Is There a Future Role for Circular 230 in the Internal Revenue Service’s Efforts to Improve Tax Compliance?

In this post, Michael Desmond of the Law Offices of Michael J. Desmond discusses recent judicial developments highlighting limits on IRS and Treasury’s authority under Circular 230 to regulate aspects of practitioner conduct. The post explains the connection between the IRS’s efforts to use Circular 230 in a more muscular way and its lack of resources. The post comes on the heels of a panel presentation at the ABA Tax Section this past month in Denver where Mike, Stuart Bassin and Professor Steve Johnson appeared on a panel of the Standards of Tax Practice Committee. Les

In 1984, the Treasury Department and the Internal Revenue Service (“Service”) first amended Circular 230 to target practice standards on “tax shelter” transactions. Since then, Circular 230 has been amended on a number of occasions. Many of these amendments have refined the focus of Circular 230 on new generations of aggressive tax planning through, for example, the much-maligned and now repealed “covered opinion” rules in former section 10.35. Other amendments have addressed more mundane aspects of practitioner conduct ranging from the fees that can be charged to a practitioner’s ability to endorse refund checks and the failure by a practitioner to file a client’s tax return electronically. A common theme reflected in these changes is the use of Circular 230 as a tool to improve compliance, as distinguished from the more general role of fostering good practice standards.

The 30-year evolution of Circular 230 and, more broadly, the Service’s effort to use Circular 230 as a tool to improve compliance, has recently been called into question. The D.C. Circuit’s opinion earlier this year in Loving v. IRS, 742 F.3d 1013 (D.C. Cir. 2014) was the first shoe to drop. Loving has been discussed extensively in recent months and is noteworthy not only for the fact that it upheld the District Court’s order enjoining the Service from implementing key components of its highly publicized and far reaching return preparer initiative, but also because it marked the reversal of a prior leaning in the courts to uphold the Service’s authority to regulate a broad range of conduct under Circular 230. While Loving raises fundamental questions about what role Circular 230 will play in the Service’s enforcement toolbox going forward, it also highlights shortcomings with other tools in that box, which may be the better place to focus going forward.


Legal Challenges to Service’s Authority to Regulate Practice

Prior to Loving there had been only a handful of court challenges to the scope of the Service’s authority to regulate “practice” under 31 U.S.C. § 330. In Tinkoff v. Campbell, 158 F.2d 855 (7th Cir. 1946), the appellant was a disbarred attorney who moved into the business of “advising taxpayers in filling out income tax returns.” Enforcing the limited practice rules under Circular 230 (currently found in section 10.7(c)), the Service prohibited the appellant from representing taxpayers in a non-legal capacity, “explaining adjustments and computations in their returns” and “accompanying them upon interviews” in connection with an audit of their return. The Seventh Circuit had little trouble dismissing the appellant’s constitutional challenge to the Service’s authority to regulate his return preparation “practice” under Circular 230: “We find no merit whatsoever in any of the contentions raised by appellant and are fully in accord with the District Court in dismissing the petition for injunction.” Id. at 856.

Sixty years later, in Wright v. Everson, 543 F.3d 649 (11th Cir. 2008), the Eleventh Circuit rejected a challenge to the Service’s refusal to allow, under Circular 230, an “unenrolled” return preparer to represent taxpayers through use of an IRS Form 2848 Power of Attorney. In Wright, the court framed the issue as whether the practice limits applicable to unenrolled preparers were “arbitrary, capricious, or manifestly contrary to statute” (a Chevron “Step Two” inquiry), without questioning the Service’s threshold ability to regulate “practice” under 31 U.S.C. § 330 or the scope of its authority under that statute. The Eleventh Circuit in Brannen v. United States, 682 F.3d 1316 (11th Cir. 2012) similarly had little trouble finding authority for the Service to require return preparers to obtain registration numbers, distinguishing what was then the district court’s holding in Loving by citing the specific statutory authority under Code section 6109 for requiring preparer identification numbers. Tinkoff, Wright and Brennen were not cited by the D.C. Circuit in Loving. While not involving the Administrative Procedure Act arguments at issue in Loving, the trend seen in those prior cases to uphold the Service’s broad authority to act under 31 U.S.C. § 330 was nonetheless reversed.

The Service did not seek en banc review or certiorari from the Supreme Court in Loving. Rather, the Service indicated that it would follow the Court’s holding narrowly and not apply its interpretation of the terms “practice” and “representatives” in 31 U.S.C. § 330 to other aspects of Circular 230. In other words, while Loving may have enjoined the Service from mandating testing and continuing education for paid return preparers, its holding would not be applied to other provisions of Circular 230 that also purport to regulate conduct not involving direct interaction with the Service.

The Service’s effort to limit Loving lasted less than six months. In July 2014, the U.S. District Court for the District of Columbia issued its decision in Ridgely v. Lew, 2014 U.S. Dist. LEXIS 96447 (D.D.C. July 16, 2014), enjoining the Service from enforcing the limitation on a practitioner’s ability to charge a contingent fee for “ordinary refund claims” in Circular 230 section 10.27. In doing so, the court rejected the government’s effort to distinguish Loving on the basis that the plaintiff was a practicing CPA who, at some point in his career, had had direct interaction with the Service even if not in connection with the contingent fee arrangements at issue. The Service has long relied on (and continues to rely on) this “once a practitioner, always a practitioner” position as a jurisdictional hook for Circular 230.   (n.b., in the IRS Form 2848 Power of Attorney and Declaration of Representative released in July 2014, the Service now requires that practitioners affirmatively declare that they are “subject to regulations contained in Circular 230.” The Form 2848 previously required only that practitioners declare they were “aware” of the regulations.).

The government did not appeal Ridgely and has since stated, consistent with its reaction to Loving, that it will apply the holding in that case narrowly. William R. Davis, ABA Meeting: OPR Will Narrowly Apply Ridgely, 2014 TNT 184-11 (Sept. 23, 2014 (quoting IRS Office of Professional Responsibility Director Karen Hawkins as saying “I am going to treat Ridgely the same way I treated Loving, which is I’m going to stick to the issue that was decided and the dicta is very colorful but it is not law.”). The Service has, however, yet to confront or develop a response to the basic rationale of Loving: That a person’s conduct in assisting taxpayers in any manner that does not involve direct interaction with the Service does not constitute “the practice of representatives of persons before the Treasury Department” within the meaning of 31 U.S.C. § 330(a). While some have pointed to the Service’s authority under 31 U.S.C. § 330(b) to regulate “incompetent” or “disreputable” representatives, or to the “nothing shall be construed to limit” language of 31 U.S.C. § 330(d) which applies to the rendering of certain written advice, the Service’s authority under those provisions is far more limited than under 31 U.S.C. § 330(a).

Were the logic of Loving and Ridgely to be extended, not only is the Service’s ability to regulate paid return preparers under Circular 230 limited or non-existent, but the vitality of other “non-practice” provisions in Circular 230 has also been called into serious question. If the Service cannot regulate return preparation because it does not constitute “practice” before the Treasury Department, where is its authority to promulgate the “due diligence” standards applicable to communications between practitioners and their clients under Circular 230 section 10.22(a)(3)? To promulgate the standards applicable to advice with respect to documents submitted to the Service other than tax returns under section 10.34(b)?  To enforce the “written advice” standards in new section 10.37? Or to promulgate numerous other provisions in Circular 230 that purport to regulate conduct not involving direct interaction with (or “practice” before) the Service? As a practical matter, there may be little incentive for a practitioner to challenge the Service’s authority to enforce these provisions, at least through an injunction action similar to Loving or Ridgely. If a practitioner were to be sanctioned by the Service under any of these “non-practice” rules, however, it is easy to see a judicial challenge to their validity in a district court appeal of an administrative law judge’s final determination upholding that sanction. And under Loving and Ridgely it is easy to see that challenge succeeding.

Why the IRS Attempted to Use Circular 230 to Regulate Preparers: Resource

While Loving and Ridgely provide an interesting look at the application of the Administrative Procedure Act to tax administration, their holdings—and the potential for a broad extension of their holdings—begs the question of why Circular 230 evolved into a enforcement tool targeted at “tax shelters,” “covered opinions,” contingent fee arrangements and other real and perceived compliance problems in the first place. The holdings similarly beg the question of why Circular 230 was chosen as the vehicle through which the Treasury Department and the Service would subject hundreds of thousands of paid return preparers to mandatory competency testing and continuing education requirements.   A report from the Treasury Inspector General for Tax Administration (“TIGTA”) released on September 25, 2014, helps to highlight an answer: resources.

Apart from Circular 230, the Service has unchallenged authority to regulate the conduct of paid return preparers and others who assist taxpayers in complying with the tax law (or not complying with the tax law, as the case may be) through a broad range of civil and criminal provisions in the Code. These include the preparer penalty provisions in Code sections 6694 and 6695, the penalty for promoting abusive tax shelters under Code section 6701 and the civil injunction provisions in Code sections 7407 and 7408. To enforce these provisions, however, takes a commitment of significant resources. After identifying the bad actors and developing an administrative case against them (itself a resource-intensive effort), the Service can be dragged into protracted litigation in seeking to obtain a court injunction or in defending its penalty determinations against a challenge brought by a preparer or practitioner who is highly motivated to clear their name or delay imposition of an inevitable sanction.

Notwithstanding the wide range of tools that can be used against problematic preparers, the recent TIGTA report found that the Service failed to follow up on more than one third of preparer conduct referrals, most of which were from internal sources within the Service. The TIGTA report references a prior report, which evaluated the Service’s inability to timely respond to thousands of other referrals that are submitted each year on IRS Form 14157, mostly by taxpayers who have been victimized by unscrupulous or fraudulent preparer conduct. Rather than build an entirely new regulatory regime under the questionable authority of 31 U.S.C. § 330 at a cost estimated to be up to $77 million annually, could that same $77 million could be targeted at the thousands of preparer conduct leads that seem to go unopened each year?

The problem, of course, is that committing resources to enforcing existing law must come from the Service’s general enforcement budget, an area that Congress has been moving down on its funding priority list. Using Circular 230 as the vehicle for regulating paid return preparers and “practitioner” conduct more generally sidesteps this problem because, as originally envisioned, the $77 million cost would be self-funded through user fees imposed on all (or most) practitioners. Legislative proposals authorizing the Service to regulate paid preparers (which would address the holding in Loving)similarly envision a user-fee regime to sidestep the funding problem. See Tax Return Preparer Accountability Act of 2014, section 3, H.R. 4470 (113th Con., 1st Sess.).

The funding problem raises the larger policy question of why such a basic tax enforcement issue as regulating paid return preparers should be funded by a user fee, a question the courts might have an opportunity to consider in the context of a pending challenge to the remains of the preparer user fee regime. The politics of that question extend beyond this posting, but they will have to be addressed if there is to be any comprehensive response, legislative or otherwise, to Loving and the largely unchallenged proposition that paid return preparers should be subject to broader oversight than current law appears to permit.

The Congressman James Traficant Memorial Code Section

Frequent guest blogger Carl Smith alerted us to the importance, from a tax procedure perspective, of the recent death of former Congressman James Traficant of Ohio. Congressman Traficant played an instrumental role in the passage of one of the mosre heavily discussed but little used provisions of RRA 98. Carl’s discussion below lays out the history and comes from a handout he gave to his tax procedure class. You will never think of this code provision the same after reading this post. Keith 

Section 7491 was added to the Code by the IRS Restructuring and Reform Act of 1998 to shift the burden of proof to the IRS in some civil tax cases. To understand why it was enacted and why it is deliberately so ineffective, one needs to know a little history – particularly that of former Congressman James Traficant of Ohio.


Traficant had been a college football star. Later, he worked as the head of a drug program in a county in Ohio for almost a decade. In 1980, he was elected sheriff of Mahoning County, Ohio. While running for sheriff, he took bribes from two different branches of organized crime to look the other way about their illegal activities should he be elected. Unfortunately for Traficant, the FBI caught him on tape taking some of the bribes. When the FBI played the tape to him, Traficant signed a confession. In 1983, the federal government charged him under RICO, for a pattern of bribe-taking, and, under Code section 7206(1), for filing a false 1980 income tax return. Despite the evidence against him, Traficant decided to fight the charges in court before a jury. He moved to suppress both the FBI tape and confession and lost both motions. United States v. Traficant, 558 F. Supp. 993 and 558 F. Supp. 996 (N.D. Ohio 1983). Though not a lawyer, he then decided to represent himself at trial. Shockingly, a jury of his constituents found him not guilty of all charges. The fame of his single-handedly beating a RICO charge endeared him to his constituents as a lovable rogue. So, in 1984, they elected him to Congress.

The federal government did not take its criminal litigating loss lying down. Instead, in 1984, it issued a notice of deficiency to Traficant determining additional income taxes for 1980 on $108,000 of unreported bribes and a civil fraud penalty. In Tax Court, Traficant admitted to taking a much smaller amount of bribes. He also was permitted to take the Fifth Amendment when asked certain questions by IRS counsel. The Tax Court held that under its Rule 142(a), Traficant had the burden of proving the exact amount of the bribes and that his failure to testify was not affirmative evidence meeting that burden. The Court upheld the deficiency. It also ruled that under Code section 7454(a) and Rule 142(b), the IRS had the burden of proving fraud by clear and convincing evidence, and that the IRS had met that burden. The Court rejected Traficant’s argument that his criminal acquittal barred the IRS from seeking the tax or penalty as a civil matter. Traficant v. Commissioner, 89 T.C. 501 (1987), affd. 884 F.2d 258 (6th Cir. 1989).

Traficant was furious about this loss, and decided to make it his personal crusade to shift the burden of proof to the IRS on all issues in civil tax cases. Thus, he wanted to make it the IRS’ burden in Tax Court to, say, disprove that you made the charitable contribution of $5,000 that you listed on Schedule A of your income tax return – even if you had thrown out all your records and cancelled checks and were uncooperative with the IRS in the audit. His bill, H.R. 367, introduced in the 105th Congress in 1997, proposed a new Code subsection, which would read simply: “Notwithstanding any other provision of this title, in the case of any court proceeding under this title, the burden of proof with respect to all issues shall be upon the Secretary.”

In Congress, Traficant was famous for his unorthodox behavior and speech, his bad and badly-fitting clothes, and, most of all, his terrible bouffant gray hair. Traficant also loved to go to the well of the House at night and make one-minute speeches to the empty chamber railing against government waste and, most especially, the IRS. He peppered his speeches with the famous phrase from “Star Trek”, “Beam me up!” The speeches were so unusual that they got quite a following on C-Span. It was like watching a terrible “American Idol” audition or a car wreck. You knew you shouldn’t, but it was hard to resist. But, the speeches had the effect Traficant desired. Eventually, over years, members of Congress from all over the country got more and more constituent mail demanding that the burden of proof be shifted to the IRS in civil tax cases. To give you an idea of Traficant speeches on this subject, below are two that had been delivered from the well of the House, quoted from his website (which has since been taken down):

September 23, 1997:

Mr. Speaker, according to news reports, the IRS has a quota system. IRS agents got bonuses for ripping off taxpayers. And many times, taxpayers settled their cases, even though they were innocent. What is so shocking about that? The American people have known this for years. And the American people have been telling us, ‘The IRS is incompetent. The IRS is arrogant. The IRS has abused their powers.’ It has gotten so bad, the IRS is even above the law. That is right: In America, the accuser has the burden of proof, but not in a civil tax case. The IRS accuses; the taxpayer must prove their case. Beam me up! Let me say this: There can be no true reform in American tax law without changing the burden of proof. It is time to handcuff them to a chain link fence and flog them with their own hefty Tax Code. I yield back their unauthorized seizures and excessive penalties.

See Congressional Record 105th Congress. For video footage, see “September 23, 1997 House Session,” C-SPAN, at 00:03:30.

October 6, 1997:

Madame Speaker, asking the Congress to stay out of it, the IRS is promising to reform themselves. Like a wounded TV evangelist, the IRS is begging the American people for forgiveness. They said, ‘This time we really mean it. Cross our hearts. Hope to die.’ Spare me, Mr. Speaker. Who is kidding whom? Allowing the IRS to reform themselves would be like allowing Jeffrey Dahmer to head up the Boy Scouts. The IRS is guilty, guilty, guilty! And every time they get caught with their finger in our 1040’s, they plead for forgiveness. Enough is enough! I say it is time to kick these computer cowboys right up their hard drives. Pass H.R. 367 and change the burden of proof in a civil tax case. That will get it done. With that, I yield back all those crocodile tears at the Internal Revenue Service.

See Congressional Record 105th Congress. For video footage, see “October 6, 1997 House Session,” C-SPAN, at 00:05:10.

Knowledgeable members of the private sector and the government resisted Traficant, knowing that if his proposal were adopted, the IRS would probably never win another case in the Tax Court. Not only revenue from tax deficiencies would disappear, but revenues from voluntary reporting of taxes would tumble. So, for a time in 1997, there was a stalemate. On September 11, 1997, Traficant lashed out at his critics with another speech from the well of the House:

Mr. Speaker, the American Bar Association does not want it. Former IRS Commissioners do not want it. The current IRS Commissioner does not want it. Tax attorneys do not want it. IRS collection agents do not want it. All of these bureaucrats and special interest people do not want Congress to change the burden of proof in a civil tax case. Some surprise, Mr. Speaker. All of these bureaucrats and special interest people have one major thing in common: They all make big bucks off the backs of the American people. Beam me up! I must admit: The only people in America that support changing the burden of proof in a civil tax case are the American people, in record numbers, and it is very simple: They are taxed off. They are fed up. And they want Congress to right this major wrong. Congress was not elected to represent special interest bureaucrats and the IRS.

See Congressional Record 105th Congress. For video footage, see “September 11, 1997 House Session,” C-SPAN, at 00:04:45.

Eventually, the drafters of the 1998 IRS Restructuring and Reform Act knew that they would have to include a provision which they could say to their constituents shifted the burden of proof to the IRS in civil tax cases, without its really doing so in the vast majority of cases. So, Congress enacted Code section 7491. The section is largely cosmetic. It is deliberately designed to fail nearly all the time because of the conditions attached therein before the burden is shifted. Essentially, section 7491 almost always requires a taxpayer to prove his or her case the same way as in the old days. Only then, after proving the case, the burden shifts to the IRS. But at that point, the IRS usually has nothing to introduce as contrary evidence, so the taxpayer wins, and the burden shift is irrelevant.

And what became of Congressman Traficant? First, he claimed victory in section 7491. Second, he continued his corrupt ways while in Congress: He demanded thousands of dollars in goods and services from businessmen in return for official favors, including contacting the Director of the FAA, the Secretary of State, and the King of Saudi Arabia. He paid inflated salaries to his staffers, who were required to kick back the difference to him. He even forced his Congressional staffers to bale hay, repair plumbing, and reinforce barns at his show-horse farm.

In May 2001, an Ohio federal grand jury indicted Traficant for bribery, obstruction of justice, conspiring to defraud the United States, filing false tax returns, and RICO. Once again, Traficant defended himself in court. This time, he wasn’t so lucky. He was convicted, expelled from Congress, and, in 2002, sent to jail. See United States v. Traficant, 368 F.3d 646 (6th Cir. 2004). The national news media had great fun covering his second trial, his expulsion from Congress, and even his release from jail on September 2, 2009. (When he was released, he immediately did all the Cable TV news shows.) But the media found that the biggest story of all was in publishing his prison mug shot. Only then was it revealed that the terrible hair on the top of his head was just a bad toupee. He had been bald all along.

nice hair


nice hair 2

Summary Opinions for 9/19/14


Another great tax procedure week.  We have news on two (alleged for one) celebrity tax cheats.  More importantly, the Tax Court issued another qualified offer holding regarding concessions, and one on what constitutes a prior opportunity to dispute a liability when the Service denies such a request.  Plus a handful of other tax procedure matters, and an interesting case on when the proceeds from suing your accountant will not be taxable income.


  • The Tax Court, in Bussen v. Comm’r, had another holding on whether a full IRS concession is tantamount to a settlement for purposes of qualified offers under Section 7430(c)(4)(E)(ii)(I).  For those of you unfamiliar with the issue, I wrote on it in the infancy of PT here , and Keith followed up with an excellent post focusing on interesting issues in the Knudsen appeal.  A full concession by the Service during the pendency of the court case has been held to both be a settlement and not a settlement in the past, although the majority of the holdings appear to be leaning towards concessions being settlements.  I am not sure I agree with the holdings, and think it advances a Service-favorable policy that is contrary to the statute, allowing the Service to go well beyond the ninety day qualified offer period and still thwart fees.  Unfortunately, Bussen is a terrible fact pattern for the taxpayer.  In Bussen, the taxpayer withheld the information from the Service that it needed to make its determination.  The Service requested the information repeatedly.  Only after filing with the court did the taxpayer provide the information, and the Service promptly conceded.  This is not the type of case where the taxpayer equitably seems entitled to costs.  Jan Pierce of Lewis and Clark Law school, who knows as much on this topic as just about anyone, also noted that in Bussen the Service conceded before the actual trial, where in other cases, notably Knudsen, the Service waited until after the trial.

 Given the bad facts, if a court were inclined to hold concessions were not settlements, perhaps an appropriate holding in Bussen would have been a limiting of the “reasonable administrative costs”  and “reasonable litigation costs” because it was unreasonable for the Bussens to protract the process and not provide the requested information-thereby making the costs unreasonable and not appropriately payable.   Keith also noted that the statute specifically provides that a prevailing party that unreasonably protracts the proceedings will not be entitled to costs.  See Section 7430(b)(3).

  • In Johnson v. Comm’r, the Tax Court offered an interesting discussion of what constitutes a prior opportunity to dispute a liability.  In a prior CDP hearing, the settlement officer affirmatively told the taxpayer he could not challenge amount or existence of the underlying liability in connection with an unclaimed notice of deficiency.  In a subsequent CDP hearing, the taxpayer was denied the opportunity to question the amount or existence of the underlying liability because he may have had the right in the first hearing and did not challenge the settlement officer’s preclusion.   It is hard to find that the second settlement office abused his or her discretion, but the Service did bar the taxpayer from contesting the underlying liability when it perhaps was allowed, leaving a somewhat inequitable result.
  • Not exactly tax procedure, but the Tax Court, in Cosentino v. Comm’r,  has held that malpractice proceeds received by taxpayers from their accountants was not taxable income.  The accountants assisted the taxpayers in the disposition of some rental property pursuant to a bunk plan that increased basis somehow offsetting boot received in a 1031 exchange.  The plan was disallowed, and the taxpayers paid tax on the gain (or at least the boot).  The taxpayers sued their accountants for bad advice, and were made reimbursed for the tax paid.  The Service took the position this was taxable income, while the taxpayers argued they would have otherwise done a 1031 exchange with no boot, thereby not recognizing the gain.  The Court agreed that the malpractice proceeds were a return of capital and not taxable.
  • In Dynamo Holdings, LP v. Comm’r, the Tax Court has allowed the IRS to use predictive coding in digging through very large quantities of electronic documents to determine what is and what is not privileged and relevant to the IRS discovery requests.  We may have more on this in the future, so I won’t delve too much into the topic.  And, my knowledge of coding is about as strong as Keith’s knowledge on the Jersey Shore (I would say Les also, but I think he secretly loves that show)…more on that below.
  • In the most recent celebs behaving tax badly, the Situation has ended up before a judge on tax evasion charges(Keith was not familiar with the Situation’s work, and is on a Jersey Shore binge this weekend after completing some amazingly long MS bike ride ).  Sometimes you just completely misjudge a celebrity.  I was certain that Mike “the Situation” Sorrentino was smart enough not to get embroiled in tax evasion, he just seemed to have such a good head on his shoulders.  TMZ (I am starting to question the amount of times we have referenced them) reports that the Sitch is blaming his business manager, who is, of course, his brother, and claiming he knew nothing of his finances (sort of believable).  His Bro, in turn, is blaming their accountant.  The NY Times reports (now I feel slightly better about covering this) the indictment was based on the Situation and his brother running personal expenses through their pass through entities to reduce their taxable income, including personal grooming expenses (appropriate tanning salon and hair gel jokes are made).  All of which may have been hidden from the accountant.
  • In the immortal words of just about every rapper ever, “I gotsta get paid”, and, as such, I’m a pretty big fan of Section 6323(b)(8) giving lawyers a super priority in settlement provisions for reasonable compensation in obtaining the settlement.  The Eastern District of Louisiana recently reviewed this provision in Barnett v. D’Amico.  Although the case did not break any new legal ground, it did provide an outline for the reasons behind the priority and what lawyer fees could be deemed to relate to the settlement (and were reasonable), and which advances were properly made under Louisiana law and could be part of the priority lien.

A Cogent Look at the “What is a Return?” Question

In Briggs v. United States, 511 B.R. 707 (Bankr. N.D. Ga. 2014), Bankruptcy Judge Wendy Hagenau carefully examined the facts of the case and the applicable law in concluding that a Form 1040 filed after the IRS assessed taxes based on a substitute for return procedures met the requirements for filing a return. I previously blogged about the mess created by the litigation and legislation in this area. Judge Hagenau worked her way through existing precedent and arrived at a conclusion that offers hope to many taxpayers who fail to timely file their return and later seek relief through bankruptcy. 


The Briggs case presents a classic set of facts. The taxpayer did not file his 2002 return by the due date as extended. Eventually, the IRS calculated his liability using IRC 6020(b) procedures and sent him a statutory notice of deficiency. He did not petition the Tax Court within 90 days. The IRS assessed the tax (over $200,000) and began collection. He eventually filed a Form 1040 showing that his correct tax liability was $149,870 rather than the $226, 536 assessed. The IRS accepted the Form 1040 as a claim for abatement and abated his tax to the lower amount. The IRS partially collected the lower liability through levy and offset but he still owed a substantial liability for 2002 when he filed bankruptcy on March 23, 2013. 

The IRS made two arguments in support of its position that BC 523(a)(1)(B)(i) excepts the 2002 taxes from discharge. First, it argued that the tax “debt” arose from the IRS assessment and not from the late filed Form 1040, making the debt one from which the debtor had an unfiled return at the time it arose. This argument represents later thinking by the Government than its original position on this issue and seeks to create a bright line test not available through the Beard test. Second it made its original argument slightly modified by the passage of BC 523(a)(*), that an untimely return filed after assessment does not qualify as a “return” under applicable non-bankruptcy law. 

The Court first addressed the “debt” argument and used bankruptcy definitions to reject it. My guess is that the IRS will appeal the case because it has had several successful outcomes with this argument and it represents a clear path to victory. Judge Hagenau, citing Rhodes v. United States (In re Rhodes), 498 B.R. 357 (Bankr. N.D. Ga. 2013), rejected this argument because the term “debt” in bankruptcy focuses “on the nature and source of debt . . . not on the mechanism to determine debt.” Under bankruptcy law the debt to the IRS arises at the end of the tax period and not when assessment occurs. The assessment or non-assessment of a tax does not “change the fact that the right to payment existed.” So, Judge Hagenau placed no importance on the assessment as creating the debt before the later filed return since the debt for bankruptcy purposes arose long before either of these events. Her interpretation makes the most sense given the bankruptcy definition of debt. The IRS will continue making this argument because of its ability to create a clear statement regarding discharge. 

The Court next addressed whether the late-filed Form 1040 qualifies as a return. This is the original issue on which the IRS won in In re Hindenlang, 164 F.3d 1029 (6th Cir. 1999), although now with the overlay of BC 523(a)(*) adopted in 2005. Remembering the peculiar facts of Hindenlang provides important background information. Like Briggs, Mr. Hindenlang did not timely file his return and the IRS made an assessment after using the substitute for return procedures and issuing a notice of deficiency from which he did not petition the Tax Court. Mr. Hindenlang’s subsequent Form 1040, however, merely mirrored the substitute for return prepared by the IRS. He did not report any more tax or, like Mr. Briggs, any less tax than the IRS determined from its examination. That unusual fact pattern must have influenced the 6th Circuit as it reviewed the Hindenlang case. 

The late filed Form 1040 submitted by Mr. Briggs reported a tax liability over $75,000 less than the amount assessed by the IRS using the substitute for return procedures. The IRS accepted his Form 1040 and abated the liability down to the amount shown on the form. Mr. Briggs’ form had meaning while Mr. Hindenlang’s form really added nothing to the situation. A Form 1040, such as the one Mr. Hindenlang filed, really does not seem like an honest attempt to file a return under the circumstances; however, a return like the one Mr. Briggs filed had meaning and the IRS abated his liability based on that meaning. Judge Hagenau drew from that fact. Before simply applying the facts in the Briggs case to the Beard test she analyzed BC 523(a)(*) to determine what new requirements the 2005 changes imposed, if any, since the Hindenlang decision started the inquiry regarding late filed returns. 

Judge Hagenau’s analysis of the requirements led to a discussion of the cases decided after 2005. A line of cases, led by McCoy v. Miss. State Tax Comm’n (In re McCoy), 666 F.3d 924 (5th Cir. 2012), interprets the 2005 amendment to encompass a timeliness element that makes any untimely filed Form 1040, even if only one day late, something other than a return for purposes of the discharge provisions. The IRS does not agree with this interpretation but the Court here looked at this line of cases before concluding – correctly in my opinion – that the term applicable non-bankruptcy law in BC 523(a)(*) “does not incorporate the timeliness requirements of the tax code.” Judge Hagenau explained that the interpretation in McCoy and its progeny does violence to the overall workings of the bankruptcy code. 

Judge Hagenau then turned at last to the Beard test, which requires that a document must meet four tests to be a return: (1) purport to be a return, (2) be executed under penalty of perjury, (3) contain sufficient data to allow calculation of tax, and (4) represent an honest and reasonable attempt to satisfy the requirements of tax law. In these cases the focus is almost always on the fourth test. Remember that Hindenlang’s Form 1040 really served no purpose except to seek to start the two year period for discharge. Here, the Court agreed with the minority view of cases lead by In re Colson that a return such as the one Mr. Brigg’s filed does meet the Beard test. Therefore, the Court determined that the remaining 2002 taxes were discharged. 

This issue bears careful watching. The IRS chose not to file a petition for cert when it lost Colson in 2006. If its new argument that the debt arose before the late filed return fails and it does not adopt the McCoy argument, it is left with the fact specific Beard argument. Without a bright line legal argument the IRS takes on a lot of administrative risks with this issue because it is not discharging taxes in these situations. It leaves these liabilities on its books and restarts collection action after bankruptcy. If it ultimately must concede this issue, fifteen years or more of post-discharge taxes will exist on its books that it must address. Similar to the situation that now exists in the post-Rand concession, the IRS will need to clean up its assessment records and with the discharge injunction hanging over its head the burden will clearly be on the IRS and cannot be pushed off to the taxpayer. The path it has taken on post-Hindenlang is a risky path and one that is difficult to administer. It tried to fix the problem in 2005 but got language that has proven inadequate. Keep an eye on this issue if you have clients with late filed returns who may need bankruptcy as a refuge. 


For Those Keeping Track: Preparers in the Spotlight

Over the last year, we have extensively covered issues relating to the IRS’s efforts to leverage preparers to combat the tax gap. Post-Loving, in the last couple of months there are many interesting developments relating to practitioners. In this brief post, I highlight some of the developments and point to some areas where we are likely to see some more developments.


Earlier today I saw the link on Tax Prof to the 60 Minute piece where a federal prosecutor complained about how easy it is for preparers to get id numbers to prepare and electronically file tax returns. The point the prosecutor made was that the lack of barriers to entry made it easier for those who wish to game the system and juice up phony refund bloated returns.

TIGTA also recently released a report criticizing IRS’s failure to manage the flow of complaints relating to preparer misconduct. The TIGTA report, which did describe some progress IRS has made in its processing and review of potentially misbehaving preparers, also showed that IRS is not fully using the information it has to combat preparer misconduct. Juxtaposing that with the IRS’s efforts to expand its oversight through testing and education does not lead to a pretty picture and opens IRS up to criticism along the lines of the following: IRS has information and powers at its disposal; IRS is failing to use either properly; IRS should at least manage what it has before expanding powers and imposing costs on preparers and taxpayers

Tax Girl has a nice discussion of the class action suit alleging the IRS has improperly collected user fees from preparers seeking initial or renewed PTINs. The user fees were imposed ostensibly to help defray the costs of the thrown-out unlicensed preparer education and testing regime.

Last month IRS released National Research Project compliance data as it relates to EITC returns; I wrote about that here. The information in that report relating to preparers is interesting, though incomplete. The report details higher error rates associated with unenrolled preparers, the class of preparers the IRS has sought to impose additional oversight, and the group likely most impacted by the IRS’s voluntary plan that the AICPA has challenged in federal court.

Moreover, as we discussed this past July, in Ridgely v. Lew a federal district court relied on Loving to invalidate Treasury Circular 230 10.27 insofar as it prevents the charging of contingent fees for refund claims practitioners charge for preparing and filing refund claims after an original filing and before the Service has commenced an audit. The recent ABA Tax Section meeting in Denver had a panel discussing the case and its potentially broad implications on OPR oversight of practitioner activities. We hope to highlight some of the panel’s insights in the near future.

What to make of the above developments? The judicial spotlight is on IRS and OPR, with courts likely weighing in on the legality of IRS actions with respect user fees and the reach of Circular 230, with Congress on the sideline unless it resolves what it views as the appropriate IRS role when it comes to preparers. Stay tuned, as preparers are still in the tax administration spotlight.


Extracting Yourself from a Tax Court Case

I learned something this past week I should have known. It is possible to extract yourself from a Tax Court case without a decision. I grew up in a world of deficiency proceedings. When I first started litigating in the 1970s, the IRS still did a fair percentage of examinations of returns, they did them face to face and they examined a fair number of small businesses. I did most of my early litigation with small businesses that would never be audited today but which presented interesting factual issues. 

Due to significant cuts in the past 35 years, the IRS audits a minuscule number of returns, about 75% of the time it audits by correspondence and, for the most part, it does not bother with small businesses where the bulk of the tax gap lies. I think the safest place for a taxpayer to go might be a small business in a TEFRA partnership since the IRS does not have the time to spend to go through records of small businesses and does not understand TEFRA but that’s just a view from the outside that has nothing to do with this post. 


In deficiency cases if the taxpayer goes to Tax Court there is only one door out of the proceeding and that door involves a decision (See Estate of Ming v. Comm’r, 62 T.C. 519 (1974)). Once a taxpayer files a Tax Court petition based on a notice of deficiency, the taxpayer cannot decide that they no longer want to be in Tax Court and simply nolle pros the case as might happen in other civil litigation. The Tax Court keeps the case to the end and the taxpayer cannot escape once in the door. (A small exception to this exists for taxpayers who do not pay the filing fee at the outset. They have a short period of time to pay up or be kicked out as though they never arrived. I am not suggesting that a taxpayer on the fence about whether to file a Tax Court petition file the petition and not pay the fee in order to buy an additional 30 days or so after the end of the 90 day period in the notice of deficiency but the effect of the Court’s practice with respect to the fees leaves open this possibility.) 

Once in Tax Court the taxpayer must either agree to a deficiency, convince the IRS to concede that no deficiency exists (or that a refund exists), have a deficiency imposed by a decision on the merits or enforcing a stated but not followed through upon settlement (See Dorchester Indus., Inc. v. Comm’r, 108 T.C. 320 (1997); see also T. Keith Fogg, Go West: How the IRS Should Foster Innovation in its Agents, 57 Vill. L. Rev. 441 (2012)) or have the Tax Court case dismissed which, contrary to the belief of many of my clients, means the IRS has permission to assess the full amount of the proposed deficiency as if the taxpayer did not petition the Tax Court in the first place (See Dorl v. Comm’r, 57 T.C. 720 (1972) (citing 26 U.S.C.A. § 6512(a)); Fiorentino v. United States, 226 F.2d 619 (C.A. 3, 1955)). 

Despite the rules I knew in the deficiency cases before the Tax Court, I did not previously realize that things differ when the taxpayer arrives in Tax Court through a determination. The clinic represents a taxpayer in a collection due process case (CDP) and the Chief Counsel attorney wanted the taxpayer to concede that the relief sought in the proceeding was not available. After reviewing the case, we agreed that the client would not obtain relief through the CDP case in Tax Court, discussed with the client how the case might be resolved through another process and informed the Chief Counsel attorney we were in agreement. 

I thought that the Chief Counsel attorney would draft a decision document, we would sign it, present it to the Court, the Court would sign it and then the case would come to an end.   Instead, the Chief Counsel attorney wanted the taxpayer to file a motion to dismiss the case. This did not make sense in my deficiency oriented Tax Court world. Taxpayers, at least ones who know what they are doing, do not file a motion to dismiss their Tax Court case because that is not an option. So, I asked my students to research the matter and to get a sample motion from the Chief Counsel attorney. I got nothing. My students did not understand what I was asking, could not find a sample and could not obtain a sample from the Chief Counsel attorney. 

At this point I could have actually researched the issue myself since I knew what concerned me and wondered if the deficiency process on this issue carried over to determination cases but instead of actually doing the work I phoned a friend and former colleague who still works at Chief Counsel’s office and who I thought would know the answer immediately and I was right because she did know the answer immediately (actually I emailed rather than phoned.) It turns out that the Tax Court decided this issue over a dozen years ago but I had not taken notice. In Wagner v. Commissioner, 118 T.C. 330 (2002), the Tax Court held that a CDP case may be dismissed without prejudice upon motion by the taxpayer, distinguishing CDP cases from cases holding that taxpayers may not withdraw a petition under section 6213 to redetermine a deficiency.  See also Settles v. Commissioner, 138 T.C. 372 (2012)

The result makes perfect sense but was not a situation I had previously confronted. Like most dinosaurs, I just assumed things always worked as they had in the past. I write this post in case there are any other dinosaurs out there so I can help you to avoid being as uninformed as me on this issue. Dinosaurs are not extinct. They morphed into old attorneys who do not keep up and who are too lazy to hit the books (or the bits and bites) to do the work necessary to find the right answers. 



Summary Opinions for 9/12/14

Sum Op for the week of the 12th is running a bit behind schedule because of a really wonderful two part guest post by A. Lavar Taylor on what constitutes an attempt to evade or defeat taxes for Section 523(a)(1)(c) of the Bankruptcy Code, which can be found here and here.  The post generated quite a few strong comments and responses, so I would encourage everyone interested in the topic to review those also.  Here are the other items we didn’t cover two weeks ago:


  • The Tax Court in Duarte v. Comm’r has remanded an Appeals decision to reject an OIC and proceed with collection action against an immigrant who ran a roofing business.  The Court found it was unclear if the settlement officer abused his discretion in rejecting the OIC when a prior settlement officer had already approved the OIC, but then the Service failed to process the  offer for unexplained reasons for quite a while.  The opinion framed Mr. Duarte as working very hard to solve his tax issues, including making the payment associated with the agreed upon OIC.  The second settlement officer determined there was significantly more collection potential, but the record did not indicate as why various decisions were made, actions were taken or actions were not taken.  It did seem clear, however, that the Tax Court did not like the result, and wanted the Service to, at a minimum, fulfill its obligations fully before implementing such a result.
  •  As Big Dan Teague said, “Yes, the word of God…there’s damn good money during these times of woe and want,” even when you take a vow of poverty.  That can cause an issue when you want to keep that money, so sometimes you need to divert those dollars to a shell entity in order to keep your vow of poverty and minimize taxes…Wait, that seems really shady, which is what the Service thought about the scheme.  On the slightly positive side, the whole thing may have been a tax play, which seems less insulting to the congregation members.  In Cortes v. Comm’r, for 2007 to 2009, the taxpayer, Mr. Cortes, a pastor, signed a “vow of poverty”, and created “A Corporation Sole” that received bi-weekly checks from the church.  Mr. and Mrs. Cortes had unfettered access to the account held by the corporation.  Mr. Cortes argued that his vow of poverty was evidence that he did not have income in the years in question.  The Court found that the signed paper did not change the fact that Mr. Cortes was effectively paid a salary that Mr. Cortes had full control over and used for personal expenses.  Mr. Cortes did highlight a line of cases where someone took a vow of poverty, was paid an income stream, but assigned that stream to a tax exempt organization.  The Court found the cases inapplicable because…Mr. Cortes was just cheating on his taxes (Mr. Cortes alleges that any such failure to pay was inadvertent).   Tony Nitti over at Forbes has more coverage.  The Service, in 2012, flagged the Corporation Sole set up as questionable.
  • It seems so much less offensive when the fraud doesn’t involve a church.  Like in US v. Bennett, where employees of a logistics company fraudulently directed around $600,000 to shell companies for fake expenses to the detriment of their employer and the IRS.  The Service charged the co-conspirators and one of their wives with tax evasion, and all three were convicted.  One of the two employees, Mr. Hogeland, spent months faking an illness to get out of his criminal proceeding by injecting himself with potassium chloride causing his blood to have elevated potassium levels.  Mr. Hogeland’s lawyer claimed Mr. Hogeland’s wife may have been behind the elevated potassium levels to set Mr. Hogeland up because of some tension relating to her having an affair.  Hogeland did end up dying – so perhaps he was actually ill— and at the time both Hogeland and his co-defendant Bennett were both appealing the conviction.  Bennett modified his appeal to take into account Hogeland’s death, arguing that Hogeland’s death abated the entire criminal proceeding ab initio (this was true of Hogeland’s conviction).  The Court was not impressed, holding on the first point that the reasoning for Hogeland’s reversal was that a defendant should not be denied the right to appeal, even by death.  Further, the punitive purpose cannot be served by a dead guy.  Neither applies to Bennett, who was still free to appeal and go to jail.  Bennett did argue other reasons the death should spring him from the slammer, but the court was likewise unimpressed and held Hogeland’s misfortune would not benefit Bennett.
  • The Service has issued Chief Counsel Advice , which is not really procedure related but I found interesting, stating that a controlled foreign corporation that “holds” a debt obligation of its United States sole shareholder  gives rise to taxable interest on the accrued but unpaid interest amount, which is treated as US property under Section 956(c).  This in turn will likely increase the US shareholder’s taxable income under Section 956 relating to US property.  The regulations provide the CFC will “hold” a debt where the CFC is treated as the pledgor or guarantor on the shareholder’s loan from a third party, and the “obligation” amount in question becomes the unpaid principal and accrued but unpaid interest.  Following the mental leap, the interest is payable to the CFC holder of the debt, which then flows through to the US shareholder who owes the interest to a third party.  So, to simplify, I think the CCA states that if a US parent company borrows funds from an unrelated third party and the CFC is guarantor, the accrued but unpaid interest is taxable income to the CFC, which passes back through to the US parent.  I do not profess to be an expert in this area and read the CCA quickly, so I could be wrong, but this seems to be a bad result.
  • The DC Circuit has agreed to an en banc review of Halbig v. Burwell.  We had some prior coverage on the matter here.   As you can imagine, the decision has caused quite a bit of partisan debate.
  • So, SOCTUS is getting an education in hip hop.  This is not tax procedure related, but I thought it was interesting.  The article indicates that while SCOTUS will occasionally reference song lyrics, it has apparently never quoted rap lyrics.  It also implies the Justices don’t know anything about hip hop (and perhaps question the artistic value of rap lyrics).  Although it would have been fun to assist in the drafting of the amicus brief, it might be more efficient and entertaining to just enlist the Roots, Jimmy Fallon and JT  to show up and perform the various songs (there are two others if you are interested and somehow missed this—you should have no trouble finding them on the internet).  A sort of  pop-star chamber, except without the abuse of power.   If you’re looking for rap music about taxes, and who isn’t, check out Slim Thug’s “Still a Boss”, with a solid nod to claiming fake dependents.

What Constitutes An Attempt To Evade Or Defeat Taxes For Purposes Of Section 523(a)(1)(C) Of The Bankruptcy Code: The Ninth Circuit Parts Company With Other Circuits (Part 2)

In yesterday’s post A. Lavar Taylor discussed the case law in other circuits and the bankruptcy opinion in Hawkins v Franchise Tax Board. Today’s post turns to the Ninth Circuit and its decision to part ways with the other circuits. Lavar explains why he believes for both legal and practical reasons the Ninth Circuit’s view is correct. Les

Now I turn to why the Ninth Circuit reached the correct result in Hawkins by concluding that “improper” expenditures, by themselves, do not constitute an attempt to evade or defeat a tax liability. There are both legal and practical reasons why the Ninth Circuit’s holding in Hawkins is the correct one.  I first discuss the legal reasons.

The Legal Reasons Why the Ninth Circuit Is Correct

The Ninth Circuit noted that the purpose of a bankruptcy discharge is to give an individual debtor a “fresh start.” It noted that this “fresh start” philosophy argues for a more narrow  interpretation of the “attempt to evade or defeat” exception from discharge. The Ninth Circuit also concluded that both the structure of section 523(a) of the Bankruptcy Code and its legislative history support a narrow reading of the “attempt to evade or defeat” exception to discharge.


The Ninth Circuit also took note of the Supreme Court’s holding in Kawaauhau v. Geiger, 523 U.S. 57 (1998), in which the Supreme Court narrowly construed the term “willfully” for purposes of section 523(a)(6) of the Bankruptcy Code.

But the key to the Ninth Circuit’s ruling is the fact that the Supreme Court, in Spies v. United States, 317 U.S. 492 (1943),  held that a mere willful failure to file a return, coupled with a mere willful failure to pay the tax, does not constitute a willful attempt to evade or defeat the tax for purposes of section 7201 of the Internal Revenue Code. Section 7201 uses language almost identical to the language in section 523(a)(1)(C) of the Bankruptcy Code.  The Supreme Court held in Spies that the taxpayer must take some sort of “willful commission” (in addition to the willful omissions), or engage in an “affirmative act,” in an effort to evade the tax, in order to commit tax evasion under section 7201.  Whether a particular act taken by a taxpayer is an affirmative act taken in an effort to evade the tax is to be decided by the trier of fact.

Because the language in section 523(a)(1)(C) of the Bankruptcy is virtually identical to the language in section 7201 of the Internal Revenue Code, it makes sense to construe section 523(a)(1)(C) in the same manner in which the Supreme Court construed section 7201 of the Internal Revenue Code in Spies.  The elements discussed above in  in the Fretz case, which were used by Judge Carlson in the Hawkins case and were used by all other Courts of Appeal to consider this issue, are elements required to convict a taxpayer of a willful failure to file or a willful failure to pay under IRC section 7203. See, e.g., United States v. Tucker, 686 F.2d 230 (5th Cir. 1982).

Section 7203 uses very different language than the “willful attempt in any manner to evade or defeat” language contained in IRC §7201 and Bankruptcy Code section 523(a)(1)(C).  The failure by Congress to incorporate the language of IRC §7203 into section 523(a)(1)(C) of the Bankruptcy Code, coupled with the incorporation into section 523(a)(1)(C) of the language contained in section 7201, indicates that the holdings of the other Courts of Appeal were in error.

The Practical Reasons Why the Ninth Circuit is Preferable  

The Ninth Circuit’s approach is also preferable for practical reasons.  The most obvious practical problem for courts relying on the standard used in other Circuits is determining in a principled manner what expenditures by the debtor are “unnecessary” once the duty to pay the taxes arises. Only a principled approach can provide future guidance to courts,  future litigants, debtors who wish to avoid a fight over whether they attempted to evade or defeat the taxes that they owed, and professionals who advise debtors who wish to avoid this fight.

Judge Carlson offered precious little principled guidance  on how to decide what expenditures are “unnecessary” in other factual contexts. We know that a “nuanced approach” should be used, depending on the debtor’s pre-existing income and lifestyle, but we know very little about how to define those “nuances” or about how to apply those “nuances” in future cases where the taxpayer’s circumstances differ from those of Mr. Hawkins.

Can a debtor pay for extraordinary medical expenses for a parent or for a beloved pet, at the expense of not paying their taxes? What about paying modest private school tuition for their children? What about paying tuition for the debtor to obtain an advanced degree in the hopes that the debtor will obtain a much higher paying job? Does the potential level of earnings once the degree is earned make a difference?  Can the debtor pay to go on any vacations at all? What if the debtor’s therapist recommends that the debtor take a vacation because of stress related to a difficult marriage or related to financial difficulties?

What about debtors who owe business debts? Will some of these debts be deemed “necessary” and other “unnecessary?”  Will it matter if payment of the business debt will give rise to a tax deduction which would reduce the amount of taxes owed? If a debtor pays state taxes without paying federal taxes, is that an attempt to evade or defeat the federal taxes? If the debtor pays federal taxes without paying state taxes, is that an attempt to evade or defeat the state taxes? What about payment of alimony and child support?

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?

If the debtor reasonably believes that he owns property that will  appreciate enough for him to fully pay his taxes within several years, must the debtor lower his or her level of living  expenses while waiting for  the property to appreciate? Will the expenses paid while waiting for the property to appreciate be deemed to be “excessive” through hindsight if property values suddenly and unexpectedly decline?

The number of questions regarding “necessary” and “unnecessary” expenses which could arise under the standard employed by Judge Carlson and other Circuits is virtually limitless. Under this standard, courts, debtors and their counsel can look forward to innumerable Circuit splits on all of the exciting issues mentioned immediately above, among many others.

Simply put, if the standard for determining whether a taxpayer/debtor has attempted to evade or defeat the tax is whether the taxpayer/debtor made “inappropriate” expenditures, there is no principled way for courts  to draw the line between what expenditures are “appropriate” and what expenditures are “inappropriate.”  Cases will be decided based on the whims and fancies of individual judges, each of whom will have their own sense of what expenses are “appropriate” and what expenses are “inappropriate.” One judge may conclude that it was entirely proper for a taxpayer to spend $25,000 furthering their education in an effort to significantly increase their earnings capacity instead of paying the money over to the IRS, while another judge may conclude that the taxpayer attempted to evade or defeat the tax by spending $25,000 on educational expenses instead of paying the $25,000 over to the IRS.

In addition, IRS and other tax agencies could invoke the “attempt to evade or defeat” exception merely because they do not like the way the debtor/taxpayer spent their money. Such a standard carries with it a significant potential for abuse of taxpayers by tax agencies.  The potential for abuse drastically decreases if tax agencies are required to prove the traditional elements of tax evasion in order to invoke the “attempt to evade or defeat” exception in section 523(a)(1)(C).

Under the standard used by Judge Carlson, it is impossible for tax professionals to advise their clients on whether the clients can make certain expenditures, assuming that the use of bankruptcy to discharge tax liabilities is  a possibility at the time the advice is solicited.  If the standard used by Judge Carlson applies, no competent professional will ever offer meaningful advice on this subject out of fear of the potential consequences of giving incorrect advice.

The Dissent

As a final note, I have several comments about the dissenting opinion in Hawkins. First, this dissent makes a statement that is downright scary. At page 17 of the Slip Opinion, the dissent states:

At the family court hearing, Hawkins’ bankruptcy attorney “testified that Hawkins’ intent was not to pay the tax debt, but to discharge it in bankruptcy. . . .” Id., p. 19. This testimony is a strong indication of a willful intent to avoid the payment of taxes by hook or by crook.

I am troubled by the dissent’s language, given that, at the time the statement was made by the attorney, Hawkins was insolvent and lacked the ability to pay the taxes in full. (I will ignore the fact that this statement regarding Hawkins’ intent was not made by Hawkins himself.) In addition, 3DO was in financial difficulties and headed for chapter 7. Planning to discharge taxes in bankruptcy at a time when you are insolvent and lack the ability to pay the taxes in full is not an attempt to evade or defeat a tax liability. And Hawkins paid to the IRS and the FTB many millions of dollars between the date of that statement and the date of the bankruptcy petition.

I am also troubled by the dissent’s conclusion that the majority opinion “gives Hawkins a pass.” The majority opinion does no such thing. The majority remands the case so that the trial court can apply the correct legal standard. The trial court may now have to decide the issue previously ducked by Judge Carlson (who has now retired from the bench), namely, whether Hawkins acted with intent to defraud in filing the tax returns in question. At a minimum, the trial court will have to decide whether the actions taken by Hawkins leading up to his chapter 11 bankruptcy were taken with Spies-type intent to evade the tax liability.  Hawkins has not been given a “pass.”  Rather, his conduct is going to be judged under the appropriate legal standard, rather than under a standard that is no standard at all.

For those of you who disagree with my statement that the standard relied upon by Judge Carlson (and by the dissent and by other Circuits) is no standard at all, I invite you to carefully review Judge Carlson’s opinion and tell me how you would apply the “standard” set forth in that opinion to the vast majority of taxpayers whose financial circumstances are much more modest than those of Mr. Hawkins.  I’ve read and re-read Judge Carlson’s opinion.  All I can take away from that opinion is that some expenditures are “appropriate,” some expenditure are “inappropriate,” that Bankruptcy Judges must take a “nuanced approach” in deciding which expenditures are “appropriate” and “inappropriate” for purposes of determining whether the debtor “attempted to evade or defeat” a tax liability, and that, if you continue spending “too much” money in the face of known tax liabilities for “too long,” you will have engaged in an “attempt to evade or defeat” the tax liabilities, regardless of your motives for spending that money.

How you apply that standard to all other taxpayers other than Mr. Hawkins in a principled manner I haven’t a clue. Which is why I believe the Ninth Circuit got it right in Hawkins.