, and sought judgment on the pleadings.  Of course, the Government's original pleadings were filed before the Claytons took bankruptcy, so the Government's pleadings did not address the Section 523(a)(7) discharge issue.

Clayton urged that the general discharge in bankruptcy discharged the taxes in issue in the civil suit and that, if the Government had disagreed, the Government should have contested dischargeability in the bankruptcy proceeding.  The Government  asserted au contraire -- that, under Section 523(a)(1)(C), the exception from discharge for taxes related to fraud, the taxes were not discharged, and that it was not required to contest dischargeability in the bankruptcy proceeding.  The Court addressed the procedural issue as follow (case citations omitted):

First, to the extent Clayton argues that the United States had an obligation to contest nondischargeability under § 523(a)(1)(C) in his bankruptcy proceeding, he is mistaken. It is true that "a chapter 7 discharge eliminates the debtor's liability on most kinds of debts."  Debts falling within § 523(a)(1) are not among them, however. Moreover, § 523(a)(1) claims do not lie exclusively within the jurisdiction of the bankruptcy courts, and thus the Government may elect to litigate them in the bankruptcy court or wait to do so in another court having jurisdiction over the creditor's claim. Consequently, unless the debtor or Government elects to litigate the nondischargeability of a debt under § 523(a)(1)(C) in the bankruptcy court, the claim survives the bankruptcy, is unaffected by the discharge, and may be brought later in another court. 11 U.S.C. § 727(b),  As a tactical matter, the Government "may wait until the bankruptcy discharge is invoked as a defense to its collection efforts, and then prove a factual basis for the tax fraud exception [under § 523(a)(1)(C)] in the collection proceedings." It is evident, therefore, that the Government's decision not to contest dischargeability of Clayton's taxes in his bankruptcy proceeding does not foreclose its present claim that the tax debts are nondischargeable under § 523(a)(1)(C).  n3
   n3 Clayton's contention that this results in unfairness to him rings hollow. Under the Bankruptcy Code, Clayton, too, could have filed an adversary proceeding to force resolution of the dischargeability of his tax debts. Beyond that, any claim of unfairness should be directed to his elected Congressional representatives who passed the legislation. 

Clayton raised another procedural issue, one of pleading fraud which the Government had not yet formally done in the pleadings.  Generally, in American jurisprudence, a party who relies in litigation for affirmative relief or defense based upon fraud must allege it in the pleadings and state the basis with specificity.  FRCP Rule 9(b), here.  The Court sliced it pretty thin on this issue, finding that the Government was not proceeding on the "fraudulent return" prong of nondischargeability in Section 523(a)(1)(C) but rather upon the willfully attempted to evade or defeat prong.  In common parlance, of course, the latter prong describes conduct that would normally be labeled fraudulent (see also my discussion in the notes at the end of this blog entry), but that is not the statutory text used.  Here is what the court said (some case citations omitted):

inapposite. While it is true, as Clayton contends, that allegations of fraudulent tax evasion must be pleaded with specificity, see Roper v. Barclay (In re Roper), 266 B.R. 418, 421 (Bankr. E.D. Ark. 2001), 4 proof of fraud is not required when the United States pursues the theory that a debtor willfully evaded tax payments, Rule 9(b)'s heightened pleading requirements simply do not apply, therefore, to § 523(a)(1)(C) exception claims where the Government does not charge fraud. Here, the Government has expressly stated that it does not contend that Clayton filed fraudulent tax returns and, instead, charges that he attempted to willfully evade payment of his taxes. Accordingly, the Government has no obligation to plead a claim under the willful evasion prong of § 523(a)(1)(C) with the particularity required by Rule 9(b).
   n4 The In re Roper opinion, relied upon by Clayton, used broad language in reaching its holding that claims under § 523(a)(1)(C) must be pleaded with particularity. 266 B.R. at 420-21 ("[A]s the party raising an issue which is essentially one of fraud, and objecting to dischargeability on that basis, the state's [sic] is required to plead the basis for its assertion that the debtor willfully evaded the tax obligation with specificity."). In re Roper, however, did not address the distinction between the two bases of liability under § 523(a)(1)(C), one of which is "aimed at a debtor who has 'made a fraudulent return'" and the other of which is "aimed at one who has 'willfully attempted in any manner to evade or defeat' his income taxes." See United States v. Fretz (In re Fretz), 244 F.3d 1323, 1327 (11th Cir. 2001); see also In re Birkenstock, 87 F.3d 947, 951 (7th Cir. 1996) (noting the distinction). To show that an individual has willfully evaded his taxes, the "United States must simply meet the test for 'civil willfulness,' which is a lesser standard than that of fraud." United States v. Jacobs (In re Jacobs), No. 305CV252J99HES, 2006 WL 2691516, at *15 (M.D. Fla. Sept. 19, 2006), aff'd, 490 F.3d 913 (11th Cir. 2007). In fact, "[a] debtor's attempts to evade or defeat his tax obligations is considered 'willful' for purposes of § 523(a)(1)(C) if it is done 'voluntarily, consciously or knowingly, and intentionally.'" Id. at *14 (quoting In re Fretz, 244 F.3d at 1330). And under Rule 9(b), "[m]alice, intent, knowledge, and other conditions of a person's mind may be alleged generally." Fed. R. Civ. P. 9(b); Swierkiewicz v. Sorema N.A., 534 U.S. 506, 513 n.3 (2002).

Clayton then urged that he was entitled to judgment any way based upon the state of the pleadings.  Keep in mind that the Government's pleadings were filed before the bankruptcy when discharge was not in issue; hence those pleadings did not say anything about discharge.  Clayton, therefore, sought relief because "the Government's complaint fails to allege any ground for recovery that survives his bankruptcy discharge, which he raised as a defense in his answer."  When Clayton raised this argument, the Government responded tersely that it did not have to amend the pleadings.  The Court stated:

The court is not persuaded that Clayton's contention that he is entitled to judgment on the pleadings, at least to the extent of the Government's proffered claim for willful evasion, can be so cavalierly dismissed, especially based on the limited authority the Government has provided the court.

The Court then proceeds to educate the Government on its responsibility to have correct pleadings, stating in effect that the Government should have moved to amend the complaint to assert the exception from bankruptcy.  Basically, the Court requires more specificity at to the defense to discharge even if not the full bore Rule 9(b) requirements.  Nevertheless, the Court, in the spirit of liberal amendment required by FRCP 15(a)(2), the Court allowed the Government 10 days to amend the pleadings to cure any defect.

JAT Notes:

1. I am not convinced about the distinction between a making "a fraudulent return" or "willfully attempted in any manner to evade or defeat such tax."  Section 7201 describes the capstone tax felony as "willful[] attempt[] in any manner to evade or defeat any tax imposed by this title or the payment thereof" which is obviously the inspiration for the tax discharge rule.  That tax felony encompasses fraudulent returns.  The crime is commonly described as criminalizes either evasion of assessment or evasion of collection, and I dare say most evasion prosecutions are for evasion of assessment through fraudulent returns.  The point I make is that the conduct described is certainly fraudulent conduct as to returns and, I think, basically the same genre of fraudulent conduct, as to other ways to evade tax through evasion of collection.  For that reason, I am not persuaded that the policy reasons for Rule 9(b)'s requirement that fraud be alleged with the specificity do not or should not apply to Section 523(a)(1)(C)'s willful attempt prong.  If I were the Government attorney filing that amended pleading, I think I would use a belt and suspenders approach and meet that stricter pleading requirement, even though there may be authority not to.

2. The key point for most readers of this particular entry is that the general bankruptcy discharge does not foreclose the Government raising the Section 523 exceptions to discharge in other proceedings where it is relevant.  As the Clayton court notes, either the bankrupt or the Government can have that issue specifically resolved in the bankruptcy proceeding, but if they do not, the defendant is at risk of adverse resolution in the future.