Author: Dan Stroh, Associate Member, University of Cincinnati Law Review
A current circuit split poses an imperative question: Can a hypothetical multi-millionaire, like Monty Brewster, spend his millions frivolously without fear of a tax penalty following him through bankruptcy?[1] The United States Bankruptcy Code generally allows debtors to discharge all debts arising prior to filing of bankruptcy.[2] One exception to this general rule prohibits a debtor from discharging any tax debt “with respect to which the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat such tax.”[3] However, the Ninth and Tenth Circuits disagree on the debtor’s degree of culpability required to deny a discharge of indebtedness under this exception.[4] In In re Vaughn and Hawkins v. Franchise Tax Bd .of California, both debtors utilized tax shelters that were later disallowed. Due to excessive spending in the timeframe prior to assessment of the tax penalties, both debtors were unable to pay their tax penalties.[5] In Vaughn, the Tenth Circuit held that a debtor need only to spend excessively while aware of a potentially significant tax burden in order to establish the level of culpability needed to find that the debtor attempted to evade the tax. [6] In a conflicting opinion, the Ninth Circuit in Hawkins found that a debtor must spend excessively with specific intent to deplete personal wealth to a level where the impending tax burden cannot be paid.[7]
BLIPS, FLIP, and OPIS: The Background of Vaughn and Hawkins
Section 727 of the Bankruptcy Code broadly allows discharge of all debts, with specific exceptions. The exception found in §523(a)(1)(C) denies the discharge of any tax debt a debtor attempts to evade.[8] Both the Vaughn and the Hawkins cases arose from debtors using KPMG accountants who recommended tax shelters as part of a broad scheme from 1998 to 2003 KPMG marketed and advised clients to use four different types of tax shelters in order to offset income from capital gains.[10] In addition to advising clients to use these shelters, KPMG also issued letters to clients stating that it was “more likely than not” that the shelters would withstand scrutiny from the IRS if audited.[11] The trouble for both defendants came years after utilizing the tax shelters when the IRS imposed assessments for back taxes that the defendants no longer had the funds to pay.[12] While the circumstances in the cases differed slightly, both courts noted that part of the reason the debtors were unable to pay their IRS obligations was profligate spending, well beyond the means of a debtor with a large impending tax payment.[13]
The Tenth Circuit’s Vague Analysis in Vaughn
Despite the factual similarities of the two cases, the courts differed in their decisions on the mental state required to “willfully” evade taxes.[14] In Vaughn, sufficient culpability is established when: “1) the debtor had a duty under the law; 2) the debtor knew he had the duty; and 3) the debtor voluntarily and intentionally violated the duty.”[15] The court held that Vaughn was culpable under this standard. However, in applying this standard, the court’s understanding of duty is vague. The bankruptcy court argued that Vaughn should have known the tax penalty was going to be assessed and thus his spending meant that he was avoiding the tax.[16] The problem with this requirement is that while the court held a duty existed, there was no legal requirement that Vaughn could comply with while he was spending frivolously. The exact duty is not explicitly stated and appears to be that Vaughn should have known that he would be assessed a back tax in regards to the disallowed transaction.[17] However, because no back taxes were assessed prior to Vaughn’s excessive spending, he did not owe money during his spending spree. By requiring that Vaughn should have planned ahead for this tax, the court imposes a burden on debtors beyond that normally required for tax evasion. Vaughn, a man whose business success was in spite of his lack of a high school diploma, relied on professional tax advisors in making complex tax decisions and is being punished for it.[18] By holding that Vaughn should have known of an impending payment, the court created a higher standard than should be imposed upon debtors.
The Ninth Circuit, Requiring Specific Intent, Should Be Upheld
Contrary to Vaughn, in Hawkins, the Ninth Circuit held that, for a debt to survive bankruptcy, a debtor must spend frivolously with the intent to avoid paying tax debts.[19] By considering both the overall purpose of the Bankruptcy Code and criminal statutes interpreted by the Supreme Court—which are analogous to the exception in question in Vaughn and Hawkins—the court determined that the specific intent requirement is the correct standard. For both of these reasons, the Supreme Court should grant certiorari to the Vaughn petition and overrule Vaughn.
- The Bankruptcy Code’s Purpose
The Supreme Court has stated that bankruptcy law is intended to provide debtors with a fresh start and thus the exceptions that prohibit discharge of debts should be read narrowly.[20] In Vaughn, the Tenth Circuit imposed the unreasonable duty on debtors to predict future tax penalties.[21] As noted in Hawkins, spending to excess is generally the reason people end up in bankruptcy court, regardless of tax penalties.[22] By determining that profligate spending by a millionaire will be deemed to be tax evasion, the court in Vaughn undermines the purpose of bankruptcy. While wealthy persons who spend their way into bankruptcy are not sympathetic characters, punishing their excessive spending is not the purpose of the bankruptcy laws. Thus, as the goal of bankruptcy is to provide a fresh start, creating a broader exception to discharges of debt does not fit into this scheme.
- Analogous Criminal Tax Provisions
The Supreme Court has addressed the difference between a willful failure to pay taxes and a willful evasion of taxes.[23] The language of §523(a)(1)(C) closely resembles that of 26 U.S.C.S. §7201 (felony tax evasion).[24] According to the Supreme Court’s decision in Spies v. United States, an individual must affirmatively avoid taxes in order to be found guilty of tax evasion.[25] Therefore, an individual cannot be found guilty of tax evasion simply by omission.[26] In Spies, the defendant failed to file tax returns and therefore did not pay taxes. The Court held that the defendant’s omission did not rise to the level of tax evasion.[27] In both the Vaughn and Hawkins cases, the debtors did not take any affirmative, purposeful action to evade taxes. Both debtors filed returns and noted the transaction in question on their tax returns.[28] Neither hid any information. While the line between tax avoidance and tax evasion is not always clear, in this case it is obvious that neither individual was attempting to hide income, and thus evade taxes. They were simply following the guidance of tax professionals in what they believed was a legal avoidance of tax. Yet the Tenth Circuit found that this less fraudulent conduct was somehow culpable enough to meet the standard for evasion. In Vaughn, the court imposed an overly burdensome standard by stating that the debtor’s omission of not preparing to pay a tax yet to be assessed constituted tax evasion. This standard simply does not comply with precedent and it should be overturned.
Conclusion
While the cases of Vaughn and Hawkins are both examples of wealthy persons spending beyond their means, neither indicates a specific intent to avoid taxes. By spending millions of dollars, these debtors created a problem when their attempt at tax avoidance was deemed to be illegal years down the road. However, such spending should not prevent either from receiving a fresh start under the bankruptcy laws. The Supreme Court should use the opportunity presented in Vaughn to provide guidance to the lower courts and end the circuit split.
[1] Brewster’s Millions (Universal Pictures 1985).
[2] 11 U.S.C.S. § 727 (LEXIS through PL 114-6, 2015).
[3] 11 U.S.C.S. § 523(a)(1)(C) (LEXIS through PL 114-6, 2015).
[4] Vaughn v. United States IRS (In re Vaughn), F.3d 1174 (10th Cir. 2014); Hawkins v. Franchise Tax Bd. of California, 769 F.3d 662 (9th Cir. 2014).
[5] Vaughn, 765 F.3d at 1179, Hawkins, 769 F.3d at 665.
[6] Vaughn, 765 F.3d at 1181.
[7] Hawkins, 769 F.3d at 669.
[8] 11 U.S.C.S. § 523(a)(1)(C).
[9] Internal Revenue Service, KPMG To Pay $456 Million For Criminal Violations, IR-2005-83 (2005) available at http://www.irs.gov/uac/KPMG-to-Pay-$456-Million-for-Criminal-Violations.
[10] Pfaff v. United States, 989 F. Supp. 2d 301, 303 (S.D.N.Y. 2013). The four types of shelters were Bond Linked Issue Premium Structure (BLIPS), Foreign Leveraged Investment Portfolio (FLIP), Offshore Portfolio Investment Strategy (OPIS), and Short Option Strategies (SOS).
[11] Vaughn, 765 F.3d at 1176.
[12] Vaughn, 765 F.3d at 1179; Hawkins, 769 F.3d at 665.
[13] Vaughn, 765 F.3d at 1177-1179; Hawkins, 769 F.3d at 665-665.
[14] 11 U.S.C.S. §523(a)(1)(C); Vaughn, 765 F.3d at 1181; Hawkins, 769 F.3d at 668.
[15] Id. (citation omitted).
[16] Vaughn, 765 F.3d at 1181.
[17] Id.
[18] Reuters, 2 Ex-KPMG Managers Sentenced Over Tax Shelters, N.Y. Times, (April 1, 2009), http://www.nytimes.com/2009/04/02/business/02kpmg.html; In an another unfortunate turn of events for Vaughn, several of the advisors that he relied upon for these transactions were later convicted of criminal tax evasion charges.
[19] Hawkins at 669.
[20] Id at 666.
[21] Vaughn, 765 F.3d at 1181.
[22] Hawkins, 765 F.3d at 669.
[23] Id at 668.
[24] 15 U.S.C.S. §523(a)(1)(C); 26 U.S.C.S. §7201 ((LEXIS through PL 114-6, 2015).
[25] Id.; See also Spies v. United States, 317 U.S. 492, 499 (1943) (Holding that omission by not filing tax returns and not paying taxes was not enough to constitute willful evasion. Willful evasion requires an affirmative action rather than just an omission.)
[26] Spies, 317 U.S. at 499.
[27] Id.
[28] Vaughn, 765 F.3d at 1176-1177, Hawkins, 769 F.3d at 664-665.
