The Ninth Circuit Court of Appeals is often criticized for having a high reversal rate. A cursory read of the facts in Hawkins v. Franchise Tax Board of California, decided by the Ninth Circuit on September 15, 2014, may lead to the conclusion that this is another case where the Ninth Circuit may be reversed. After all, the decision allows an individual debtor who lived an incredibly extravagant lifestyle to discharge substantial tax debts in a chapter 11. A careful reading of the Ninth Circuit’s analysis, however, as well as the implications of a contrary decision, suggests that this is one the Ninth Circuit “got right.”

Hawkins involved an individual chapter 11 case of a former Apple employee and co-founder of Electronic Arts, Inc. After earning millions of dollars in the 90’s, Hawkins invested in a number of off-shore tax shelters to shield capital gains from taxation. This led to an inevitable tax audit and ultimately to an aggregate IRS assessment of $21 million. The California Franchise Tax Board made an assessment of $15.3 million for the same tax years.

While the disputes with the taxing authorities were ongoing, Hawkins and his second wife lived an admittedly lavish lifestyle, which did not abate even when the debtors realized that they had become insolvent. Indeed, the bankruptcy court found that during an 18 month period the debtors’ living expenses exceeded their income by anywhere between $500,000 to $2.35 million.

The Hawkins’ eventually filed a chapter 11 case and sought to discharge their tax debts. The debtors filed a declaratory action seeking a ruling that the tax debts were were not excepted from discharge under 11 U.S.C. § 523(a)(1)(C). The bankruptcy court ruled for the IRS and Franchise Tax Board, which was affirmed by the district court. The Ninth Circuit overturned these rulings.

Section 523(a)(1)(C) excepts from discharge any debt “with respect to which the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat such tax.” The taxing authorities did not argue that the debtors had made fraudulent returns, but argued that the debtors’ lavish spending habits, especially when they knew they were insolvent and owed significant sums to the IRS and Franchise Tax Board, was a willful act to evade the payment of taxes. The Ninth Circuit rejected this argument, holding that this section requires a finding that the debtor had the specific intent to evade the payment of tax. And while the facts of this case could be construed to show that the debtors’ actions demonstrated that they had the specific intent to evade the payment of taxes, neither lower court addressed that specific question. The Ninth Circuit thus reversed and remanded the case for determination of this issue.

The Ninth Circuit points out that the “willful evasion of tax” exception to discharge is included in the same subsection as “filing a fraudulent tax return.” Categorizing types of activities has meaning, and the Ninth Circuit read this particular subsection to make non-dischargeable specific acts by a debtor that are fraudulent or akin to fraud. Fraudulent acts require proof of specific intent, and tax evasion should require a similar finding of specific intent to evade taxes.

The importance of this rule is far-reaching. As the Ninth Circuit states, “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.”  This is undoubtedly correct.  The Bankruptcy Code is intended to provide all honest debtors with a fresh start.  Creating a rule that spending beyond one’s means renders tax debt non-dischargeable would be an exception that could swallow the rule.  Exceptions to discharge should be narrowly construed, and on remand the taxing authorities should be required to present adequate facts to support their assertion that the debtors consciously intended to evade payment of taxes.  Scandalous facts aside, this case is one where the Ninth Circuit got it right.