Willful Attempt to Evade or Defeat the Payment of Tax

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One possible though rarely used basis for prosecuting taxpayers uses IRC 7201 to prosecute someone for not paying their taxes while seeking affirmatively to evade the payment. Bankruptcy has a parallel provision in the provisions concerning discharge of taxes. Almost 20 years ago the IRS first argued that the exception to discharge set out in B.C. 523(a)(1)(C) should apply to prevent a taxpayer who affirmatively sought to prevent the IRS from collecting the tax. Recently, the 10th Circuit affirmed lower court decisions holding that a taxpayer who participated in a BLIP transaction in 1999 could not discharge the now incredibly large tax liability resulting from the disallowance of the benefits claimed in the shelter transaction. While the participation in the tax shelter played a part in the court’s decision, the taxpayer’s lifestyle in the years after the claiming of the shelter caused him to lose his effort to discharge the liability. The other day Jack Townsend’s excellent tax crimes blog discussed this case though largely examined its potential implications in the context of statute of limitations issues. I write to focus more on the case’s important bankruptcy issues and how certain taxpayer conduct after the tax liability is rung up can lead to taxes never being discharged in bankruptcy.

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Facts

Mr. Vaughn, like most tax shelter participants, did well in business. He sold a business, made a lot of money, got advice from KPMG and ended up in a tax shelter so that he would not have to pay tax on the money he made from the sale. The investment in the tax shelter plays a significant role in the outcome of the case not so much for what he knew before he bought it but for what he knew and then what he did afterwards.

The circuit court spent some time discussing the nature of the tax shelter and the advice given to Mr. Vaughn in connection with the investment. The case initially caught my eye because the bankruptcy court considered the shelter purchase tax fraud before settling on evasion of payment. If the court had determined that the purchase of the shelter resulted in tax fraud, the case might have shaken up the shelter industry a bit since it might have signaled that debts arising from shelter purchases could never get discharged. Instead, the bankruptcy court and courts that followed it focused on Mr. Vaughn’s lifestyle rather than the purchase of the shelter as tax fraud. For the reasons discussed below, the possibility of arguing that shelter purchases meet the criteria for excepting taxes from discharge remains a future possibility.

Two divorces caused Mr. Vaughn’s fall from financial heights. The divorces came rapid fire after the transaction that made him wealthy and caused him to purchase the shelter. Each divorce settlement caused him to lose about half of his previous net worth. His spending habits caused him to lose more. This led, about six years after the shelter year, to a bankruptcy filing in which he sought to discharge the significant tax liability asserted by the IRS. Ordinarily, the age of the taxes would have resulted in a discharge; however, Mr. Vaughn ran into the little used provision on fraud or evasion of payment.

Apparent Winners

Before getting into the bankruptcy weeds to discuss why Mr. Vaughn can never discharge this tax in bankruptcy, it is worth pausing a moment to think about the apparent winners in this case. I say apparent because I do not know what other collection action the IRS may be taking in the case. One apparent winner is KPMG which got paid an enormous sum, about a half million, to put him into the bogus shelter. Could/should the IRS go after that money? The other apparent winners are the ex-wives. They got divorce settlements based on the pre-tax value of Mr. Vaughn’s holdings. The divorces occurred after the sale but before the unraveling of the tax position. So, they appear to have received a percentage of his assets without discounting for the tax liability. As mentioned above, it is unclear if the IRS is seeking or will seek to recover some of the unpaid taxes from them. Mr. Vaughn’s step-daughter also received a sizable distribution from him from the funds before the taxes were assessed and also appears to be a winner in the absence of knowing what other collection actions the IRS has chosen to take here.

Bankruptcy Law

Bankruptcy excepts from discharge three types of taxes. First, it excepts taxes classified as priority claims. These are generally taxes arising within three years of the filing of the bankruptcy petition although the provision has much more complexity than this. Second, as discussed in an earlier blog What is a Return – The Long, Slow Fight in Bankruptcy Courts, the provision excepts from discharge taxes on returns never filed or filed late and within two years of the bankruptcy petition. Third, it excepts taxes “with respect to which the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat such tax.” This post focuses on the third exception which is also the least used exception.

Most of the cases using the third exception arise after the IRS has established the fraud penalty. If the fraud penalty exists, the application of the third exception follows automatically. The IRS does not assert the fraud penalty often. To sustain the fraud penalty, the IRS must prove the fraud by clear and convincing evidence. That standard exists for tax merits determinations.

As the bankruptcy standard for fraud is only preponderance of evidence. It is possible to prove fraud for purposes of bankruptcy discharge with less evidence than a tax merits determination requires. When I read the headline describing this case, I thought perhaps the IRS had sought to obtain an exception to discharge based on a shelter investment using the lower standard of proof necessary for proving fraud in the bankruptcy discharge context. The bankruptcy court may also have thought this a possibility. Ultimately, however, the case went on a different track.

In 1994 the IRS first won a circuit court case Toti v US arguing that a taxpayer’s actions in seeking to keep money from the IRS fit the language of the statute in trying to attempt to evade the tax “in any manner.”   The 6th Circuit’s decision in Toti opened the door for the IRS to argue that engaging in an extravagant lifestyle at the same time you are stiffing the IRS on back taxes can result in those taxes getting excepted from discharge when the taxpayer files for bankruptcy. In the years since the Toti decision the IRS has asserted this argument on a number of occasions. Its assertion against Mr. Vaughn is not unique but is also not routine.

These cases have certain characteristics. The taxpayer needs to owe a fair amount of money. The IRS will not bother with this argument if the amount of the debt does not catch the eye. The taxpayer needs to spend their money (or the IRS might argue the “people’s” money) in a way that goes well beyond acceptable norms. The cases typically involve either a long pattern of spending on luxury or unnecessary items or the payment of a large ticket item that goes over the top. Expensive private education, expensive weddings, expensive cars, expensive vacations head the list of the types of expenditures that will trigger the application of this provision.

Mr. Vaughn met the criteria for the application of the exception to discharge under 523(a)(1)(C) from all angles. First, his tax shelter activity marked him as someone who sought to evade the payment of his taxes from before he ever filed his return. Second, he found out that the IRS was auditing another person with the scheme and he was counseled by KPMG to come into the IRS with a voluntary disclosure. Third, after he knew that the IRS thought the shelter was bogus and it was targeting the participants in the shelter, he lived an extravagant lifestyle and he put $1.4 million into a trust for his step daughter. By his actions both before and after the filing of the return, he made it clear that paying the taxes on his gain was not in his plans.

Conclusion

This case and the other cases following Toti provide a cautionary tale for the small segment of taxpayers who have significant tax debt and who continue to live a lavish lifestyle after the accumulation of the debt. The decision here provides another example in a small but now well established line of cases. The fact that the bankruptcy court seemed willing to consider the more direct issue of the fraud from the investment itself presents the more interesting aspect of this case. If the IRS goes after tax shelter investors in bankruptcy in an effort to except from discharge the taxes arising from that assessment even where it has not established fraud in the merits of the liability, then the case signals a more important cautionary tale.

 

 

Comments

  1. Keith: I spoke on this particular issue at an ABI Northeast in the mid 2000’s. IRS has been relentless in its quest to overturn the dischargability of individual income taxes since 1978 and having had the benefit of selecting cases with horrible facts to take to circuit courts, the issue is now settled. 523(a)(1)(C) is now discretionary with the Service. The argument, taken from 6672 cases, is that the taxpayer earned the income and had thus received as a compent of that income the aliquot tax liability that comes with that income. Stated another way, the taxpayer having chosen to spend the money that was the tax component of the income did the equivalent of 6672 debtors, paying someone other than the tax authorities when a liability was known to be due. The discretionary aspect is that the Service gets to decide whether the funds expended went to a good or bad place. Funding medical expenses of a terminally ill child is a good expenditure. Vegas is my home and I loved it there even though I lost all my money is a bad expenditure. In your case, the Circuit wanted to hold him to his debt. I don’t think the tax shelter investment itself is the ratio descedendi but the expenditures after receiving notice were and the factor is I think that after knowledge of the tax debt, that he didn’t pay it when he could have, sunk him. If you take out the gloss of the BLIPS shelter and replace it with knowledge of unpaid and unarguably due taxes from whatever source, it is the post-tax debt knowledge conduct that has, in the line of cases starting with Toti, allowed 523(a)(1)(C) to prevail as enforced. It is folly these days to attempt to render a 523(a)(1)(C) opinion.

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