First Circuit to IRS: Collect Taxes Post-Bankruptcy Discharge at Your Peril by Robert S. Horwitz
In 1998 Congress added §7433(e) to the Code. It provides that a taxpayer can sue the US for damages as a result of collection action that “willfully violates” either the bankruptcy stay imposed by 11 USC §362 or a bankruptcy discharge order under 11 USC §524. The statute provides:
(e)Actions for violations of certain bankruptcy procedures –
(1) In general: If, in connection with any collection of Federal tax with respect to a taxpayer, any officer or employee of the Internal Revenue Service willfully violates any provision of section 362 (relating to automatic stay) or 524 (relating to effect of discharge) of title 11, United States Code (or any successor provision), or any regulation promulgated under such provision, such taxpayer may petition the bankruptcy court to recover damages against the United States.
(2) Remedy to be exclusive
(A) In general: Except as provided in subparagraph (B), notwithstanding section 105 of such title 11, such petition shall be the exclusive remedy for recovering damages resulting from such actions.
(B) Certain other actions permitted; Subparagraph (A) shall not apply to an action under section 362(h) of such title 11 for a violation of a stay provided by section 362 of such title; except that—
(i) administrative and litigation costs in connection with such an action may only be awarded under section 7430; and
(ii) administrative costs may be awarded only if incurred on or after the date that the bankruptcy petition is filed.
Despite subsection (e) having been around for twenty years, it was not until June 7, 2018, that a court of appeal issued an opinion interpreting “willful violation.” In IRS v. Murphy, Dkt. No. 17-1601, the First Circuit considered whether there is a willful violation of a discharge order if the IRS had a good faith belief that its taxes were not discharged.
Murphy filed a bankruptcy petition. Approximately 90% of his debts were taxes owed the IRS. He was granted a discharge in February 2006. Between that date and February 2009 the IRS “repeatedly informed” Murphy that his taxes were not discharged and that it intended to take collection action. It finally issued levies in February 2009. Six months later Murphy filed an adversary proceeding to determine that his tax liability was discharged. In response to Murphy’s motion for summary judgment Assistant U. S. Attorney assigned the case failed to offer any admissible evidence to support the IRS’s fraud claim. The bankruptcy court determined his liability was discharged. The Assistant U. S. Attorney was subsequently diagnosed with dementia.
In February 2011 Murphy petitioned the bankruptcy court under §7433(e). The bankruptcy court held there was a willful violation of the discharge order. The district court reversed and remanded the case to the bankruptcy court to determine whether the Assistant U. S. Attorney’s dementia collaterally estopped the IRS from litigating the issue of whether the tax was discharged. The parties settled. The IRS agreed to pay Murphy $175,000 subject to a final determination that its collection action was a “willful violation.” The First Circuit held that a good faith belief that the tax was discharged does not shield the IRS from liability for a willful violation of the discharge order.
The Court looked at the definition of “willfully violates” in the context of bankruptcy cases existing on the date §7433(e) was enacted. As of 1998, the courts had held that there is a willful violation of the automatic stay if a person knows of the stay and intentionally acts to violate the stay. There was no good faith defense. Shortly after enactment of the statute the First Circuit applied the same definition of “willfully violates” to violations of the stay and of the discharge order.
To further support its decision, the First Circuit turned to Internal Revenue Manual, which provides that a willful violation of the stay occurs when the IRS receives notice of the bankruptcy filing or discharge order and does not timely act to stop collection action.
The Court rejected the IRS’s argument that “willfully violates” should be narrowly construed because §7433(e) is a waiver of sovereign immunity. The Court reasoned that its construction of “willfully violates” was consistent with the purpose of the bankruptcy code to provide debtors with a fresh start. It also rejected the IRS’s argument that a ruling that good faith is not a defense would require it to seek a pre-enforcement determination that its tax was not discharged before it could ever take action to collect taxes post-discharge. The Court stated that the IRS does not need to seek a pre-enforcement determination. It can just collect and then defend if the taxpayer challenges the IRS claim that the tax was not discharged.
Judge Lynch dissented. He construed the statute as waiving sovereign immunity only where the IRS action is not reasonable and in good faith and interpreted “willfully violates” as an intentional violation of the discharge order rather than an intentional act that violates the order. He pointed out that several appeals court cases decided before 1998 supported the IRS’s interpretation. Finally, he believed that the Court’s decision would wrap the IRS up in time consuming and often pointless litigation to determine whether its tax was discharged.
The majority however may be correct in its interpretation of Congressional intent. Subsection (e) was added to the Code as part of the 1998 IRS Restructuring and Reform Act, part of whose purpose was to provide taxpayers with the means to slow down the IRS collection process, such as collection due process rights. The majority’s reading of “willfully violates” is consistent with this purpose.
Prior to enactment of subsection (e) a number of cases had applied the First Circuit’s reading of “willfully violates” to cases in which the IRS violated the automatic stay. But the automatic stay is a bright red line. Once a bankruptcy case is filed any collection action is prohibited unless the creditor obtains an order lifting the stay. The discharge order does not contain a bright line for taxes. While some taxes are discharged, others are not, including priority taxes, taxes where a return was not filed, taxes where there was fraud and taxes where there was an intent to evade or defeat. For many types of tax (i.e., those for which a return was due within three years of bankruptcy, withholding tax, etc.) it is easy to determine whether the tax is discharged. Others (i.e., fraud where there is no prior judicial determination, an attempt to evade or defeat) require intensive factual determinations. While the First Circuit’s decision may make the IRS’s collection efforts post-discharge more problematic for the latter types of liabilities, ultimately it may not severely impact the IRS’s collection efforts any more difficult.
ROBERT S. HORWITZ – For more information please contact Robert S. Horwitz, email@example.com or 310.281.3200. Mr. Horwitz is a principal at Hochman, Salkin, Rettig, Toscher & Perez, P.C., a former Assistant United States Attorney of the Tax Division of the Office of the U.S. Attorney (C.D. Cal) and represents clients throughout the United States and elsewhere involving federal and state, administrative civil tax disputes and tax litigation as well as defending criminal tax investigations and prosecutions. Additional information is available at http://www.taxlitigator.com.