Originally published on Passive Activities and Other Oxymorons on May 9th, 2011.
IN RE: MITCHELL, Cite as 107 AFTR 2d 2011-979
I sometimes think that many people believe that if you are couple of days late filing your tax return a SWAT team of armed IRS agents will surround your house. The enforcement mechanisms are much more creaky than that. It is possible to slide deeply into non-compliance and continue to live a normal life. After a while, you will just get used to it. You might think about cleaning up your act but you will be in a hole that is way too deep.
That is what happened with Larry Mitchell:
Between 1986 and early 2006, Mitchell was self-employed and worked for Kennon Parker as an independent contractor. Due to Mitchell's status as an independent contractor, Kennon Parker did not withhold payroll taxes from his commission checks, and Mitchell was responsible for remitting his outstanding federal income and employment taxes to the Internal Revenue Service (“IRS”). Until 1998, Mitchell paid all federal taxes owed; however, on multiple occasions he fell behind in payments, which resulted in levy threats and repayment plans with the IRS.
Starting in 1998, Mitchell simply stopped filing tax returns and stopped paying his federal income taxes. Mitchell maintained this pattern of noncompliance for five years, until June 2003, when he filed late returns for 1998 through 2002. At the time Mitchell filed these late tax returns, he did not make any payments toward his past due taxes for 1998 through 2002. At trial, Mitchell testified that he did not pay his taxes from 1998 to 2002 because his living, business, and divorce expenses fully exhausted his income.
You are supposed to organize your life so that you are living on your after tax income. Once you are past a certain income level, though, your taxes may well be your largest expense. If you are going to cut back in that area, why not go all the way ?
Mitchell earned an annual adjusted gross income of over $100,000 from 1998 to 2002, with the exception of 2000 when he earned approximately $88,000. When asked at trial why he had not paid anything towards his past due taxes even though in 2001 he earned over $170,000, 6 Mitchell responded: “[i]t doesn't take a rocket scientist to figure out that I'm going to owe somewhere around [$]300,000 plus interest and penalties. So at that point, I haven't filed anything. I don't have [$]300,000. I don't want to open this up yet.” . Additionally, from 2003 to 2006, despite consistently earning an annual adjusted gross income over $175,000, Mitchell did not pay any amount towards his past due taxes for 1998 to 2002, with the exception of payments made in July and August of 2006 under his installment agreement with the IRS.
I have observed in a couple of posts including this one that there are two distinct areas of tax practice. The first is the determination of the correct tax. As an individual you start that ball rolling when you file form 1040. That is the beginning and the end of that process for most people. The IRS assesses the tax that you computed and you are done. It is possible that you will be audited and not like the result of the audit. You can then appeal within the IRS. If you still don't like the result you can then go to tax court or federal district court or the court of claims. If you don't like what they have to say there are appellate courts in the various "circuits" that the country is divided into. If you don't like what the appellate court has to say there is the US Supreme Court, but they don't hear too many tax cases. Once that determination process is complete what happens if you don't pay ?
Do they throw you in jail ? Well, actually that is possible. There is, in fact, a third area of tax practice, that I don't get involved in at all. Jack Townsend has a very nice blog on the subject with the self-explanatory title of Federal Tax Crimes. Putting that aside, the second area of tax practice is collections. For most people that process begins and ends by them making a timely payment of the assessed tax. Instead you can do nothing and at some point the IRS will start the ball rolling or you can start it yourself by filing an Offer in Compromise. If the IRS has started the ball by sending you a notice of intent to levy your property you can file Request for a Collection Due Process or Equivalent Hearing. Although you can raise "doubt as to liability", generally there is no dispute about the correct tax at this point. It is all about your ability to pay.
Mr. Mitchell and his attorney worked the collection system to the max with three offers in compromise and an installment agreement that was in effect for a while. It is not my normal area of practice but I think they may have pushed it just a little beyond the envelope:
Mitchell's attorney sent a letter on November 12, 2004 to the IRS, which warned:
[I]n determining what is in the best interest of the IRS, the Service should look at reasonable collection potential ... due to the fact that the taxpayer could file bankruptcy against all of the non-payroll taxes except 2002 and 2003 (and could do so against 2002 in April, 2006, and against 2003 in April, 2007).
It reminds me of a story one of my college classmates told me. He and another Air Force attorney were at a base discussing a case with opposing counsel, who was encouraging them to settle because the expenses of the case, which the governent might have to bear depending on the outcome, could be quite high since depositions would have to be taken here there and everywhere. At that moment a fighter jet took off. My friend, who had been an electronics weapons officer before the Air Force sent him to law school, pointed to the quickly receding plane and said:
"You see that plane that just took off. It's going to use $20,000 worth of fuel before it lands. Are you really telling me that your firm is going to outspend the United States Air Force ?"
Threaten bankruptcy. I'm sure that's going to have the IRS collection guys just shaking in their boots. "Bankruptcy - Oh My God. We never thought of that. We could have had an armed escort at this meeting, but bankruptcy never entered our mind. We better settle."
The letter from the attorney did serve a purpose - to the government. It was not picked up by the trial court which discharged his tax indebtedness, but the appellate court took note of it:
Third, in November of 2004 while the third offer in compromise was pending, Mitchell's attorney sent a letter to the IRS warning that Mitchell “could file bankruptcy against all of the non-payroll taxes except 2002 and 2003 (and could so against 2002 in April, 2006, and against 2003 in April, 2007).” In other words, if the IRS refused to accept Mitchell's third offer in compromise of $35,000 for over $200,000 in tax debts, Mitchell would file bankruptcy and discharge his tax debts. Although the bankruptcy court had this letter in its possession, it apparently overlooked the paragraph in which Mitchell's attorney made this threat, and therefore it did not consider the letter as evidence of Mitchell's willfulness.
The appleate court did consider it evidence of willfulness.
So Mr. Mitchell still owes the taxes:
The bankruptcy court clearly erred in its finding that Mitchell did not act with the requisite mental state to satisfy the discharge exception of § 523(a)(1)(C). Accordingly, we REVERSE the decision of the district court and hold that Mitchell's tax debts for 1998 to 2002 fall within the scope of the § 523(a)(1)(C) exception, and therefore, such tax debts are not dischargeable in bankruptcy.