ABI Journal

Avoiding Tax Cheating with Subchapter K

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2 Copyright © American Bankruptcy Institute Utilizing Subchapter K Anti-Abuse Provisions in Individual Bankruptcies August 2016 By AmAndA L. myers I n an increasingly global world hastened by rapid technological advances, dishonest taxpayers now have more means at their disposal than ever before to evade lawful state taxes. 1 For example, business entities lacking economic substance can be orga- nized or incorporated in foreign states with an ease that would have been significantly impeded in the past. 2 Deceptive taxpayers often employ sham entities to conceal assets and artificially manipulate tax liabilities. 3 This fraud can be difficult — if not impossi- ble — to detect when taxpayers employ convoluted ownership structures that appear to facially satisfy formalistic requirements. Similarly, this can be exacerbated when those same taxpayers willfully refuse to respond to a taxing authority's investigatory requests. When taxpayers file for bankruptcy prior to an audit assessment, however, a wealth of tools becomes available to assist in detecting fraud, combating tax evasion and inducing compliance. 4 Although numerous tools are well known and consistently employed, 5 it appears that state taxing authorities have not fully realized the opportunities afforded by subchapter K anti-abuse provisions. This article proposes how state taxing authorities can employ these provisions (two in particular) to assess full tax liability, bring assets into the estate, and prevent dishonest taxpayers' discharges when they abuse partnership laws to facilitate tax fraud. This article presumes that the taxpayer at issue is an individual who intentionally abused partnership laws to evade state taxes, as well as lawful creditors. This article further presumes that the taxpayer filed for bankruptcy to obtain a discharge of debts that could be paid by the taxpayer's assets that are wrong- fully alleged to be assets of pass-through entities controlled exclusively by the taxpayer. In other words, the taxpayer's voluntary bankruptcy petition would identify little to no assets, notwithstanding that the taxpayer, in actuality, owned a significant amount of assets through pass-through entities in which the taxpayer formally claims little to no ownership. 1 While tax evasion is a serious concern facing taxing authorities, the author does not seek to imply that evasion is a common occurrence. It appears that the majority of taxpayers structure transactions and create business organizations in a good-faith attempt to lawfully avoid taxes rather than evade them. Tax fraud cases, however, often take a disproportionate share of time and resources to prosecute. Consequently, the purpose of this article is to provide a general framework that state taxing authorities can utilize in developing strategies to efficiently combat tax evasion and induce compliance in bankruptcies involving pass-through entities. 2 The foreign component of pass-through entities can raise issues because the laws of the organization's state arguably apply when analyzing the entity. For example, Nevada provides extremely strong protections against piercing the corporate veil. If an entity is organized in Nevada solely to evade tax, there are strong arguments that its laws should not apply to the analysis, particularly when ownership of the entity's assets is at issue and they are not located within that jurisdiction. 3 See, e.g., In re Wyly, 2016 Bankr. LEXIS 1995 (Bankr. N.D. Tex. May 10, 2016). 4 Promoting tax compliance is a significant consideration for taxing authorities because noncompliance harms the public interest by undermining revenue, distorting competition (putting the noncompliant at an advantage), and compromising equity among taxpayers. 5 For example, state taxing authorities can submit investigatory requests in a § 341 meeting of creditors or Rule 2004 examination. The debtor's failure to adequately respond to these requests can result in civil contempt, denial of discharge, conversion or even dismissal of the debtor's bankruptcy. Thus, the taxpayer's self-interest in withholding information or making false oaths to evade tax liability runs afoul of the taxpayer's self-interest to obtain a discharge. Amanda L. Myers Montana Department of Revenue; Helena

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