Mental State is Key to Discharging Federal Taxes in Bankruptcy
Tax professionals including attorneys and CPAs must read court cases for a living to keep up with the proper interpretation of the tax laws. The more cases you read, the more patterns start to emerge that help a tax advisor predict the outcome of tax controversies. Sometimes, cases take a surprising turn and have unexpected outcomes. In these cases, you have to “read between the lines” to understand the result—despite some culpability, the court was sympathetic to the taxpayer and thought the IRS had overreached. This is what appeared to happen in In re: Clark, a February 2019 case in the U.S. Bankruptcy Court for the Northern District of Georgia. The Court held that the taxpayer’s mental problems caused his nonpayment of tax, not willfulness. Thus, the Court allowed the taxpayer to discharge his tax debts in bankruptcy.
Rules for Discharging Tax Debts
The federal bankruptcy process allows the discharge of debts but has a strict exception for taxes. Tax debts cannot be discharged if the debtor “made a fraudulent return or willfully attempted in any manner to evade or defeat such tax…” (11 USC 523(a)(1)(C)) The Court looks at the conduct of the taxpayer and the mental state to determine if this exception is met. The debtor engages in evasive conduct if he or she engaged in affirmative acts to avoid payment or collection of the taxes. The debtor also must be shown to have acted intentionally to avoid taxes, which involves conscious and knowing acts.
Facts of the Case
A first look at the taxpayer involved, Dr. Steven Thomas Clark, shows a well-educated radiologist, making six figures a year, living in a $562,000 home, with a wife and four children, two of them in college. The IRS estimated that Dr. Clark’s nonpayment of taxes resulted in a liability of over $400,000. As the Court took a closer look, it found that Clark was in “great financial difficulty due to his irregular employment” and his wife leaving him to move to Virginia. Clark sometimes worked as an employee and sometimes worked as an independent contractor, with long periods of unemployment.
Clark also had large credit card balances, had to pawn his cars, and had no investment accounts or other liquid assets. Also, his house was in foreclosure. The Court noted that is was “clear that an ability to pay the tax debt is a factor in determining whether the actions of the Debtor constitute evasive conduct.”
Turning to his mental state, the Court noted that Dr. Clark was diagnosed with ADHD after having been previously diagnosed with anxiety and depression. The Court was persuaded that these conditions affected his ability to work successfully and adequately maintain his financial records and tax filings. The Court also noted that Clark had hired an attorney to help him with his tax problems, but those efforts were not successful.
The Court dismissed the IRS’s arguments that the fact that Clark had taken two vacations, paid for his children’s college, and bought two used cars was evidence of a “lavish lifestyle.” Although the Court agreed that buying cars for children and taking vacations, even modest ones, are not necessary to live, it noted that the cars were used, and the vacations were modest, with no evidence of sums spent on clothes or entertainment.
The Court concluded that the taxpayer did not willfully evade his tax obligations and, as a result, his unpaid tax liability was fully dischargeable in bankruptcy. The Clark case is not just a tax case, but also a human-interest story which shows that Courts will look beyond the outlines of a case and into the credibility and intent of the taxpayer to determine the true equities of the situation.
Lucia Nasuti Smeal is a guest blogger on tax topics for Frazier & Deeter. Smeal is an attorney, a tax professor with Georgia State University’s J. Mack Robinson College of Business, and former editor of Tax Notes Today published by Tax Analysts. Smeal also worked as a legislative analyst for the Congressional Research Service and is a former member of the U.S. House Periodical Press Corps. She is a frequent speaker on current tax developments.