Originally published on Forbes.com Sept 19th, 2014
William H. Hawkins or, as he is better known,”Trip Hawkins” had some good news from the Ninth Circuit this week.] A bankruptcy court had ruled that ]Trip’s “profligate lifestyle” after realizing he was insolvent amounted to a willful attempt to evade or defeat taxes The Ninth Circuit has ruled that not immediately adjusting his lifestyle when he realized he was insolvent did not constitute willfulness.
….a mere showing of spending in excess of income is not sufficient to establish the required intent to evade tax; the government must establish that the debtor took the actions with the specific intent of evading taxes. Indeed, if simply living beyond one’s means, or paying bills to other creditors prior to bankruptcy, were sufficient to establish a willful attempt to evade taxes, there would be few personal bankruptcies in which taxes would be dischargeable. Such a rule could create a large ripple effect throughout the bankruptcy system. As to discharge of debts, bankruptcy law must apply equally to the rich and poor alike, fulfilling the Constitution’s requirement that Congress establish “uniform laws on the subject of bankruptcies throughout the United States.”
Some Background
Trip Hawkins was one of the pioneers in video games for home computers and consoles. He founded Electronic Arts in 1982. Among the company’s many titles are those in the Madden NFL series.
Trip’s problems come from something of a one two punch.
In the mid-nineties he moved out of EA to run a former EA subsidiary called 3DO. He sold a lot of his EO stock to pour money into 3DO. 3DO itself filed for bankruptcy . That would not, by itself, have put him under.
What put him under was being convinced by KPMG, when he sold the EA stock, to violate Reilly’s Second Law of Tax Planning “Sometimes, it’s better to just pay the taxes” . Instead KPMG put him into a “FLIP” transaction and an “OPIS” transaction. Jack Townsend has a name for deals like those. I don’t think I should repeat it. It involves bovine excrement. For the story of how some of the smartest accountants in the country led some of the smartest entrepreneurs in the country into a tax nightmare, check out the book Confidence Games.
Pouring the illusory tax savings into a successful company would have just resulted in Mr. Hawkins having to write a painfully large check with the prospect of recovering the penalties from KPMG. As noted 3DO was not successful. So he did not have the $16 million or so that the IRS wanted when they came knocking.
The Issue
The idea of bankruptcy is to give you a fresh start. In order to have that benefit, though, you should try to pay as much as you can. If you do things like hide assets, you may not get your debts, particularly your tax debts discharged.
As we have observed “exceptions to discharge should be limited to dishonest debtors seeking to abuse the bankruptcy system in order to evade the consequences of their misconduct.”
Mr. Hawkins was not doing anything like that. The problem that the government had with his behavior is that he kept spending at a level well above his income even though he owed a lot of money. Since the Ninth Circuit started its opinion out by quoting a remark by F. Scott Fitzgerald to Hemingway “the rich are different than you and me”, I expected something really stupendous about Mr. Hawkins’s lifestyle. Something Gatsbylike.
You have to dig into the bankruptcy decision to find what they were talking about. It ends up being pretty ho-hum.
Several aspects of this Statement are worthy of note. The $33,600 housing expense included expenses for a 5-bedroom, 5.5 bath house in Atherton (later sold for $10.5 million), and a 4-bedroom, 3.5 bath condominium in La Jolla (later sold for $3.5 million). The transportation expense covers four vehicles for a family with only two drivers, and includes a $70,000 Cadillac SUV purchased ten months after Trip Hawkins had acknowledged Debtors’ tax liability and insolvency in the family court proceeding.
Two cars per driver? One of the cars about three times what I would ever spend on a car? I just can’t get that excited about that. I have to wonder if that was part of where the Ninth Circuit was coming from.
Not Out Of The Woods Yet
The Ninth Circuit did not rule that Mr. Hawkins is discharged form the tax debt. They are just telling the lower courts to take another look.
The government rightly points out that there were other facts that supported a finding of a willful failure to evade taxes that were cited as part of the decisions. However, given the heavy reliance on lifestyle choices in the decisions, it is not possible for us to determine if the district or bankruptcy court decisions would have been different without that consideration, and we decline to evaluate the other evidence tendered by the government in the first instance on appeal. Because neither the district court nor the bankruptcy court had the benefit of our conclusion that denial of discharge for “willfully attempt in any manner to evade or defeat” a tax debt requires that the acts be taken with the specific intent to evade the tax, we vacate the judgment and remand so that the courts can reanalyze the case using the specific intent standard.
Judge Rawlinson Calls Shenanigans In Dissent
Judge Rawlinson did not think that the rest of the Circuit got it right.
There is little doubt, if any, that William Hawkins deliberately decided to spend money extravagantly rather than pay his duly assessed state and federal taxes.Hawkins now seeks to discharge these taxes in bankruptcy…..
The majority opinion gives Hawkins a pass by focusing on the Bankruptcy Code’s purpose of providing a “fresh start” to debtors. However, this overly expansive interpretation of the “fresh start” policy could easily eclipse all discharge exceptions. The majority’s conclusion, in my view, creates a circuit split and turns a blind eye to the shenanigans of the rich.
Other Coverage
Tim Hull in Courthouse News Service pretty well summed it up in his title Living Large After Going Bust No Proof Of Tax Scam. The opinion on Taxlitigator.com is that the Ninth Circuit got right in (Tax) Law Must Apply Equally to the Rich and Poor Alike. A. Lavar Taylor guest blogging at Procedurally Taxing also approves of the decision, which he notes differs from other circuits. It is a two part post. In the second installment Mr. Taylor gets into the problems of evaluating the reasonableness of expenses.
For those debtors who are living a good lifestyle but are greeted by an overwhelmingly large tax liability, how long do they have to reduce their expenditures before their pre-existing level of expenditures becomes “unnecessary?” Six months? A year? If they attempt to sell their expensive house and find no buyers at a reasonable price after a year, are debtors required to sell at a fire sale or to stop paying their mortgage?
William Barrett covered the earlier stages of this case on forbes.com.
Rich And Poor
As the discussion of the case raised the issue of not requiring the rich to cut lifestyle when faced with overwhelming debt, I could not help but be reminded of Anatole France’s remark:
In its majestic equality, the law forbids rich and poor alike to sleep under bridges, beg in the streets and steal loaves of bread.