How a tech entrepreneur is hoping to avoid a huge bill for a tax dodge

You don’t have to look much further for a taste of what a federal judge recently called “the shenanigans of the rich” than the financial maneuverings of the one-time Silicon Valley millionaire Trip Hawkins.

For a time, William M. Hawkins III seemed to be on top of the world. He was one of the earliest employees of Apple Computer, then cofounded Electronic Arts, the video game company that made a mint from such titles as the Madden NFL series. As a federal appeals court put it recently, “by 1996, his net worth had risen to $100 million.”

The court cited an IRS statement to the effect that Hawkins, 60, and his second wife, Lisa, “enjoyed the trappings of wealth, such as a private jet, expensive private schooling for the children, an ocean-side condominium in La Jolla, and a large private staff.”

It was not to last. Hawkins sold his EA stock to invest in its spinoff, 3DO. The sale meant realizing about $67 million in taxable capital gains, which he sheltered in a tax-avoidance deal cooked up by the accounting firm KPMG. Then 3DO failed, taking Hawkins’ investment with it. The IRS and California tax authorities say he still owes more than $20 million in back taxes and penalties.

Here’s where the “shenanigans” come in. Even though Hawkins knew he was on the hook for that tax bill, he didn’t do much to cut back his personal spending. There’s evidence that he kept up his and his family’s lifestyle on the assumption that once he filed for bankruptcy, his debt to the government would be wiped out, like his other debts. That often happens when former millionaires go bankrupt, but not as often when the average person files. One of the hardest debts to get discharged in bankruptcy, for example, is student-loan debt.

Federal Judge Johnnie Rawlinson of the U.S. 9th Circuit Court of Appeals in San Francisco concluded that Hawkins deliberately maintained his family’s extravagant spending rather than pay his tax bill. That would make the tax bill ineligible for cancellation in bankruptcy, because it would amount to willful tax evasion. “Providing a fresh start under the Bankruptcy Code,” she wrote a few weeks ago, “should not extend to aiding and abetting wealthy tax dodgers.”

As it happens, Rawlinson was writing as a dissenter in a 2-1 ruling that favored Hawkins. The majority found on Sept. 15, in the words of Judge Sidney R. Thomas, that “bankruptcy law must apply equally to the rich and poor alike.” They’re instructing Bankruptcy Court Judge Thomas E. Carlson, who originally found that Hawkins “willfully avoided” his tax obligations by living high “when he knew he owed taxes,” to think again.

Hawkins’ lawyer, Wendy Smith, declined to predict for me how Judge Carlson would respond. But the appellate court majority says that “living beyond one’s means alone” doesn’t constitute willful tax evasion, so it doesn’t require a mind-reader to know how they expect things to work out.

The 9th Circuit ruling has produced a fair amount of legal commentary about how to define “willful tax evasion” when tax debtors keep spending rather than paying their tax bill. So it’s proper to look at what Hawkins was up to.

Smith declined to let Hawkins talk to us, on the grounds that the bankruptcy case is still alive. She also declined to confirm that a lengthy statement that appeared under Hawkins’ name in the comment section of Forbes.com was genuine. But it’s been accepted as his words by Forbes and the website Ars Technica, which published a painstakingly researched piece on Hawkins last week.

“Before I clearly understood and accepted that I had tax problems and obligations,” the statement reads, “I did spend too much money because I presumed, like most people, that my money was my money and that I was an American living in the USA.” That certainly sounds like standard-issue Silicon Valley entitlement-speak.

The first point to consider about Hawkins’ case is the nature of his tax dodge. The accounting firm KPMG provided clients with letters attesting that its experts held the scheme up to the light and pronounced it kosher. In fact, as the government later asserted, KPMG’s own professionals issued “significant warnings...that the shelters were close to frivolous and would not withstand IRS scrutiny.”

The deal used Cayman Island corporations and elaborate stock option contracts to produce fake tax losses. It involved Hawkins’ spending about $3.5 million for shares in United Bank of Switzerland in 1996 and 1998. Then, when he sold the shares in pieces through 2000, he claimed tax losses of more than $60 million.

The Forbes statement says that Hawkins “delegated” these tax matters to his experts. Even after he got audited, the statement says, “I did not think my guys had done anything wrong.” Yet it’s a little hard to believe that Hawkins, a Stanford University MBA, didn’t know the arrangement stank to high heaven. In any event, the IRS got the picture. In 2005 it forced KPMG to cough up $456 million in criminal fines and other penalties and indicted seven of its high-ranking tax experts. KPMG clients who “trusted” their accountants, like Hawkins, got audited.

Hawkins paid down some of his tax debt, in part by selling his homes, and offered to settle the rest in bankruptcy by paying an additional $500,000 and giving the tax authorities a claim on whatever he obtains from suing KPMG -- probably not more than $3 million. He also sold the plane.

What irked the bankruptcy judge, however, was that Hawkins, his wife and four children (including two from his first marriage) continued to live well beyond their means right up until he filed for bankruptcy in 2006 -- as much as $78,000 a month beyond their means.

The judge also was irked by signs that Hawkins kept spending on the expectation that the bankruptcy court would make his tax debt go away. In 2004, two years before filing for bankruptcy, Hawkins’ attorney revealed at a family court hearing that they hoped for this outcome, which Judge Carlson appears to have considered rather presumptuous.

The Hawkins statement in Forbes seeks our sympathy for the family’s crash. The statement suggests that Judge Carlson exaggerated the excess spending. “I don’t care for the suggestion that I was living a frivolous and luxurious lifestyle at a time when I was suffering from unbearable and unbreakable stress,” it says. “What has been disappointing is ... to feel so dehumanized by a government that has had the benefit of a lot of tax income from my career.”

One should, in truth, feel sympathy for Hawkins. He worked hard, enriched consumers’ lives with his labors, then made a bad investment. But he knew or should have known that the “government” -- that’s you and me -- wasn’t getting all the tax income that it was owed; even a user of Turbo-Tax knows that claiming a loss of more than $60 million on an investment in which only $3.5 million is at risk won’t wash. He lived well while the good times lasted, but, in Judge Carlson’s opinion, he took his time paring back his family lifestyle to one commensurate with no longer having millions in income.

Where the Hawkins case grates most harshly, however, is broader than Hawkins’ own particular case. It’s the appellate court’s conclusion that treating a rich, or formerly rich, person the same as a poor person means giving him a pass on an enormous tax debt. Being able to file for bankruptcy at all puts Hawkins in a privileged caste; after Congress tightened up bankruptcy law in 2005, the increased cost of filing itself put this “fresh start” out of the reach of many ordinary folks. The 2005 changes also reduced the amount of debt that could be forgiven, or discharged, in bankruptcy; that provision was largely seen as a handout to credit card issuers.

Overall, bankruptcy has become much more burdensome for the average person. For Hawkins to claim that he’s been “dehumanized” by not being allowed to kiss off a huge tax debt is a bit much -- $26 million much. Yet, as it happens, it looks like he’s about to win.

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