Tuesday, April 27, 2010

Collateral Consequences of Tax Fraud - Bankruptcy Discharge Denied (4/27/10)

Section 523(a)(1)(C) provides the taxes are not discharged "with respect to which the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat such tax." In Hawkins v. Franchise Board (Bankr Ct. ND CA No. 07-3139 4/23/10), here, the IRS and the California Franchise Tax Board sought to deny the debtors, husband and wife, bankruptcy discharge of their tax liabilities because (i) they had filed fraudulent returns and (ii) they had attempted to evade collection of tax "by dissipating his assets on unnecessary and unreasonable expenditures while he knew he owed taxes and knew he was insolvent."

The husband was well-educated and earned a lot of money working in Silicon Valley (Apple and Electronic Arts). He sold a large amount of stock and perceived a need to shelter the gain. He fell in with KPMG who hawked him FLIP and OPIS shelters (two of the shelters involved in the big KPMG criminal case in NYC). He then fell on hard times but continued to live a high lifestyle, even while knowing that he owed the IRS the tax. The Court noted that he continued the high lifestyle even after they were insolvent. After the IRS assessed some $21 million, he submitted an offer in compromise to pay about 38%. He paid some of the tax but still had unpaid tax. He and his wife filed Chapter 11 bankruptcy to deal with the tax liability. The Debtors then asked the bankruptcy court to confirm the discharge of the liability (i.e., the nonapplicability of the Section 523(a)(C) exception).

The IRS argued that the couple's returns claiming the FLIP and OPIS tax benefits were fraudulent at least as to the husband and that the their extravagant lifestyle as their finances cratered was an attempt to evade or defeat the tax. The court let the wife off the hook but hooked the husband as follows:

Fraudulent Return
It is a difficult question whether Trip Hawkins acted with intent to defraud in filing the returns in question. An objective, well-trained tax professional would have known that the claimed loss deductions lacked substance and would not be upheld if challenged. Trip Hawkins clearly has the financial acumen to understand why the FLIP and OPIS losses should not be allowed, and once the IRS challenged the deductions, Debtors never contended that the deductions were valid, and immediately tried to opt into a settlement program that would have allowed them only a small portion of the losses they claimed in their returns. At the same time, however, the FLIP and OPIS shelters were extremely complicated, and at the time Trip signed the returns in question, he held opinion letters from tax professionals stating that it was more likely than not that the claimed deductions would be upheld. These opinion letters were themselves so long and complex that they helped to disguise the lack of substance in the FLIP and OPIS transactions.

The court need not, and does not, decide whether Trip Hawkins acted with intent to defraud regarding 1997-2000 returns. As explained below, the Unpaid Taxes should be excepted from discharge on the basis that Trip caused Debtors to make unreasonable discretionary expenditures for an extended period of time after he became aware of tax obligations that he knew he could not pay.
 Willful Attempt to Evade or Defeat

The court held the husband had attempted to evade or defeat through his extravagant living after the tax debt accrued. The court recognized that some level of expenditures are required without constituting an attempt to evade or defeat, but the sheer extravagance in tough times (relatively) for the husband when a very large tax debt was due tipped the scale. The court lays out the damning details of the extravagant lifestyle. The court then sums up:

Trip Hawkins willfully evaded payment of that tax debt within the meaning of section 523(a)(1)(C) by causing Debtors to deplete their assets on large unnecessary expenditures for an extended period of time, while knowing that Debtors were insolvent, while knowing that Debtors had a $25 million tax debt that they could not pay and did not intend to repay, and while paying other creditors.
JAT Comments:

1. This statutory language for denial of discharge is not the same as the crime of evasion in Section 7201, but the concept is probably the same. The language does substantially track the unlimited civil statute of limitations provision in Section 6501(c)(1) and (2).

2. For prior discussion of the potential for an unlimited civil statute of limitations for investors in abusive tax shelters where the fraud was committed by the enablers, see my prior blog titled Civil Tax Statute of Limitations for Fraudulent Tax Shelters. Briefly, preparer fraud and perhaps enabler fraud will trigger the unlimited civil statute of limitations. For civil statute of limitations purposes, it does not appear that taxpayer culpability is required, so long as the action of someone in the chain causes the return to be fraudulent.

3. Note that the court ducked the issue of whether the taxpayer husband committed fraud because of his sophistication. Certainly that was the Government's claim as to the husband.

4.  Note also that the court seemed to think that a tax professional would know that the opinions are fraudulent.  This notion was gratuitous to its holding and may not have been adequately developed in the case, so that it is questionable how reliable it is.


  1. Jack,
    I have been following your blog and this article sparked my interest. If a criminal tax evasion defendent applied for a Ch 13 bankruptcy pre-(“BAPCPA”) Oct 17, 2005, was sentenced with a plea agreement restitution based on the "tax evasion" amount and completed the Ch 13 bankruptcy while incarcerated with the Fed IRS taxes discharged based on IRS filing no "proof of claim." Would it be conceivable to think a Judge would consider dismissing the restitution in lieu of the fact that the restituion is now based on taxes that have subsequently been discharged in the aforementioned Ch 13 bankruptcy?

  2. No. And I would be surprised that the taxes would be discharged in bankruptcy. Taxes due to fraud are not discharged and restitution applies only to taxes due to fraud. So where is the problem here? I bet these taxes have not been discharged. Was there a specific discharge or just as assumption of discharge. If the latter, you may find there is no discharge -- just wishful thinking.

    But back to the crime and restitution. Restitution has nothing to do with whether the taxes are discharged but the nature of the crime when the crime occurred. Subsequent events will not wipe out the crime or the restitution.

    Best, and good luck. Sounds like this is an your own issue or that of a good friend.

    Jack Townsend

  3. Jack,
    Thank you for the quick reply and yes a friend of mine is dealing with this situation and I have been researching this issue before I made a recommendation to get legal counsel. I also initially doubted the claim that the taxes would be discharged, but under closer examination, the "super discharge" provided for in a pre-(“BAPCPA”) Ch 13 bankruptcy does allow for all tax debts "provided for" in the plan including those that are the result of fraud. I think the last point you bring up, that the restitution is based on the "tax amount" owed at the time of sentencing, not after sentencing, would definitely resolve the issue, even though the same "tax amount" was legally discharged by the United States Bankruptcy Court. Although, it is interesting to think that had the Ch 13 bankruptcy been completed 2 weeks prior to sentencing and the "super discharge" applied, the restitution would not exist or would not be based on "taxes owed." Thank you again for you input...


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