15 - First Circuit Determines When IRS Willfully Violates Bankruptcy Discharge Order

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1 15 - First Circuit Determines When IRS Willfully Violates Bankruptcy Discharge Order IRS v. Murphy, (CA 1, 6/7/2018) 121 AFTR 2d The Court of Appeals for the First Circuit, affirming the district court in part, has held that an IRS employee "willfully violated" an order from the bankruptcy court discharging the debts of debtor-taxpayer under Code Sec. 7433(e). The Court found that IRS's good faith belief that it had a right to collect the purportedly discharged debts was not relevant to determining whether it willfully violated the discharge order. Background. Under bankruptcy law, the automatic stay of 11 USC 362(h) bars creditors (with some limited exceptions) from taking action to collect on a debt once a debtor files a bankruptcy petition. A discharge order issued pursuant to 11 USC 524(a) generally relieves a debtor from all pre-petition debt and permanently enjoins creditor actions to collect discharged debts. Code Sec. 7433(e) provides that if, in connection with any collection of Federal tax with respect to a taxpayer, any IRS officer or employee willfully violates any provision of 11 USC 362 or 11 USC 524, the taxpayer may petition the bankruptcy court to recover damages against the U.S. Before Congress enacted 11 USC 362(h) in '84 to provide a private cause of action to an individual injured by any willful violation of a stay, the standard courts had used for evaluating whether a violation was willful was the standard that governed contempt proceedings: a party generally would not have sanctions imposed as long as it had (i) acted without maliciousness and (ii) had a good faith argument and belief that its actions did not violate the stay. However, because 11 USC 362(h) created an independent statutory basis to hold violators of the automatic stay liable, courts began to apply a standard less stringent than maliciousness or bad faith to govern the imposition of sanctions in bankruptcy cases. (In re Crysen/Montenay Energy Co., (CA ), 902 F.2d 1098) Prior to the enactment of Code Sec. 7433(e) in '98, nearly all courts, and a majority of the circuits, had held that a willful violation of an automatic stay under 11 USC 362(h) occurred when an individual knows of the automatic stay and takes an intentional action that violates the automatic stay. Courts refused to incorporate a bad faith or maliciousness requirement, and in fact many specifically rejected good faith defenses. (In re Crysen/Montenay Energy Co.; In re Pinkstaff, (CA ) 70 AFTR 2d ) 46

2 Facts. On Feb. 14, 2006, the bankruptcy court granted William Murphy a discharge. However, IRS viewed Murphy's taxes as excepted from discharge under 11 U.S.C. 523(a)(1)(C), which excepts from discharge any tax if the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat such tax. On Feb. 20, 2009, IRS issued levies against several insurance companies with which Murphy then did business in an attempt to collect on these tax obligations. Bankruptcy court. On Aug. 14, 2009, Murphy filed an adversarial proceeding seeking a declaration that his tax obligations from '93-'98, 2000, and 2001 had been discharged. On June 22, 2010, the bankruptcy court granted summary judgment in Murphy's favor and declared that Murphy's tax obligations had been discharged. In February 2011, Murphy filed a complaint against IRS under Code Sec. 7433(e), alleging that an IRS employee willfully violated the bankruptcy court's 2006 discharge order in February 2009 by issuing levies against the insurance companies. IRS responded that it did not willfully violate the order because it reasonably believed his tax obligations were excepted from discharge under 11 USC 523(a)(1)(C) based on its investigation into his alleged tax evasion. On Dec. 20, 2013, the bankruptcy court granted Murphy summary judgment on his Code Sec. 7433(e) claim, finding that the term "willfully violates" has an established meaning in the context of automatic stays and discharge orders issued in bankruptcy proceedings: a willful violation occurs when, with knowledge of the discharge, a creditor intends to take an action, and that action is determined to be an attempt to collect a discharged debt. (In re Murphy, (Bktcy Ct ME 2013) 113 AFTR 2d ) The court further found that the 2010 summary judgment ruling collaterally estopped IRS from relitigating whether Murphy's tax obligations were discharged, whether IRS knew they were discharged, and whether it took actions which violated the discharge order. District court decision. IRS appealed to the district court, which vacated the bankruptcy court's decision on another issue. (IRS v. Murphy, (DC ME 2016) 118 AFTR 2d ) However, the district court agreed with the bankruptcy court's definition of "willfully violates," finding that that, by '98, 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 was not relevant to a determination of whether the violation was willful. On remand, the parties entered into a settlement agreement under which IRS waived its collateral estoppel arguments and accepted that the 2010 summary judgment ruling conclusively determined that Murphy's tax obligations had been discharged. But IRS reserved its rights with regard to its arguments that that a 47

3 debtor is not entitled to damages where a creditor's violation of the discharge reflects a reasonable belief that the debt involved was excepted from discharge. IRS's position on appeal. IRS argued that it does not "willfully violate" an automatic stay or discharge order if it has a good faith belief that its actions does not violate the bankruptcy court's order. IRS presented two arguments: (1) that, before Congress enacted Code Sec. 7433(e) in '98, all creditors could raise a good faith defense to allegations that they willfully violated an automatic stay or discharge order; and (2) that even if most creditors could not raise a good faith defense, such a defense must be available to IRS because Code Sec. 7433(e) is a waiver of sovereign immunity that must be construed narrowly. Appellate decision. The majority opinion in the First Circuit concluded that IRS willfully violated an order from the bankruptcy court discharging the debts of debtor-taxpayer William Murphy, as that term is used in Code Sec. 7433(e). The Court found that a creditor willfully violates a bankruptcy automatic stay if it knew of the automatic stay and takes an intentional action that violates the automatic stay. The Court further found that when Congress enacted Code Sec. 7433(e), it sought to apply the same generally accepted standard to violations of both automatic stays and discharge orders. In neither was a good faith belief in a right to the property relevant in determining whether the creditor's violation was willful. In concluding that the same standard applied to violations of both automatic stays and discharge orders, the First Circuit reasoned that the plain language of Code Sec. 7433(e) did not distinguish between the two orders: that provision allowed for damages where 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. Further, the Court noted that preexisting provisions of the Code already allowed IRS to raise its good faith belief, not as a defense to liability, but as a means of mitigating damages. Under Code Sec. 7430, a taxpayer who prevails in an action against IRS may recover reasonable attorney's fees, but a taxpayer will not be treated as prevailing if the government establishes that IRS's position was substantially justified. The First Circuit rejected IRS's reliance on several case where it claimed that before '98, a few circuits, including the First Circuit, had adopted a less stringent standard that allowed alleged violators to raise a good faith defense. The Court found that these decisions did not provide an alternative definition of the phrase "willful violation," but rather represented limited resolutions of idiosyncratic fact patterns. Although the First Circuit primarily relied on Congress's contemporary understanding of the phrase "willful violation" in construing Code Sec. 7433(e), post-'98 decisions from the First Circuit and administrative materials from IRS confirmed that the generally accepted definition of willful violation should control. 48

4 Since '98, the First Circuit has adopted the same definition of "willful violation" for violations of both automatic stays and discharge orders. In Fleet Mortgage Group Inc v. Kenneth A. Kaneb, (CA ) 196 F3d 265, issued only one year after Code Sec. 7433(e) was enacted, the Court explicitly adopted the generally accepted definition for violations of automatic stays. In Kaneb, the Court rejected the proposition that a stay violation could not be actionable (i.e., "willful") if the creditor had made a good faith mistake. In addition, the Court pointed out that the current version of the Internal Revenue Manual (IRM) appears to adopt the same generally accepted definition for violations of automatic stays and discharge orders. The IRM defines a "willful" act as one "that was committed intentionally or knowingly" and states that a willful violation occurs when IRS has received notice of a voluntary bankruptcy filing or of the court's granting of a discharge, and IRS does not respond timely to stop its collection activities. (IRM (Aug. 11, 2015)) Further, the First Circuit did not believe sovereign immunity required it to adopt a more narrow definition of "willfully violates." The Court found that by directly linking the phrase "willfully violates" in Code Sec. 7433(e) to 11 USC 362 or 11 USC 524, Congress sought to use the generally accepted definition of the phrase "willful violation" in this context as the limit to its waiver of sovereign immunity. And, when the Court looked past '98, the Court's subsequent caselaw and the IRS administrative materials both confirmed that the generally accepted standard should control. In addition, the First Circuit concluded that if it were to adopt IRS's definition, it would render Code Sec. 7433(e) a near nullity. Under IRS's view, it would be hard to imagine a case where a taxpayer could ever collect. Dissenting opinion. Preliminarily, Judge Lynch, dissenting with the majority opinion, noted that this was the first opinion by a circuit court construing the phrase "willfully violates" in Code Sec. 7433(e), and, importantly, the first to deprive IRS of its sovereign immunity under that statute where the U.S. acted on a reasonable and good faith belief that a discharge injunction did not apply to its collection efforts against a tax debtor. She found that there was no explicit waiver by Congress of sovereign immunity under these circumstances and that the Bankruptcy Code itself provides that a discharge injunction does not apply to a tax debt "with respect to which the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat such tax." (11 U.S.C. 523(a)(1)(C)) And here, IRS asserted that it believed in good faith that the tax debts it attempted to collect fell into this exception. Further, she concluded that the plain meaning of the phrase "willfully violates," Supreme Court precedent interpreting the term "willful" and the phrase "willful 49

5 violation," the structure of the statutory scheme, and the sovereign immunity canon all pointed toward an interpretation of Code Sec. 7433(e) that did not strip IRS of a reasonable good faith defense. 50