A Pair of High Profile Bankruptcy Cases Driven by Taxes

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A famous lawyer, F. Lee Bailey, and a famous retailer of Frost Bros. and Michaels Stores, Samuel Wyly, recently made news for their bankruptcy cases driven by their tax disputes with the IRS. I have previously discussed the Wyly case.  We have not previously discussed the bankruptcy case or the tax problems of Mr. Bailey.  More background information on his bankruptcy case can be found in a Washington Post article.  Though each case is different they share the story of the rich and famous going to bankruptcy court seeking relief from federal taxes.  Mr. Wyly has found no relief in bankruptcy court and the discussion of his case will be short.  Mr. Bailey may find the relief he needs.  This post will discuss why bankruptcy may prove helpful to one man while it spurned the other.

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Mr. Wyly engaged in securities fraud but did so unintentionally perhaps because what he really wanted to do was to avoid paying taxes.  The SEC lawyers brought an action against him and his brother for securities fraud, won the case, and then made the unusual request to peg the damages for the securities fraud to the amount of taxes the brothers sought to avoid through the transactions.  As I wrote previously, the SEC lawyers deserve a nice award and significant recognition from the IRS for their thoughtful and creative actions.  Greater details about the case are in a prior post.

The recent bankruptcy decision came after a lengthy trial under Section 505(a) of the bankruptcy code determining the actual tax liability of Mr. Wyly in the bankruptcy court.  His is the largest individual bankruptcy case ever.  The bankruptcy court determined that he owes the IRS tax of $135,478,999.00 and interest for the years 1992 through 2013 of $227,148,953.00.  In addition he owes fraud penalties of $142,463,127.00 and interest on the fraud penalties of $174,966,822.00.  In addition, he owes penalties for failure to file Form 3520-A of $408,534,822,00 and penalties for failure to file Form 5471 of  $19,080,000.00.  This is a total of over $1.1 billion.  Form 3520-A is the annual information return of a foreign trust that has a U.S. owner, under section 6048(b).  The form is filed in order to provide information on the trust, its U.S. beneficiaries, and any U.S. person who is treated as an owner of any portion of the foreign trust.  The purpose is to set forth a full and complete record of all trust activities and operations for the year and the name of the United States agent for the trust.  Form 5471 is the information return of a U.S. person, with respect to certain foreign corporations; certain U.S. persons who are officers, directors, or shareholders (i.e., a person who has some control over the corporation) in certain foreign corporations must file Form 5471 and its schedules associated to satisfy sections 6038 and 6046 reporting requirements.  The purpose of this form is also to provide a complete record of the operations and financial standing of the foreign corporation with which U.S. persons are associated.  The court also finds that the taxes and the fraud penalty are non-dischargeable.  I have not gone back into the arguments before the court but would have expected that most of the fraud penalties would be dischargeable for the reasons described in this post.  This was a B.C. 505(a) hearing to determine liability and not a hearing to determine discharge.  So, the statement at this point in the case is unusual for that reason as well.  It has not been a good year for Mr. Wyly in bankruptcy court.

While Mr. Wyly is at the end of the liability phase of his bankruptcy case which perhaps will be the most important phase, Mr. Bailey is just getting started in his foray into bankruptcy. Instead of going into bankruptcy to fight about his tax liability, Mr. Bailey took the more traditional path of litigating his liability in Tax Court.  Judge Gustafson penned a 143 page opinion at T.C. Memo 2012-96 if you are interested in all of the details.  Mr. Bailey joined the over 70% of Tax Court petitioners who represent themselves and ended up with a liability exceeding $5 million in taxes penalties and interest The tax years at issue ran from 1993 to 2001.  The penalty the Tax Court imposed was not the fraud penalty but the accuracy-related penalty and that makes a big difference in the outcome of his bankruptcy case vis-a-vis his taxes.

Bankruptcy should provide a relatively quick and easy way for Mr. Bailey to discharge the tax liability without paying it, assuming that he does not have many assets. His schedules indicate all of his property is valued at $408,176.26.  He did decide not to pursue the bankruptcy pro se.  I guess at some point even super lawyers recognize their limits.  Because the tax years are more than three years past the filing date, he timely filed his returns, and the assessments occurred more than 240 days ago, the IRS will either have a secured claim or a general unsecured claim.  Based on the assets he reports in his schedules, it looks like most of the claim will be unsecured.

A possible attack on his discharge from the IRS could come if it feels like his failure to pay the taxes was due to living a high lifestyle without regard for payment of the taxes. The IRS can ask that the exception to discharge under B.C. 523(a)(1)(C) apply if it can show he was evading the payment of his taxes even though he did not evade the liability itself.  We have written about this exception to discharge previously here and here.  I have no basis for concluding that the IRS will seek to argue this exception from discharge but raise it merely to point out that it poses a small obstacle for Mr. Bailey.

It looks like bankruptcy provides a good path for addressing and removing the taxes he owes with only a fractional payment. By going to Tax Court first to have the liability determine and then waiting more than 240 days after the IRS assessed the taxes, Mr. Bailey used the best path for using the bankruptcy discharge provisions to deal with his tax debts.  In contrast, the use of 505(a) by Mr. Wyly keeps the taxes “fresh” and usually prevents their discharge when litigating about them in a pre-assessment context.

Conclusion

These two cases not only show how the mighty can fall but also different outcomes that bankruptcy offers depending upon the penalties that apply and the place and timing of the tax determination. It looks like bankruptcy may provide a good result for Mr. Bailey while providing a terrible one for Mr. Wyly.

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