IRS Liable for Damages for Willfully Violating Bankruptcy Discharge Order

(Parker Tax Publishing June 2018)

In a case of first impression, the First Circuit affirmed a district court and held that an employee of the IRS "willfully violates" a bankruptcy discharge order when the employee knows of the discharge order and takes an intentional action that violates that order. Under Code Sec. 7433(e), the court said, the IRS's good faith belief that it has a right to collect purportedly discharged debts is not relevant to determining whether it willfully violated a discharge order and, in the instant case, the IRS met the applicable standard and violated a discharge order and was thus liable for damages. IRS v. Murphy, 2018 PTC 165 (1st Cir. 2018).

Background

In 2005, William Murphy filed a Chapter 7 petition in bankruptcy court. On Schedule E of his bankruptcy petition, Murphy listed his income tax obligations to the IRS for the years of 1993-1998, 2000, 2001, and 2003, as well as a 2003 tax obligation to the Maine Revenue Services. Murphy's tax obligations were by far the largest liabilities he sought to discharge. In his petition, Murphy listed total liabilities of approximately $600,000 of which approximately $546,000 were tax obligations. On January 20, 2006, Assistant U.S. Attorney Frederick Emery, Jr. filed an appearance on behalf of the IRS in the bankruptcy proceeding.

In 2006, the bankruptcy court granted Murphy a discharge. The discharge order stated that the "debtor is granted a discharge under section 727 of title 11, United States Code, (the Bankruptcy Code)." Beneath the bankruptcy judge's signature, was a notice which stated, in bold and capital letters, "SEE THE BACK OF THIS ORDER FOR IMPORTANT INFORMATION." The back of the order provided an explanation of bankruptcy discharge in a Chapter 7 case, stating that "[t]he discharge prohibits any attempt to collect from the debtor a debt that has been discharged." The order listed some of the common types of debts which are not discharged and specifically noted that "[d]ebts for most taxes" are not discharged.

The IRS did not believe that the discharge relieved Murphy of his tax obligations. Rather, the IRS viewed Murphy's taxes as excepted from discharge under 11 U.S.C. Sec. 523(a)(1)(C), which excludes from discharge any tax if "the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat such tax." Based on its earlier investigations into Murphy, the IRS believed that Murphy had willfully attempted to evade taxes during all of the years in question and informed Murphy of its beliefs. On February 20, 2009, the IRS issued levies against several insurance companies with which Murphy then did business in an attempt to collect on Murphy's tax obligations.

In 2009, Murphy filed an adversarial proceeding seeking a declaration that his tax obligations from 1993-1998, 2000, and 2001 had been discharged. In this proceeding, Assistant U.S. Attorney Emery (Emery) again represented the IRS. According to the IRS, Emery failed to submit evidence to the bankruptcy court that the IRS had developed during its investigation into Murphy's tax obligations. Instead, the IRS claimed that Emery merely filed a summary of the IRS's allegations of Murphy's tax evasion, without submitting any admissible evidence to support the allegations.

In 2009, Murphy filed an adversarial proceeding seeking a declaration that his tax obligations had been discharged. In this proceeding, Emery represented the IRS. In 2010, the bankruptcy court granted summary judgment in Murphy's favor and declared that Murphy's tax obligations had been discharged. The bankruptcy court later noted that it granted summary judgment in large part because the IRS's opposition to summary judgment fell far short of applicable substantive and procedural standards. The IRS did not appeal the bankruptcy court's 2010 summary judgment ruling.

Subsequently, Emery was diagnosed with frontotemporal dementia (FTD). According to the IRS, symptoms of FTD include "impairment of executive function, such as the cognitive skill of planning and organizing." Based on Emery's medical records and the opinions of three physicians, the IRS believed that Emery was already experiencing the symptoms of FTD in 2010.

In February 2011, Murphy filed a complaint against the IRS and sought damages under Code Sec. 7433(e), alleging that an employee of the IRS willfully violated the bankruptcy court's 2006 discharge order in 2009 by issuing levies against the insurance companies with which he did business and thereby attempting to collect on his discharged tax obligations. Code Sec. 7433(e) provides that if, in connection with any collection of federal tax with respect to a taxpayer, any officer or employee of the IRS willfully violates any provision of 11 U.S.C. Sec. 362 (relating to an automatic stay) or Sec. 524 (relating to effect of discharge), such taxpayer may petition the bankruptcy court to recover damages against the United States.

The IRS responded that it did not willfully violate the order because it reasonably believed Murphy's tax obligations were excepted from discharge under 11 U.S.C. Sec. 523(a)(1)(C) based on its investigation into his alleged tax evasion.

The bankruptcy court granted summary judgment for Murphy on the Code Sec. 7433(e) claim. The IRS then appealed to the district court. While the district court concluded that the bankruptcy court should have considered Emery's impairment, it nonetheless agreed with the bankruptcy court's definition of "willfully violates" as used in Code Sec. 7433(e). The district court found that, by 1998, the term had an established meaning in the context of violations of both automatic stays and discharge injunctions, and under this established meaning, a creditor's "good faith belief in a right to the property is not relevant to a determination of whether the violation was willful."

On remand, the parties entered into a settlement agreement, whereby the IRS waived certain arguments and accepted that the 2010 summary judgment ruling conclusively determined that Murphy's tax obligations had been discharged. The IRS reserved the right, however, for further appeal of its arguments that a debtor is not entitled to damages where a creditor's violation of a discharge order reflects a reasonable belief that the debt involved was excepted from discharge, and/or that the "willfully violates" language in Code Sec. 7433(e) should be construed to permit the IRS to defend against liability for violating the discharge on the basis that its employee reasonably believed that the tax involved is excepted from discharge (i.e., the "willfully violates" issue).

As part of the settlement, the IRS agreed to pay $175,000 in damages once it had exhausted the reserved right to appeal. The settlement did not resolve whether or not the deficiencies in the IRS's response to Murphy's motion for summary judgment were caused by any mental disability of the part of Emery at the time of the summary judgment proceedings. On January 4, 2017, the bankruptcy court entered final judgment against the United States, and the district court affirmed the judgment. The IRS appealed to the First Circuit.

IRS Arguments

The sole issue before the First Circuit was the bankruptcy court's resolution of a legal question involving the construction of the phrase "willfully violates" as used in Code Sec. 7433(e). The IRS argued that it cannot "willfully violate" an automatic stay or discharge order if it has a good faith belief that its actions do not violate a bankruptcy court's order. In support of its position, the IRS presented two arguments. First, it claimed that, before Congress enacted Code Sec. 7433(e) in 1998, all creditors could raise a good faith defense to allegations that they willfully violated an automatic stay or discharge order. Second, it posited that even if most creditors could not raise a good faith defense, such a defense must be available to the IRS because Code Sec. 7433(e) is a waiver of sovereign immunity that must be construed narrowly.

First Circuit's Analysis

The First Circuit affirmed the bankruptcy and district court and concluded that the phrase "willful violation" had an established meaning in the context of violations of automatic stays as of 1998 and that a creditor willfully violated the automatic stay if it knew of the automatic stay and took an intentional action that violated the automatic stay. A good faith belief in a right to

the property, the court said, is not relevant to determining whether the creditor's violation is willful.

With respect to the IRS's first argument, the court noted that the term, "willful violation" already had an established meaning in 1998 and Congress used that established meaning in Code Sec. 7433(e) to set the standard for evaluating violations of both automatic stays and discharge orders. The court also rejected the IRS's alternative argument that even if there was a generally accepted definition of "willful violation," such a definition is too broad to be applied against the United States because Code Sec. 7433(e) is a waiver of sovereign immunity and such waivers must be narrowly construed. According to the court, by directly linking the phrase "willfully violates" in Code Sec. 7433(e) to Sections 362 and 524 of the Bankruptcy Code, Congress sought to use the generally accepted definition of the phrase "willful violation" in this context as the limit to the waiver of sovereign immunity. And, when the court looked past 1998, it found that subsequent caselaw and the administrative materials from the IRS itself both confirmed that the generally accepted standard should control. For that reason, the court did not believe sovereign immunity required it to adopt a more narrow definition of the term "willfully violates."

Observation: Judge Lynch dissented, saying that to the best of her knowledge, this was the first opinion by a circuit court construing the phrase "willfully violates" in Code Sec. 7433(e) and the first to deprive the United States, through the IRS, of its sovereign immunity under that statute even where the United States acted on a reasonable and good faith belief that a discharge injunction did not apply to its collection efforts against a tax debtor.

For a discussion of civil penalties for the unauthorized collection of taxes, see Parker Tax ¶260,550.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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