Recently, a bankruptcy court decided that the co-founder of the video gaming corp., Electronic Arts, tax shelter liabilities were excepted from discharge because of willful tax evasion.  Hawkins v. Franchise Tax Board, 447 B.R. 291 (N.D. Cal. 2011).

Generally, under 11 USC §§ 507 & 523, income taxes and penalties may be discharged during a bankruptcy proceeding if the following conditions are met:

1. The tax debt is at least three (3) years old from the due date plus extensions;
2. The tax return must have been filed more than two (2) years prior to the filing of the bankruptcy;
3. The tax assessment must be at least two hundred and forty (240) days old; and
4. Fraud or willful tax evasion is not present.

Hawkins, the co-founder of Electronic Arts (“EA”) obtained stock options in EA.  Following the advice of his tax advisor, Hawkins participated in two tax shelters.  The Internal Revenue Service (“IRS”) deemed the tax shelters invalid and notified Hawkins that it was auditing his 1997 federal income tax return.

Hawkins demonstrated an understanding that this would carry a significant tax burden when, in a memorandum filed in family court, he indicated that he owed $25 million to the IRS and California Franchise Tax Board and that he was insolvent and further discussed the possibility of filing for bankruptcy.  The IRS subsequently assessed the taxpayer approximately $21 million in aggregate assessments for the tax years 1997 through 2000.

Hawkins filed an Offer In Compromise after the tax assessment.  In the 433 (Collection Information Statement for Wage Earners and Self-Employed Individuals), the debtor reported wages of approximately $17,000 per month and expenses of approximately $95,000 per month.

These expenses, amongst others, included over $7,000 per month for Food, Clothing, and Misc, $33,600 per month for Housing and Utilities, $2,700 per month for Transportation, $4,500 per month for Child/Dependent care, and $40,550 per month for Other Expenses.  The transportation expense included monthly payments of $1,207.61 on a Cadillac Escalade which Hawkins and his wife bought for $69,974.28 in October 2004 to serve as the fourth vehicle for their family of two drivers.

In September 2006, Hawkins filed a bankruptcy petition.  The bankruptcy court concluded that the debtor’s tax liabilities were not dischargeable because the taxpayer was willfully attempting to evade taxes because he knew he had substantial tax liabilities, knew he was insolvent, and continued to make unnecessary expenditures despite the knowledge of his finances.

Hawkins argued that court applied wrong standards, mischaracterized his expenditures, or lacked sufficient evidence to support willful evasion finding.  He argued that in order to determine that the debtor acted with specific intent to evade or defeat taxes, the IRS must prove the mental state and willful intent to evade taxes.  He cited other bankruptcy cases in which the debtor’s payment of expenses to other creditors, rather than paying a known tax, was not sufficient to establish a willful attempt to evade or defeat the tax debt without some additional showing of an effort to conceal assets or deceive a tax agency.

The bankruptcy court concluded in each of those cases the taxpayer made a good faith effort to meet their tax obligations and did not know the extent of their tax obligations.  Here, Hawkins knew he was insolvent and that he owed federal and state income taxes in the amount of $25 million yet continued to have “truly exceptional” living expenses.  The court noted that Hawkins had two multimillion dollar residences and had bought a $70,000 vehicle to serve as the fourth vehicle for a family of only two drivers.

Therefore, the court concluded the mental state requirement was satisfied because the debtor had a duty under the law, the debtor know he had that duty, and the debtor voluntarily and intentionally violated that duty.  The court held that the debtor violated that duty when he spent funds extravagantly.

This case is significant because it sets the precedent that the spending funds after the taxpayer is aware of a tax liability, living a nice lifestyle may preclude discharging tax liabilities through bankruptcy.