Damages limited in IRS’s willful violation of bankruptcy discharge

The IRS failed to take proper precautions to abate a couple’s discharged tax debt, a bankruptcy court holds, but it denies attorneys’ fees.
By Paul Bonner

A bankruptcy court held that the IRS's repeated collection notices and delays in abating a couple's tax debts that had been discharged in bankruptcy willfully violated the discharge, entitling the couple to damages under Sec. 7433. But the court limited the award to penalties and interest totaling less than $500 on a post-petition tax debt and declined to award other claimed damages or attorneys' fees, where none were paid to the attorney/taxpayer/co-debtor representing his wife.

Facts: Brian James McAuliffe, an attorney, and his wife, Suzanne Williams-McAuliffe, received a bankruptcy discharge in September 2019 of debts that included an IRS claim for $13,625 relating to tax years 2010 and 2011, of which $7,231 was secured. During the bankruptcy proceedings, they accrued a new liability for the 2018 tax year.

Despite the discharge, the IRS sent letters in February and March 2020 seeking to collect the 2010 and 2011 liabilities. McAuliffe wrote the IRS letters, including one in March 2020, contesting the collection and advising the IRS of the discharge. The IRS did not acknowledge this letter, however, until late September 2020, when it replied it would need 60 days to review the liability. However, the IRS had already abated the 2010 and 2011 taxes the day before the date of its reply.

In December 2020, the bankruptcy court reopened the McAuliffes' case, and a few days later the couple filed an adversary proceeding against the IRS, seeking damages for violations of the bankruptcy discharge order. On the eve of trial, McAuliffe removed himself as plaintiff in the case, leaving his wife as the sole plaintiff. He continued to represent her in the case, however.

Williams-McAuliffe sought as damages the costs of the action and another $15,000 in damages because the couple sold their house for $15,000 less than what they would have because they accelerated the sale out of fear of an IRS levy. Although McAuliffe was representing Williams-McAuliffe for free after he removed himself as a party in the case, Williams-McAuliffe also sought to recover legal fees incurred in pursuing the action.

Issues: The issue before the court was whether Williams-McAuliffe could recover damages for violations of the discharge order in the McAuliffes' bankruptcy case when the IRS attempted to collect tax debts that had been discharged.

Generally, a bankruptcy court has wide powers in a bankruptcy case to levy sanctions under Bankruptcy Code Section 105 for violations of a discharge order under Bankruptcy Code Section 524. However, in a case involving the IRS, the only statute under which a debtor can recover damages against the IRS for a willful violation of a discharge order is IRC Sec. 7433(e).

The IRS, citing Murphy, 892 F.3d 29, 39 (1st Cir. 2018), and In re Helmes, 336 B.R. 105 (Bankr. E.D. Va. 2005), contended that Sec. 7433(e) requires proof that a specific IRS officer or employee, rather than the Service as a whole, willfully violated the discharge order, and that a creditor should not be held in contempt of an order where the violation was inadvertent and due to clerical error. The Service argued that its notices to the couple were automatically generated and thus inadvertent. Moreover, it argued, they were nonthreatening and should not be regarded as an attempt to collect the discharged debt. The IRS also argued that its delays were caused by the COVID-19 pandemic and were exacerbated by the couple's having replied to the wrong service center.

Holding: The bankruptcy court concluded that the IRS was aware of the McAuliffes' discharge but failed to take proper precautions to abate their discharged debts. Therefore, the court held that the IRS had committed a willful violation of the discharge under both Bankruptcy Code Section 524 and IRC Sec. 7433.

The court stated that Helmes, far from supporting the IRS's argument, instead supported Williams-McAuliffe's position. In Helmes, a bank that failed to properly mark a debt as discharged when reporting to a credit agency took remedial action when it learned of the mistake. By contrast, after the McAuliffes had repeatedly notified the IRS of its error, it persisted in attempting to collect the debt. The court found that the situation resembled that of the debtor in In re Shealy, 90 B.R. 176 (Bankr. W.D.N.C. 1988), in which a state revenue agency was found in violation of an automatic bankruptcy stay after its computer system automatically sent multiple notices to the debtor. In that case, the debtor informed the agency multiple times that it needed to update its computer records, yet the agency took no action until it was threatened with sanctions. According to the bankruptcy court in Shealy, the agency's violation of the automatic stay could have been prevented if "the agency had taken proper precautions to update the system which spawned the notices" (Shealy, 90 B.R. at 179—80).

As for the IRS's argument that its notices should not be seen as an attempt to collect and were nonthreatening, the court disagreed. The court observed that the letters, which included a monthly payment amount due immediately, threatened default if the payments were not made and did not include any disclaimer that they were not an attempt to collect. Thus, the court determined that they served no purpose other than to collect the McAuliffes' discharged personal liabilities.

With regard to damages, the court denied an award of attorneys' fees, noting that no money was exchanged, nor was any fee agreement entered into between the spouses. It cited McPherson, 840 F.2d 244 (4th Cir. 1988), in which the Fourth Circuit similarly denied legal fees to an attorney/taxpayer who prevailed in representing himself against the IRS. The bankruptcy court dismissed the taxpayers' claim for the lost home sale proceeds because they were "unduly speculative" and "too distant in time and nature" from the abatement.

However, the court did grant damages of $498 for the interest and penalties that accrued on the McAuliffes' 2018 tax debt before the IRS accepted an installment agreement on it. The court accepted the couples' testimony that they attempted over two years to enter into the agreement but were unable to because of the IRS's error regarding their 2010 and 2011 debts.

The court also ordered a refund of the $350 filing fee for reopening the bankruptcy case, which it determined that the McAuliffes were not required to have paid under a court fee schedule.

Paul Bonner is the JofA's editor, tax.

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