Nonpayment of Tax Liabilities Can Be Evasion and Defeat Discharge in Bankruptcy (12/10/12)

A recent district court case denying a discharge in bankruptcy serves as a warning for taxpayers and practitioners.  Rossman v. United States, 2012 Bankr. LEXIS 5615 (Bkr Ct D MA 2012), here.  11 USC § 523(a)(1)(C), here, titled Exceptions to Discharge, provides in part relevant that a discharge does not apply to any tax "(C) with respect to which the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat such tax."  The question is whether nonpayment can constitute an attempt to evade or defeat tax.

The opinion is long, so I won't try to summarize it here.  The tax arose from a tax shelter investment in the 1980s.  The tax was thus a 1980s tax with resulting substantial interest now well exceeding the amount of the tax liability.  The aggregate liability was now substantial.  The shelter was a hokey shelter that has been litigated over many years, but by the early 2000s, although the taxpayer's case had not yet resulted in an assessment, the liability was clear and the assessment was only a matter of time.  The assessment was made  by 2004.

After the date that he knew of the liability and after the assessment was made,  the taxpayer earned substantial amounts of income.  Taxpayer made no payments.  And, although there appeared to be no evidence of a profligate lifestyle, the taxpayer failed to explain why he could not have made substantial payments during the period, given the amount of his income.

After making extensive findings of facts,  the Court concluded as follows:

The record is devoid of any direct evidence of the Debtor's willful intent to evade taxes in the form of implausible or inconsistent explanations of behavior; inadequate financial records; transfers of assets that greatly reduce assets subject to IRS execution; and transfers made in the face of serious financial difficulties. See Beninati, 438 B.R. at 758. Similarly, the Debtor did not engage in any manipulative conduct by failing to make estimated payments or failing to pay annual taxes after 1986 when due, and there was no evidence that he routinely applied for extensions of time within which to file returns. See Lacheen v. IRS (In re Lacheen), 365 B.R. 475, 484-86. Indeed, the Debtor testified, and the IRS did not dispute, that, with the exception of his tax liabilities from Rancho Madera Partners and Vista Ag-Realty Partners, Rossman paid all federal and state taxes on time and in full from 1987 to the commencement of his bankruptcy case.

Thus, in the instant case and except as discussed below, Rossman engaged in no conduct suggesting an intent to evade his 1986 tax obligations and most of the types of circumstantial evidence used to evaluate a debtor's state of mind for purposes of willfulness are absent. Nevertheless, in Lacheen, the court highlighted evidence of an intent to evade the payment of taxes arising from circumstances where the taxpayer had the financial resources or disposable income to pay but simply did not, as well as evidence of a lavish lifestyle. Those circumstances are at the heart of the IRS's contention that any obligation owed to it by the Debtor should be nondischargeable.

The Court then reviewed some of the taxpayer's expenditures over the year, but they really did not appear to be that lavish.  Clearly, though, they were far  less than Rossman's income.  Therein lay the rub:

The Court, however, cannot ignore Rossman's earnings in the years after 2002 when the IRS issued Form 4549A. Rossman earned substantial income in 2004 and 2005 when his partnership distributions were $1,620,000 and $660,000, respectively, and his adjusted gross income was higher as a result of other sources of income. In those years, Rossman's income far exceeded his income in both prior and later years. In view of his substantial income in those years, the Court finds that the burden of proof shifted to him to explain how he spent that  extraordinary income and why he did not make some payment toward his tax liability. He did not address that income during his testimony. Thus, the inescapable conclusion is that Rossman had disposable income from which he could have made some payments to the IRS and the failure to use at least some of that income to satisfy the increase in tax owed in 1986 (i.e., $157,132) evidences an evasion of tax liability. Both his conduct in failing to make payments toward the balance due from 1986 and circumstantial evidence of willfulness derived therefrom supports the conclusion that he intended to evade at least some part of his obligations to the IRS. See In re Fegeley, 118 F.3d at 983 (conduct requirement satisfied when debtor in any manner evades or defeats tax liability). 

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The facts of this case compel but one conclusion. The IRS established that Rossman intentionally violated the duty to pay the amount of additional tax owed in 1986 and some interest, but not the amount of interest that is subject to dispute  [*59] in the Tax Court. The Debtor had the ability to make payments toward the balance of taxes owed of $157,132 for 1986, particularly as a result of the income he received in 2004 and 2005 which amounts were substantially greater than years prior to and after those years. Rossman recognized that in view of the successful challenge to the tax status of Rancho Madera Partners and Vista Ag-Realty Partners, he owed more tax in 1986 than he paid. He testified credibly that upon receipt of the October 8, 2002 Form 4549A Income Tax Examination Change he had no ability to pay the full amount demanded by the IRS, but he had the ability to make some payments to the IRS either from his regular income, particularly in 2004 and 2005 or from his pension income from the Town of Swampscott.

The Court then reasons that the case is like In re Bryen, 433 B.R. 503 (Bankr. E.D. Pa. 2010), aff'd, 449 Fed. Appx. 165 (E.D. Pa. 2011), aff'd, 449 Fed. App'x 165 (3d Cir. 2011) [the CA3 opinion is here] where Third Circuit held:

Once the Tax Court held that his tax shelters were shams, Bryen was aware he owed back taxes to the IRS. While he did not know the specific amount of the tax deficiency until 2001, he was aware that it would be substantial. Nonetheless, Bryen continued to live high on the hog. He earned income that exceeded his modest, fixed living expenses. He made no attempt to save in anticipation of the tax debt. Further, after he signed the stipulations with the IRS, he did not change his behavior. He did not make any payments to the IRS to reduce his tax liability and continued to deal in cash to avoid having creditors attach his bank accounts. Thus, the totality of the circumstances justify finding that he was attempting to evade his taxes under § 523(a)(1)(C). 

* * * * 

Section 523 only references taxes, not assessed taxes and a delay in enforcement cannot mean that a taxpayer, aware that he owed the IRS a substantial sum, can never have the requisite intent to evade. As the Bankruptcy Court noted, "it is hard to imagine that the outstanding tax debt did not loom over [Bryen] like a 'Sword of Damocles.'" In re Bryen, 433 B.R. 503, 519 (Bankr. E.D. Pa. 2010). Yet, unlike the Damocles of legend, Bryen never sought to give up his lifestyle to free himself of this sword. His lifestyle, combined with his deliberate attempts to avoid his creditors, justifies the Bankruptcy Court's finding that he acted intentionally and voluntarily in evading his tax obligations. See In re Fegeley, 118 F.3d at 984 (finding that the Debtor's evasion was willful when he "probably had enough money to pay th[e] taxes[,] . . . spent too much[,] . . . was much too lavish[, and] . . . didn't make good judgments about the allocations of his resources."); see also In re Gardner, 360 F.3d 551, 561 (6th Cir. 2004) (finding the taxpayer's lifestyle which included numerous vacations coupled with his lack of payment of his tax debt suggested a willful evasion of the tax debt).

Rossman's case does not appear quite as bad as Bryen's, but the point is clear that a taxpayer with substantial income beyond reasonable expenses takes a great risk to eventual discharge if he or she does not make some payments that can be construed as good faith in dealing with outstanding IRS debts.