Avoiding the Federal Tax Lien in Bankruptcy

In United States v. Warfield (In re Tillman), No. 21-16034 (9th Cir. 2022) the Ninth Circuit reversed the lower courts and determined that the chapter 7 trustee could not avoid the federal tax lien on the debtor’s homestead.  The trustee filed a motion for rehearing en banc and the 9th Circuit has ordered a response from Appellant by December 4.  A copy of the response is attached here.  So, the discussion below may not be the end of the story.

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Ms. Tillman purchased a house in Prescott, Arizona.  Prior to the filing of the bankruptcy petition the IRS filed a notice of federal tax lien on the property stemming from a penalty she owed.  Ms. Tillman claimed a $150,000 homestead exemption in the house under Arizona law.  The trustee sued to avoid the tax lien on the exempt property in order to obtain the benefit of the lien for the bankruptcy estate.  At the time of the bankruptcy, she had paid off the underlying taxes set out in the lien notice but owed about $25,000 in penalties.

The issue pits different bankruptcy codes sections against each other that deal with exemptions and with the treatment of penalties in chapter 7 cases.

BC 522 generally permits a debtor to claim certain property as exempt.  The amount of property is almost always dictated by the state in which the debtor lives at the time of filing bankruptcy.  Arizona has a generous homestead provision which Ms. Tillman claimed.  Under almost all circumstances a debtor gets to keep the exempt property which cannot be used to satisfy the claims of creditors in the bankruptcy case; however, claiming property as exempt protects it from the claims of unsecured creditors not those who have a security interest in the property claimed as exempt.

BC 522(c)(2)(B) holds that exempting property does not protect it from a tax lien where the IRS has properly filed the notice before the bankruptcy petition.  The notice of federal tax lien would not specifically mention a taxpayer’s real estate but attaches to all property and rights to property belonging to the taxpayer.  To perfect the lien against a taxpayer’s real estate, the IRS would need to file the lien in the locality in which the property was located.  If, prior to the filing of a bankruptcy case, the IRS filed the notice in the city or county in which the property was located and if the notice properly identified the taxpayer, the IRS would have a perfected lien that would survive the debtor’s attempt to claim the property as exempt.  It would not receive payment for its lien in the bankruptcy case but would have the ability to pursue the property after bankruptcy.  Because the IRS is reluctant to administratively or judicially take taxpayer’s homes, sometimes taxpayers get to keep their homes safe from other creditors because of the federal tax lien’s priority, and then the IRS never pursues the property allowing some lucky taxpayers to walk away from both their tax obligations and their other debts.

Chapter 7 trustees do not have the same reluctance or policies regarding debtor’s homes that the IRS does.  The trustees carefully review debtor’s schedules and other available information to determine if selling the debtor’s home or other assets would bring a benefit to the unsecured creditors of the bankruptcy estate (as well as a commission to the trustee.)  Here, the trustee sought to use the existence of the tax lien combined with BC 724 and 726(a)(4) to sell the property for the benefit of the unsecured creditors.

BC 724(a) says that a chapter 7 trustee can avoid a “lien that secures a claim of a kind specified in section 726(a)(4)” for the benefit of the estate.  BC 726 describes how property in a chapter 7 case should be distributed to creditors, providing first for claims listed in BC 507 which would include the unsecured claims to which Congress has given priority, second to unsecured claims with no priority, third to unsecured claims filed late, and fourth to claims for penalties, whether secured or unsecured.

The trustee reasoned that because the underlying tax had been paid, the IRS’s claim (secured by the notice of federal tax lien) was merely a claim for a “penalty” within the meaning of BC 726(a)(4), and therefore under BC 724 the lien could be avoided.  The bankruptcy code disfavors penalty tax claims allowing the avoidance of the liens for these claims through the procedures described in BC 724 and 726.

However, the trustee had one more hoop to jump through: under BC 551 the property preserved must be property of the estate. This requirement was key to the government’s argument.  Section 551 comes immediately after the bankruptcy code provisions allowing for the avoidance of certain transfers.  It seeks to preserve the property avoided for the bankruptcy estate unless the property would not have met the definition of property of the estate described in in BC 541.  In other words, the avoidance provisions cannot transform property that would otherwise have remained outside the estate into property of the bankruptcy estate.

The bankruptcy and district courts held that the trustee could avoid the federal tax lien, rejecting:

The government’s argument that the court’s holding would cause inequitable results for the Debtor, because the Debtor’s exemption could be reduced twice as a result of the same lien—first, as a deduction from the amount that Debtor could exempt, and then, again, when the Debtor is required to satisfy the value of the lien to the IRS. The Bankruptcy Court reasoned that the Debtor would not have to unfairly pay twice on the same lien because the IRS Tax Lien “never attached to the Debtor’s homestead exemption.” “[T]he value of the Debtor’s exemption was always subordinate to the Tax Lien” and “[w]hen the Tax Lien is avoided, the Trustee steps into that avoided position.” Therefore, the court explained, “[i]f it so happens that the IRS’s now unsecured claim is also nondischargeable, it is no different than any other nondischargeable claim which will need to be paid by the Debtor.”  

Essentially, the IRS argued that the debtor’s homestead exemption withdrew the exempt property from the bankruptcy estate which would mean it is unavailable for the unsecured creditors of the estate.  The Ninth Circuit finds that:

When a debtor properly exempts a property interest under § 522, the exemption withdraws that property interest from the estate and, thus, from the reach of the trustee for distribution to creditors….

In reaching our holding, we conclude that the Bankruptcy Court erred by overlooking the key question of first impression before us: whether a trustee may use § 724(a) to avoid a lien secured by a debtor’s exempt

property. The Bankruptcy Court did not analyze this question. Instead, the Bankruptcy Court appears to have assumed that the Trustee could use § 724(a) to avoid a lien on the Debtor’s exempt property.

The majority was especially concerned that its result kept the debtor from having to pay the debt twice.  The majority took pains to distinguish the decision in Hutchinson v. IRS (In re Hutchinson), 15 F.4th 1229 (9th Cir. 2021).  I wrote about the bankruptcy and district court opinions in that case here and here.  It’s difficult to find a light of daylight between the two opinions except that the government did not raise the issue in Hutchinson but merely conceded that the result the trustee sought could attach.

I agree with the majority in Tillman.  While it may look like the avoidance provision seeks to preserve property for other creditors, in this instance applying the law as was done in the lower court opinions puts debtors in the bad position of paying twice since the exempt property will now be used to pay unsecured creditors who would otherwise not have the opportunity to get paid from this property while the debt owed to the IRS is not extinguished and can be collected after the bankruptcy.  The existence of the tax lien should not create a benefit for the unsecured creditors.

The dissent looks to the powers of the trustee to avoid liens and to the position of the IRS when it has a lien claim.  It finds the majority’s concern with the consequence of avoidance of the lien to be a troubling result does not matter because what matters is the language of the bankruptcy code.  The defense finds that the plain text supports the position of the lower courts.

Contrary to the IRS and majority’s view, the trustee’s authority to avoid a federal tax penalty lien isn’t nullified because it encumbers exempt property. The majority incorporates § 726’s reference to the distribution of the “property of the estate” to bar a trustee’s avoidance authority. The IRS instead relies on § 551’s limitation of preservation of liens “only with respect to property of the estate.”

This issue will not go away easily and may soon result in a successful Supreme Court petition.

Ken Weil, who knows a lot more about tax issues in bankruptcy than me and who occasionally writes guest posts for PT, sent me this case.  When I sent him my draft, he offered these comments which provide a slightly different, and probably better, perspective on the case:

The IRS objected to the trustee’s use of BC 724(a), presumably because it determined that collection of the nondischargeable tax penalty would be more difficult without the NFTL attached to the property. The tax year at issue was 2015.  The taxpayer filed for bankruptcy in January 2019.  Tax penalties in Chapter 7 are dischargeable after three years from the due date of the return, including extensions, for the failure to file penalty, or three years from the payment due date for the failure to pay penalty.  BC 523(a)(7); and see United States v. Wilson, No. 15-1448, Docket entry No. 10 (N.D. Cal. 2016) (opinion withdrawn as parties settled) (tax year at issue 2008; petition filed July 2012; 2008 return filed on extension; parties agreed that failure-to-pay penalty was discharged; held, failure-to-file penalty not discharged).  One has to wonder why the bankruptcy filing was not delayed until after April 15, 2019, at the least. 

The IRS argued that exempt property is not property of the bankruptcy estate.  Schwab v. Reilly, 560 U.S. 770, 775-776 (2010).  For avoidance to be available to the trustee, BC 724(a) and 551 require that the property in question be property of the bankruptcy estate. 

More precisely, an exempt interest in property is not property of the bankruptcy estate.  Schwab v. Reilly, 560 U.S. 770, 794-795 (estate retained interest in property beyond the exempt amount) (2010).  In other words, while the value of the homestead left the bankruptcy estate, the rest of the house remained in the bankruptcy estate.  In that situation, what is the property of the estate?  Does the trustee have the authority to use BC 724(a) if the part of the real property against which the trustee can avoid the IRS lien is out-of-the-bankruptcy estate yet the property itself remains property of the bankruptcy estate?  Without diving into the Schwab v. Reilly issue, the Circuit Court found that the applicable property interest was not property of the estate, and BC 724(a) was not available to the trustee.  The dissent felt that the house was property of the estate, and, under the literal terms of the statute, the IRS lien could be avoided.

As a policy matter, the IRS argued, and the lower courts agreed, that allowing the trustee to avoid the lien as to the homestead would cause a double payment by the taxpayer.  This is a true statement, but also this argument is a red herring.  If the secured tax obligation is nondischargeable, there is always the potential for a double payment, regardless of whether the property at issue is exempt property.  The first payment is made from property that otherwise would have paid the tax debt, and that money is spread among all creditors.  The second payment potentially comes postpetition from the debtor to the taxing authority because the debtor’s tax obligation was not discharged.

Here, the trustee could have potentially avoided the issue at-hand by timely filing an objection to the homestead exemption.  Then, the argument as to whether the homestead interest had left the bankruptcy estate would not have been available.  Instead, the argument would be whether the trustee can object to the exemption because the trustee has rights in the property under BC 724(a).

Ken also offered the following fact pattern as a way to think about the problem:

Suppose, Taxpayer

>Files for bankruptcy;

>Taxpayer has a nice car;

>Taxpayer makes a claim of exemption in an interest in that car, which exemption claim does not cover the entire value of the car, and the trustee does not object; and

>The IRS only has a FTL and not a NFTL.

The claim of exemption would scrub the FTL from that interest in the car but the FTL would remain attached to the rest of the car, which is property of the bankruptcy estate and subject to the trustee’s control.

Don’t know that there is anything to come of this because the trustee can avoid the FTL.  But, I suppose the trustee could decide the car was not worth administering and abandon it.  Then, the debtor gets the car back, and it is partially lien-free and partially subject to the FTL.

Exempting the Earned Income Tax Credit from the Bankruptcy Estate

In In re Medina, No. 22-10233 (Bankr. D. N.M 2022) the bankruptcy court held that the portion of the debtor’s refund attributable to the earned income tax credit (EITC) was not exempt from the debtor’s bankruptcy estate.  The case points out a split in the outcome for debtors.  This split is not based upon a split in the interpretation of bankruptcy law but a split in how states approach exemptions.  Guest blogger Phil Rosenkrantz wrote about this several years ago in a post regarding the child tax credit. 

The bankruptcy code allows each state to decide which assets a debtor may choose to exempt from the bankruptcy estate.  Most states have exempted EITC refunds because the payments meet the state definition of payment for the welfare of the individual.  Similarly, most states have exempted the advanced child tax credit (ACTC); however, each state statute stands on its own.  Ms. Medina finds out to her sorrow that New Mexico has not drafted its statutory exemptions in a manner allowing for the exemption of the EITC.  As discussed below, this is an area where Congress should step in.  We should not require a state by state determination of whether to exempt federal anti-poverty payments.

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Ms. Medina filed her bankruptcy petition on March 24, 2022, making her 2021 refund a pre-petition asset.  As she filed she claimed an exemption of her federal and state tax refunds for 2021 using New Mexico’s wildcard exemption which is capped at $500.  She chose to use the New Mexico exemptions rather than the federal exemptions provided in BC 522 because she wanted to protect the equity in her home and New Mexico, like most states with a Spanish rather than English colonial heritage, has a generous homestead exemption.

The wildcard exemption did not provide enough protection for her 2021 refunds:

Based on her filed tax returns, Ms. Medina was entitled to a 2021 federal tax refund of $4,845 — out of which $3,618 was due to the federal EITC — and a 2021 state tax refund of $1,016 — out of which $724 was due to New Mexico’s EITC (the Working Families Tax Credit). Ms. Medina’s total 2021 tax refunds were therefore $5,861. The tax preparer fees were 10% of the total refunds.

She did not receive the refunds until after filing her bankruptcy petition – though that fact is not legally significant.  She spent the refunds by April 21, 2022, making “important home repairs such as repairing her air conditioner and hot water heater.”  The trustee objected to exemption of the portion of her refund that exceeded the wildcard amount except that the trustee did not object to the portion of her refund based on the Child Tax Credit (CTC).

In most fights interpreting state law, the EITC has fared better than CTC because CTC is not exclusively an anti-poverty provision.  Taxpayer eligible for the CTC include middle class households as well as households falling into the poverty guidelines of most states.  Usually, the ACTC has a better chance than the CTC of exemption from the estate because of the most restrictive requirements for ACTC.  The trustee’s concession on CTC surprised me.

Although represented at the outset of the case, Ms. Medina was pro se at the time of the fight over the exemptions.  She raised four arguments but only the argument regarding the ability to exempt the EITC portions of the refund bears discussion.

The court describes the EITC and its anti-poverty purpose but ends the descriptive section by stating:

Despite its anti-poverty purpose, Congress has not enacted exemptions for EITC refunds similar to the protections for Social Security benefits under 42 U.S.C. §407 and veterans’ benefits under 38 U.S.C. §5301(a).

That statement might serve as a basis for seeking a change in the bankruptcy law to provide protection for the anti-poverty payments administered under the IRC.  These payments represent a significant portion of the federal anti-poverty payments.  They should be recognized with the other payments mentioned by the court without the requirement to litigate this issue state by state.

The court notes that many states have passed legislation exempting EITC from the reach of creditors, some states have broad exemptions for public assistance benefits generally and many courts have interpreted EITC to meet the exemptions for public assistance.  The case contains good citations for state laws and court decisions on this subject.  The court did a nice job of researching state law and case law in a pro se case where her submissions would have left big gaps in this research.  See it below in bonus material.

While the court finds that EITC payments are public assistance payments, it finds that New Mexico lacks a broad public assistance exemption.  It carefully analyzes the state statute and then notes that

Other courts have similarly held that an exemption under a public assistance act does not apply to EITC tax refunds where the exemption is limited to public assistance granted under the act because EITC tax refunds are granted under federal and state tax codes. In Nevada, the bankruptcy court held that the Nevada exemption for “assistance awarded pursuant to the provisions of this chapter,” which referred to chapter 422 of the Nevada Revised Statutes, did not include EITC because it was “not paid or payable pursuant to a state-administered public welfare program under Chapter 422.” In re Thompson, 336 B.R. 800, 802 (Bankr. D. Nev. 2005). Similarly, in Arizona, the bankruptcy court concluded that the Arizona exemption for “assistance granted under this title” and “money paid or payable under this title” did not include EITC, because EITC is granted by the federal tax code, not by Arizona’s public assistance statute. In re Builder, 368 B.R. 10, 11-12 (Bankr. D. Ariz. 2007).

So, Ms. Medina cannot exempt the EITC portion of her state or federal refunds, except to the extent of the $500 wildcard exemption, which were the largest portions of those refunds.  The court finds that spending the refunds for necessary expenses does not exempt them.  The court does not say what she must do now that she now longer has the money.  If she cannot repay the money to the estate, I expect that her bankruptcy will be dismissed without her receipt of the discharge of debts she sought in filing.  This is a tough result for her but not one for which the court should be blamed.

Bonus material

For those interested, I copy below the court’s research on the state of the exemption of EITC from both a state law and case law perspective.

State law:

Several states have passed statutes that expressly exempt EITC from the reach of creditors, including Colorado, Indiana, Kansas, Louisiana, Mississippi, Nebraska, and Oklahoma.5 New Mexico has not done so.

5Colorado: Colo. Rev. Stat. Ann. §13-54-102(1)(o) (exempting full amount of any federal or state income tax refund “attributed to an earned income tax credit”); Indiana: Ind. Code Ann. §34-55-10-2(c)(11) (exempting interest in a refund or credit “received or to be received” under federal and Indiana EITC provisions); Kansas: Kan. Stat. Ann §60-2315 (exempting “right to receive” federal and Kansas EITC); Louisiana: La. Rev. Stat. Ann. §13:3881(A)(6) (exempting federal EITC “except for seizure by the Department of Revenue or arrears in child support payments”); Mississippi: Miss. Code Ann. §85-3-1(i) (exempting an amount not to exceed $5,000 of “earned income tax credit proceeds”); Nebraska: Neb. Rev. Stat. Ann. §25-1553 (exempting “full amount of any federal or state earned income tax credit refund”); Oklahoma: Okla. Stat. Ann. tit. 31, §1(A)(23) (exempting “[a]ny amount received pursuant to the federal earned income tax credit”).

Case law:

Many courts hold that EITC tax funds are public assistance within the meaning of state exemptions applicable to public assistance grants generally.6 Such courts reason that “the clear purpose and effect of the earned-income credit is public assistance.” In re Brasher, 253 B.R. 484, 489 (M.D. Ala. 2000). “Economically, the earned-income credit does not function as ‘mere tax relief’ but rather is ‘in essence, a grant.’” Id. (quoting In re Longstreet, 246 B.R. 611, 614 (Bankr. S.D. Iowa 2000)). This view is consistent with the notion that exemptions are to be construed liberally in favor of the debtor. See In re Foah, 482 B.R. 918, 921 (10th Cir. BAP 2012); In re Bushey, 559 B.R. 766, 774 (Bankr. D.N.M. 2016); Hewatt v. Clark, 44 N.M. 453, 1940-NMSC-044, ¶ 15. Such liberal construction effectuates the humanitarian purposes of exemption provisions. Foah, 482 B.R. at 921 (citing In re Carlson, 303 B.R. 478, 482 (10th Cir. BAP 2004)). Generally, the “purpose of having exemptions is to permit a debtor to retain certain necessities . . . without fear of creditors taking them.” In re Warren, 512 F.3d 1241, 1249 (10th Cir. 2008); In re Bushey, 559 B.R. 766, 771 (Bankr. D.N.M. 2016) (quoting Warren). The New Mexico exemption statute in particular was “adopted as a humane policy to prevent families from becoming destitute as the result of misfortune through common debts which generally are unforeseen.” Hewatt v. Clark, 44 N.M. 453, 1940-NMSC-044, ¶ 13 (internal quotation omitted).

However, at least one court has held that EITC tax refunds do not fall within a broad state exemption for “public assistance” because an EITC tax refund is a “tax overpayment” and not a “welfare grant.” See In re Trudeau, 237 B.R. 803, 807 (10th Cir. BAP 1999). This Court disagrees.7 An EITC tax refund is not dependent on the amount of tax paid and is available even to a qualified taxpayer who pays no tax at all. The EITC is not a refund attributable to an actual tax overpayment.

6E.g., In re James, 406 F.3d 1340, 1343-45 (11th Cir. 2005) (holding that EITC was exempt under Alabama exemption for “public assistance for needy persons”); In re Corbett, No. 13-60042, 2013 WL 1344717, at *2-3 (Bankr. W.D. Mo. Apr. 2, 2013) (holding that EITC was exempt under Missouri exemption for “public assistance benefit”); In re Fish, 224 B.R. 82, 84-85 (Bankr. S.D. Ill. 1998) (holding that EITC was exempt under Illinois exemption for “public assistance benefit”); In re Tomczyk, 295 B.R. 894, 896-97 (Bankr. D. Minn. 2003) (holding that EITC was exempt under Minnesota exemption for “all relief based on need”); In re Moreno, 629 B.R. 923, 932-34 (Bankr. W.D. Wash. 2021), aff’d, No. WW-21-1124-LBS, 2021 WL 6140115 (9th Cir. BAP Dec. 23, 2021) (holding that EITC was exempt under Washington exemption for “assistance”); Flanery v. Mathison, 289 B.R. 624, 628-29 (W.D. Ky. 2003) (holding that EITC was exempt under Kentucky statute exempting “public assistance benefits”); In re Longstreet, 246 B.R. 611, 617 (Bankr. S.D. Iowa 2000) (holding that EITC was exempt under Iowa exemption for “public assistance benefit”); In re Jones, 107 B.R. 751, 751-52 (Bankr. D. Idaho 1989) (holding that EITC was exempt under Idaho exemption for benefits provided by “public assistance legislation”).

Freezing Refund Did Not Violate The Automatic Stay

In United States v. Waters (In re Waters), No. 21-1219, 2022 WL 17086310 (2d Cir. Nov. 21, 2022) the court sustains the decision of the lower court that holding onto the debtor’s refund did violate the automatic stay.  I thought this issue was settled almost three decades ago by the Supreme Court in Citizens Bank of Md. v. Strumpf, 516 U.S. 16, 21 (1995) but debtor’s arguments here put a slight twist to the matter.

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When a taxpayer goes into bankruptcy owing money to the IRS, the IRS wants to collect the outstanding debt in a manner that provides the most certainty.  If the taxpayer has a pre-petition tax debt and a pre-petition refund, the most certain way to collect the money is to offset it.  Offsetting avoids the muss and fuss of filing a proof of claim and hoping the estate has sufficient assets to satisfy the claim.  Sending a refund to a taxpayer at a time when the taxpayer owes taxes does not sit well with the IRS nor with any creditor.

Prior to 2005 the automatic stay at BC 362(a)(7) specifically prohibited offset as part of the automatic stay.  The Strumpf case arose in the context of the statute as it existed prior to 2005.  Strumpf did not involve the IRS but rather a bank.  It came out of the Fourth Circuit which had previously held that the IRS violated the automatic stay when it froze a taxpayer’s refund after the filing of a bankruptcy petition.  In Strumpf the Supreme Court said that the bank could freeze a debtor’s account in the situation where the debtor had an outstanding liability to the bank.  It rejected the debtor’s argument that the freeze amounted to an offset which the automatic stay prohibited.  The Court stated:

In our view, petitioner’s action was not a setoff within the meaning of § 362(a)(7). Petitioner refused to pay its debt, not permanently and absolutely, but only while it sought relief under § 362(d) from the automatic stay. Whether that temporary refusal was otherwise wrongful is a separate matter-we do not consider, for example, respondent’s contention that the portion of the account subjected to the “administrative hold” exceeded the amount properly subject to setoff. All that concerns us here is whether the refusal was a setoff We think it was not, because-as evidenced by petitioner’s “Motion for Relief from Automatic Stay and for Setoff”-petitioner did not purport permanently to reduce respondent’s account balance by the amount of the defaulted loan.

That decision opened the door for the IRS to also freeze refunds.  The Strumpf case did not say, however, that a creditor could freeze the debtor’s money indefinitely.  It contemplated that the creditor freezing the funds would relatively promptly come to the bankruptcy court seeking a lifting of the automatic stay and showing the necessity to do so in order to adequately protect the interest of the creditor as a secured creditor in the amount of the debtor’s funds it held.

In 2019 a district court decision, Wells Fargo Bank, N.A. v. Weidenbenner (In re Weidenbenner), No. 15-CV-244 (KMK), 2019 WL 1856276, at *4 (S.D.N.Y. Apr. 24, 2019) showed the hazards facing creditors who froze funds and did not act promptly to resolve the account.

In the bankruptcy court, Mr. Waters argued that the freeze of his refund violated BC 362(a)(1)(2) & (6).  He did not argue that it violated BC 362(a)(7) perhaps because of Strumpf or for other reasons.  In a footnote the Second Circuit notes:

Here, the IRS never sought the bankruptcy court’s approval to put in place or maintain its approximately two-year freeze. On other facts, such a lengthy freeze — coupled with the IRS’s failure to seek court approval — might constitute a violation of the automatic stay. But we need not pursue that possibility here because, for the reasons stated in text, no such violation occurred in this case.

Maybe Mr. Waters could have succeeded in arguing for a stay violation had he pushed the issue under subparagraph (a)(7).  Instead, he correctly dropped his arguments about subparagraphs (a)(1) and (5) in the appeal before the Second Circuit.  His arguments on those subparagraphs could go nowhere because both of those subparagraphs needed the IRS to commence an action or proceeding against him or a lien creation.  That did not occur under these facts.

He moved forward arguing that the freeze violated subparagraph (a)(6).  Here the court finds that the freeze did not violate this paragraph saying:

The IRS’s administrative freeze also did not violate Section 362(a)(6) because, on the facts of this case, the freeze did not constitute an act to collect, assess, or recover a claim against Waters. To determine whether a creditor violates Section 362(a)(6), courts routinely look at two standards. Some, including the district court below, evaluate whether a creditor’s conduct was of a nature that “(1) could reasonably be expected to have a significant impact on the debtor’s determination as to whether to repay, and (2) is contrary to what a reasonable person would consider to be fair under the circumstances.”… Applying the first standard, the district court determined that the IRS’s conduct “merely maintained the status quo” and did not constitute an act to collect, assess, or recover a claim. In making this determination, the district court relied on undisputed facts that Waters’s amended tax return claiming refunds for most of the taxes he paid violated a 2002 bankruptcy court order and that the IRS’s freeze was necessary to prevent Waters’s circumvention of that order.

The Court’s decision makes sense and follows the finding in Strumpf.  The fact that Mr. Water’s violated a court order in filing his claim kept him from making something out of the delay by the IRS in seeking resolution of the freeze.  The violation of the order may also have been why the IRS did not feel the need to seek a speedy resolution of the freeze.

Today, the landscape is different.  In 2005 Congress amended the bankruptcy code.  It did not eliminate the automatic stay with respect to offset, leaving subparagraph (a)(7) in the code, but it added a subparagraph to 362(b) the section describing exceptions to the automatic stay.  BC 362(b)(26) now allows the IRS to offset a pre-petition refund against a pre-petition liability if the refund and the liability both result from the same type of tax, e.g., both derive from income taxes or both derive from employment taxes. 

In most cases today, the IRS does not need to freeze refunds because it can offset them.  Only where the refund results from a different type of tax does the IRS need to freeze it and go through the same type of steps it needed to follow prior to the changes to the bankruptcy code in 2005.  Because freezing is now relatively rare rather than routine, the possibility that the IRS would fail to move quickly to resolve the freeze would seem to be greater though I have not noticed cases suggesting that debtors have pursued the IRS for stay violations of this type.

The 2005 change does not allow the IRS to offset a post-petition refund against a pre-petition liability and neither would the Strumpf decision allow a freeze in this context.  So, there are still times where freezing could cause problems for the IRS but those situations occur much less frequently that the ones the 2005 change now permits.

First Circuit Looks at One Day Rule Again

I have written many times about the one day rule adopted by the First Circuit in the case of In re Fahey, 779 F.3d 1 (2015).  You can find earlier posts here and here (discussing the bankruptcy court decision in Kriss) with links in those posts to the many earlier ones.  This rule prevents a debtor from obtaining a discharge of taxes for a tax year if the debtor filed his taxes even one day late.  As I have written on many occasions, the rule makes no sense to me and could not have been what Congress intended.

Kriss v. United States (In re Kriss), No. 21-1206, 2022 WL 17100572 (1st Cir. Nov. 22, 2022) offers the First Circuit the chance to take another look at the issue.  On the brief for Mr. Kriss is John Pottow, a professor at Michigan Law School who has taken up the sword on this issue to try to get the law back on the right path.  Unfortunately, both the facts and prior history of the case prevent the reversal of First Circuit precedent sought in this case.  It did seem to me, however, that the First Circuit acknowledged that it may have gotten the law wrong in Fahey.

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Mr. Kriss failed to timely file his 1997 and 2000 tax returns.  The IRS assessed a liability against him for 1997 in March of 2003 using the substitute for return IRC 6020(b) procedures and in September of 2003 did the same for the year 2000.  The IRS began unsuccessful collection efforts.  The opinion states that Mr. Kriss submitted Forms 1040 for the two years in 2007 but does not say what liabilities were reported or, if he reported less than the amount assessed by the IRS using the substitute for return procedure, whether the IRS abated the amount due down to the liability reflected on the late filed Forms 1040.  Some balance due remained after the filing of the Forms 1040.

In 2012 Mr. Kriss filed a chapter 13 petition.  He remained in bankruptcy for the five year life of the plan receiving a discharge in 2017.  The bankruptcy and district courts, no doubt following the decision in Fahey, held that his discharge did not discharge the 1997 and 2000 taxes.

The First Circuit acknowledges that it has decided the issue of discharge in a late filed return; however, it notes that its decision in Fahey involved the taxes owed to Massachusetts and not to the United States.  It acknowledges that unlike Massachusetts, the IRS interprets the statutory provisions differently and considers “many late-filed federal returns to be returns within the meaning of section 523(a)(*).”

This sidesteps the issue Professor Pottow sought to litigate though giving a tip of the cap to those arguments:

Ultimately, we need not decide whether Fahey entirely applies to federal returns just as it applies to Massachusetts returns. Nor need we consider the cogent arguments well marshalled by Kriss on appeal for rethinking Fahey. Rather, even if Fahey does not control, Kriss loses because his much belated filings did not qualify as returns under section 523(a)(*) even under the alternative test put forward by Kriss in the bankruptcy court. See United States v. Lara, 970 F.3d 68, 78 (1st Cir. 2020) (“We need not decide which standard applies in this case, as [appellant’s] challenge fails under either standard.”); United States v. Burgos-Montes, 786 F.3d 92, 105 (1st Cir. 2015).

Mr. Kriss argues that his late filed returns meet the Beard test.  We have discussed that test here.  In essence his arguments seek to push aside any impact of section 523(*) and take the case back to the pre-2005 debate which the amendment to the statute was designed, though poorly written, to eliminate.  He argues that his late filing of the returns coming long after the IRS had already created substitutes for return was an honest and reasonable attempt to satisfy the filing requirement.  This is the argument accepted by the 8th Circuit in In re Colson, 446 F.3d 836 (8th Cir. 2006).  In the courts below he argued for a rejection of the one day rule based on the three circuit court decisions rejecting that rule: In re Justice, 817 F.3d 738 (11th Cir. 2016), In re Giacchi, 856 F.3d 244 (3d Cir. 2017), and In re Smith, 828 F.3d 1094 (9th Cir. 2016), all of which rejected the Colsen objective test.

Mr. Kriss changed his argument because he not only needed a rejection of the one day rule but he needed a rejection of the majority view that after the IRS has prepared a substitute for return it is too late for a debtor to meet the Beard test.  It is unfortunate that the facts of this case did not involve a taxpayer who filed late but before the IRS filed a substitute for return.  That would have presented a clean case for the First Circuit to reconsider its decision in the Fahey case.

The First Circuit rules against Mr. Kriss because the cases he cited rejecting the one day rule also reject granting a discharge in his circumstances and because he did not argue Colson below.  The Colson decision creates a test that is virtually impossible for the IRS to administer.  It sought a change in the statute trying to get a legislative rule that once it had made an assessment based on an unagreed substitute for return, the debtor could not later file a Form 1040 and have that treated as a return.  Instead, the IRS got legislative language that is unclear and has caused problems for the past 17 years.  The IRS has succeeded in convincing almost all courts that the Colson test does not work and is not the proper test.  It has succeeded in convincing the most recent circuits addressing the one day rule that such a rule is an improper interpretation of section 523(*).  It would be nice to have the Supreme Court weigh in on the issue and settle it once and for all in order to eliminate both circuit splits that exist.  Unfortunately, Mr. Kriss did not have the right facts nor make the right arguments below to bring this issue to the Supreme Court. 

The language of the First Circuit stating “nor need we consider the cogent arguments well marshalled by Kriss on appeal for rethinking Fahey,” makes me think that maybe it would reconsider Fahey if presented with the right facts properly argued below.  That would be good.  Even better would be a Supreme Court decision sustaining the position of the Third, Ninth and Eleventh Circuits.

Chapter 11 Confirmation and Lifting of Automatic Stay

In Cochran v. Commissioner, 159 T.C. No. 4 (2022) the Tax Court decided in a precedential opinion that confirmation of a chapter 11 plan of reorganization of an individual does not lift the automatic stay imposed by BC 362(a)(8).  The decision reverses an earlier Tax Court decision issued before a crucial change in the law.  This decision will impact a small minority of individuals.  The situation has a fairly easy work around in most cases but still deserves some attention as a precedential opinion of the Tax court.

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Each year debtors file a relatively tiny number of bankruptcy petitions under chapter 11 of the bankruptcy code. For the 12-month period ending Sept. 30, 2022, there were 4,762 chapter 11 bankruptcy filings. In contrast, there were 229,703 chapter 7 filings and and 149,077 chapter 13 filings. Individual chapter 11 filings make up only a fraction of the total number of chapter 11 cases. For the the 12-month period ending June 30, 2020, there were only 464 filings. Of that minuscule number of individual chapter 11 cases only a much smaller number will have a pending Tax Court case.  So, this decision has a limited universe of impacted individuals.

Individuals seeking to reorganize their debts typically file chapter 13 cases because it is easier and cheaper to do so; however, some individual debtors cannot file in chapter 13 because of the amount of debt they owe.  Chapter 13 places dollar limitations on the debtors who can seek relief under its provisions.  The individuals who do not qualify for chapter 13 because of debts in excess of the limits can nonetheless seek reorganization through chapter ll.  That’s what the Cochrans did here.

After filing their chapter 11 petition, the Cochrans took all of the actions necessary to obtain a confirmation of their chapter plan.  At issue in their Tax Court case is the impact of obtaining a confirmed plan.  While I mentioned at the outset that the case involves the automatic stay imposed by BC 362(a)(8), the relevant sections for determining the impact of the plan on this provision of the automatic stay are BC 1141(d)(5) addressing the effect of a chapter 11 confirmation and BC 362(c) addressing the termination of the automatic stay.

Starting with the central Bankruptcy Code section at issue, it’s helpful to understand that BC 362(a)(8) is a bit of an outlier in the list of eight things that the filing of a bankruptcy case brings to a halt.  The automatic stay seeks principally seeks to protect the bankruptcy estate.  Once a debtor files bankruptcy, the debtor has sent up large signal flares that severe financial troubles exist.  it would create havoc if these signals caused creditors to come in an start picking apart the debtor’s assets.  So, the automatic stay generally requires creditors to stand back in order to allow for an orderly disposition of the estate.  Subparagraph (a)(8) was a late legislative addition to the list of stayed actions and has a different tenor than the others.  The principle purpose of (a)(8) was to keep the debtor from abandoning a Tax Court case because of lack of financial concern for the outcome.  The stay gives the trustee time to come in and protect the interest of all creditors by pursuing the case or, alternatively, postponing the Tax Court case so that the outcome is of concern to the post-petition debtor and no other creditors of the estate.

The reason for the existence of the stay, I think, drove the arguments of the petitioner in this case.  The Tax Court describes their argument as follows:

Petitioners also broadly cite Kovitch v. Commissioner, 128 T.C. 108, 112 (2007), People Place Auto Hand Carwash, LLC v. Commissioner, 126 T.C. 359, 363 (2006), and 1983 Western Reserve Oil & Gas Co. v. Commissioner, 95 T.C. 51, 57 (1990), aff’d, 995 F.2d 235 (9th Cir. 1993), for the proposition that an automatic stay under 11 U.S.C. § 362(a)(8) “should not apply unless the Tax Court proceeding possibly would affect the tax liability of the debtor in bankruptcy.”

The Court responded by stating:

These cases are distinguishable on the basis that they were concerned with ascertaining which entities related to a debtor should fall within the scope of 11 U.S.C. § 362(a).

Both the Court and the petitioners are right.  The Court is technically right that it does make a difference whether the debtor is an individual or an entity because the discharge provisions and there for the provisions dealing with the end of the automatic stay differ.  The petitioners are right that the reason for the creation of the automatic stay makes no difference in this case.  Since moving forward with the Tax Court case at this point does nothing to preserve the assets of the case or protect the petitioners as debtors, there is no point to using the automatic stay to keep the Tax Court case from proceeding.  The decision here, however, follows a unbroken line of Tax Court decisions strictly limiting its ability to move forward due to (a)(8) until a technical lifting of the stay occurs even if the stay does nothing to protect the debtor or the estate in the specific context of the case.

So, we have a code section that the Tax Court strictly interprets and one that says Tax Court cases stop when the automatic stay exists.  The parties agree that the automatic stay came into existence with the filing of the bankruptcy petition.  The legal disagreement, aside from the policy disagree discussed above, is the impact of the confirmation of the petitioner’s chapter 11 plan on the automatic stay.  The Tax Court gets the impact precisely right in a relatively short opinion. 

Under the version of the Bankruptcy Code enacted in 1978, the plan confirmation lifted the stay.  That outcome was reflected in the Tax Court’s earlier decision on this issue in Moody v. Commissioner, 95 T.C. 655, 658 (1990).  However, in 2005, during the last major change to the bankruptcy laws, Congress amended the relevant bankruptcy code section regarding the effect of plan confirmation in individual chapter 11 cases because of other changes it made principally regarding discharge.  It amended BC 1141(d)(5) addressing the impact of plan confirmation of the plan of individual debtors.  The provision now says confirmation does not discharge the individual’s debts and that discharge will not occur until some later time.

The amendment to the impact of the confirmed plan has an impact on when the stay comes to an end.  As already mention the stay came into effect with the filing of the bankruptcy petition.  In order to get around the prohibition of BC 362(a)(8), the Tax Court is looking to see if the stay has lifted to allow the case to move forward.  BC 362(c) provides the rules regarding the lifting of the stay and states that the stay is lifted at the earliest of the closing of the bankruptcy case, the dismissal of the bankruptcy case or the granting or denial of a discharge to the debtor. 

With the change to the effect of confirmation in an individual case, the plan confirmation does not impact discharge.  The confirmation of a plan does not close or dismiss the bankruptcy case.  So, nothing had happened in the Cochran’s bankruptcy case to trigger a lifting of the stay and BC 362(a)(8) sits there stopping the Tax Court case from moving forward even though at this point the Tax Court case will have no adverse impact on the bankruptcy.  The decision while technically correct does not serve any real purpose.

Instead of fighting about this with the Tax Court, it should be fairly easy in these type situations to convince the bankruptcy court to enter a specific order lifting the stay to allow the Tax Court case to move forward.  That’s the workaround.

Congress might consider putting more effort into drafting BC 362(a)(8) to define the situations in which the stay applies to the Tax Court in a way that has it apply only when it would be meaningful to do so.  I suspect, aside from the fact there is a relatively easy work around in most cases to this problem, Congress simply feels it has more important things to do.

Debts Owed by Insolvent Taxpayers to the IRS

As we have mentioned on many occasions, Les suggested that we start this blog because of the work we do to update the treatise “IRS Practice and Procedure.”  At the moment Marilyn Ames, my former colleague in IRS Chief Counsel and occasional guest blogger, and I are updating and rewriting Chapter 16 of the treatise dealing with the priority of IRS debtor over other creditors.  In updating the chapter Marilyn found several important cases in the area of the priority of IRS debt for insolvent debtors which we have not written about on the blog.  In this post she discusses several of these cases as well as the general background of the insolvency procedures.  For those of you who use the treatise or who may consider using it in the future, look for major changes to Chapter 16, including major changes to the bankruptcy section, in the next several months.  Keith

Lurking in Title 31 of the United States Code is an unpleasant surprise for all creditors whose debtor also owes a debt to the United States.  This provision, located at 31 USC § 3713 and known as the Federal Priority Statute, has been in force without material change since 1797, and was held to be constitutional in 1805 in United States v. Fisher, 6 US 358 (1805). This statute provides that when a person indebted to the United States is insolvent and some action occurs such as the debtor making a voluntary assignment of his property that threatens the government’s ability to collect its debt, or when a deceased debtor dies and the property of the estate is insufficient to pay all the debts of the debtor, the claim of the United States is to be paid first. Section 3713 does not create a lien; the government’s priority is created solely by the statute. The only statutory exception in Section 3713 was added when the Bankruptcy Code was passed to provide that Section 3713 does not apply in a bankruptcy case brought under Title 11.

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To create an incentive for the United States to receive its priority payment, the fiduciary holding the property of the person or administering the debtor’s estate can be held personally liable if the claim of the United States cannot be paid in full after the fiduciary pays any other debt over which the United States’ claim has priority, provided the fiduciary knew about the debt to the United States when the payment to a lesser creditor was made.

When the claim owed to the United States originates within the Internal Revenue Code, Section 3713 is not as easily applied as appears on its face. Congress later provided protection to third parties, including creditors, against the vast reach of the federal tax lien that arises when a tax debt has been assessed and remains unpaid when it passed the Federal Tax Lien Act of 1966, codified in Section 6324.  In Section 6324 of the Internal Revenue Code, Congress listed various parties who should be given a priority position against a tax debt. So, when the stars align and both the United States and a private creditor claim priority to a debtor’s limited assets under these competing statutes, who should be paid first? In United States v. Romani, 523 US 517 (1998), the Supreme Court addressed this and held that Section 6324 represented Congress’s judgment as to when a federal lien for unpaid taxes is not valid against certain third parties, and that Section 3713 should yield to this later Congressional act when there is not enough money to pay both the United States and the third party.

The courts have also created judicial exceptions that limit the reach of the Federal Priority Act.  The costs of administering the estate of the debtor may be paid before a tax claim, including such expenses as court costs and reasonable compensation for the fiduciary and other professionals such as attorneys. Funeral expenses and spousal allowances have also been allowed before the government’s claim. However, in United States v. McNicol, 118 AFTR2d 2015-5150, 829 F3d 77 (1st Cir. 2016), the court held that the fiduciary must be able to show that the property transferred was used to pay these expenses.

So what is a fiduciary to do when it is unclear who the debtor’s limited funds should go to? One popular remedy is to file an interpleader action, joining all possible adverse claimants to the funds, and allow the court to sort out the priorities. This procedure is illustrated in the case of Karen Field, Trustee of Deshon Revocable Trust v. United States, 129 AFTR2d 2022-1007 (ED Ca. 2022), in which the court determined who had priority to the funds and in what order the claims should be paid – or remain unpaid. In this case, the decedent had embezzled funds, taxes were owed on the embezzled money to both the federal and state governments, and the victims of the embezzlement wanted to be repaid. The Department of Justice Tax Division has a directive that when the tax claim and the claim of the victims of embezzlement arise from the same transaction and the funds at issue can be traced to the victims’ property the victims should be paid before the tax claim. Despite this directive, the court applied Section 3713 and gave the tax claim priority, holding that the directive in question is merely internal agency policy, and not a source of enforceable legal rights for the victims.  The procedural aspects of an interpleader action are also illustrated in Findling v. United States, 121 AFTR2d 2018-1450 (ED Mich. 2018).

In another case involving government policy, the court took a contrary position in Estate of Graham v. Wells Fargo Bank, 2022 WL 2300940 (Cal. App. 3 Dist. 2022), when the executor of an estate asked the trial court to determine the order in which the proceeds from sale of a piece of estate property should be distributed.  The executor requested that the federal taxes be paid first pursuant to Section 3713, but the court held that the federal taxes did not take priority over a purchase money security interest with respect to the property in question. Although Section 6324 says nothing about purchase money security interests, the Service announced in Rev. Rul. 68-57, 1968-1 CB 553 (1968) that a perfected security would be given priority over a federal tax lien with respect to the property the loan was used to acquire. Accordingly, the claim of the bank advancing the money for purchase of the property should be paid before the federal tax liability.

The potential danger to a fiduciary in not paying a tax claim entitled to priority is illustrated in the recent case of Estate of Lee v. Comm’r of Internal Revenue, 2022 WL 3594523 (3rd Cir. 2022), a CDP case in which 3713 played a pivotal role.  The estate taxes owed by the petitioner in this case had been miscalculated, resulting in a deficiency, and the estate requested that the Internal Revenue Service accept an offer-in-compromise as the estate assets had been distributed to the beneficiaries, including over $640,000 paid out after the notice of deficiency was issued.  The Service rejected the offer made, taking the position that the reasonable collection probability was greater than the amount offered.  The Tax Court agreed that the IRS did not abuse its discretion in rejecting the OIC, and the Third Circuit agreed, pointing out that the government could seek to collect from the fiduciary, who had distributed assets after learning of the tax claim and so could be held personally liable.

For a statute that clearly states that the United States should be paid first, and that a fiduciary who fails to do so may need to pay the claim from the fiduciary’s funds, Section 3713 is not as clear as a mere reading would make it seem.  Given the holding in Estate of Romani, the judicially created exceptions for administrative expenses, and the question of whether a government policy directive waiving the right to payment first applies – or doesn’t – any professional even dealing tangentially with insolvent debtors or estates should be familiar with the existence of Section 3713 and its implications on when the United States should be paid before other creditors.

Tracing Social Security Payments          

Social security funds provide a safety net for recipients and generally receive protected status from creditors.  The case of In re Weber, 130 AFTR2d 2022-5161 (Bankr. M.D. Fla. 2022) examines what happens to social security payments when the taxpayer uses them to pay federal income taxes and then receives a refund partially based on the social security payments.  The bankruptcy court allowed Mr. Weber to shield the portion of his tax refund which represented the return of his social security payments citing to 42 USC 407.  The decision speaks to the power of the exemption of social security funds from private creditors.

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Mr. Weber filed a chapter 7 bankruptcy petition in February of 2022.  At issue is his 2021 income tax refund which the trustee seeks to claim as an asset for the benefit of the general unsecured creditors of the bankruptcy estate.  Mr. Weber argues that a substantial portion of the refund resulted from his decision to have money withheld from his monthly social security payments to pay federal taxes.  He overestimated what his federal tax obligation for 2021 would be for reasons not explained in the opinion.  Mr. Weber’s position is that just because he had a portion of his social security payment used to pay an anticipated federal tax liability did not change the character of the funds to such a degree that they lost the protection afforded to social security payments.

You might ask why Mr. Weber had any taxes withheld from his social security payments.  The opinion indicates that he had a part time job as an employee.  The income from that job in 2021 was only $378.00 per month.  Based on that level of income, he would not have triggered any of his social security payments to become taxable, and he could have used wage withholding from the job to cover any taxes from his employment.  The facts suggest that his decision to withhold from his social security in 2022 was unnecessary.  We are not given information about prior years when his wages could have been higher and could have come from work as an independent contractor rather than an employee.  Higher income could have triggered tax on a portion of his social security payments making the withholding of a portion of the payment logical.  If he worked as an independent contractor, he might have found it simpler to have some of this social security payments withheld than to make quarterly estimated tax payments.  We just don’t have enough information to evaluate his thought process in having the withholding.  We do know that he overwithheld from his social security payments and that a significant portion of his 2021 refund resulted specifically from that withholding.

The trustee argued that once Mr. Weber’s social security payment went to the IRS as withholding for payment of taxes it lost its character as a protected social security payment and transformed into simply a tax payment the refund of which the trustee could reach for the benefit of the estate.  The trustee’s position is supported by the decision of the bankruptcy court in In re Crutch, 565 B.R. 36 [119 AFTR 2d 2017-1428] (Bankr. E.D.N.Y. 2017).

The bankruptcy court in Mr. Weber’s case stated:

Under 42 U.S.C. § 407, social security benefits are not subject to execution, levy, attachment, garnishment, or other legal process, and no other provision of law may limit or modify the exemption from execution except by express reference to the statute.

It acknowledged the Crutch decision but cited to another bankruptcy court decision, In re Spolarich, 2009 WL 10267351 (Bankr. N.D. Ind. Sept. 30, 2009), which it found more persuasive.  The court in Spolarich found the protection for Social Security payments exceptionally expansive and only subject to modification by express statute.  It determined that when a social security recipient uses a portion of that payment for tax withholding, the individual’s consent to the use of those funds extends only to the payment of tax liabilities and not to the payment of other claims stating:

[B]y the clear language of 26 U.S.C. §§ 3402(p)(1), the election to withhold [funds from social security payments] benefits only the Internal Revenue Service, and does not constitute a general waiver of the protections of § 407(a) with respect to Social Security benefits vis-à-vis other entities.

The bankruptcy court in Mr. Weber’s case agreed with the analysis in Spolarich and allowed him to exempt that portion of his 2021 tax refund traceable to the withholding of his social security payments.

We have discussed tracing of payments exempt from IRS levy in several posts.  This post written by Les discusses the issue and links to earlier post which also discussed the character of a protected payment once moved to an unprotected source. The issue of tracing arises in many contexts.  While the language of the social security statute may be particularly strong, the analysis here may be useful in other settings.  The policy issue of when a protected payment loses its special status is one worth considering.  If the Weber court got it right should the language of 42 USC 407 serve as a model for other statutes in which taxpayers receive payments protected from levies?  Can Weber assist taxpayers trying to fend off a levy to their bank account find assistance from the approach here?

Court Awards Damages When IRS Tried To Collect Following Discharge: Pandemic No Excuse

McAuliffe v United States involves IRS mistakenly sending collection letters following a bankruptcy discharge. Following bankruptcy, IRS opens itself up to damages claims if an IRS employee willfully violates the effect of a discharge or an automatic stay.

McAuliffe concludes that the pandemic does not excuse the IRS from failing to update its records; nor does the automatic nature of the collection process, which arguably severed the actions from any one misbehaving IRS employee. While the opinion finds the IRS actions willful, it notes that unlike with other misbehaving private creditors who fail to respect a discharge, the court has little discretion over the amount of damages it can award.

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In McAuliffe the husband and wife were co-debtors in a Chapter 13 case they filed in 2016. The IRS asserted a claim for $13,624.58 relating to tax years 2010 and 2011, of which $7,230.78 was secured. Prior to the bankruptcy, the taxpayers had entered into an installment agreement, but as per the Chapter 13 case, they terminated the agreement and paid the debts through their repayment plan. The taxpayers/debtors received a discharge on September 24, 2019. As an unsecured creditor, the IRS received a 22% distribution on the $6,393.80 unsecured portion of the claim.

Things went awry after the discharge. On February 5 and March 4, 2020, the IRS sent the McAuliffes two demand letters seeking to collect the liabilities from the discharged 2010 and 2011 tax years. On March 20, 2020, Mr. McAuliffe, a bankruptcy attorney, sent the IRS a letter addressed to the IRS’s Cincinnati Service Center advising the IRS of the discharge. On August 15, 2020, the McAuliffes received another IRS collection letter, leading to their filing a motion to reopen the bankruptcy case.

The IRS did eventually acknowledge McAuliffe’s March 2020 letter, with a September 29, 2020 letter stating it would need sixty days to review the liability. Despite the letter stating that IRS needed to review the account, on September 28, 2020, IRS actually abated the assessment.

In addition to the liabilities that were covered by the discharge, the McAuliffes also owed on their 2018 tax year. The taxpayers asserted that the IRS’s mistaken belief that the McAuliffes still owed for the discharged years led to a delay in setting up an installment agreement for the 2018 liability, which led the IRS to issue a soft notice of intent to levy, threatening to seize state tax refunds.

What led to the delay in updating its account to reflect the discharge and the six-month delay in responding to McAuliffe’s March 2020 letter? IRS blamed the combination of COVID and McAuliffe sending the correspondence to the Cincinnati Service Center rather than a bankruptcy specialist.

All of this factual background leads to the main issues in the case: whether the IRS is liable for damages and if so, how much?

Is IRS Liable for Damages?

In light of the IRS actions, the debtors reopened the bankruptcy case, and sought damages under Section 7433(e) for the IRS’s mistakes. That case was stayed pending a possible administrative resolution. The IRS and the McAuliffes failed to resolve the matter within six months, teeing the matter up for the bankruptcy court.

To find a violation of 7433(e) a debtor must show by clear and convincing evidence that the IRS “had knowledge [actual or constructive] of the discharge and willfully violated it by continuing with the activity complained of.”  IRS raised a number of arguments in support of its position that the actions were not willful.

First, IRS argued that the court needed to find that a specific employee willfully violated the discharge order, rather than the entity as a whole.  Moreover, IRS, in arguing that there was no willful violation, cited to cases where courts concluded that clerical errors alone were insufficient to justify finding damages:

The IRS’s attempts to characterize the actions here as “inadvertent” in light of these cases is unpersuasive. While the IRS here failed for nearly twelve months to enter the discharge in its systems, the debtors on their own behalf called and mailed multiple notices to correct the issue. The IRS instead disregarded these warnings and continued direct attempts to collect the discharged debts.

The opinion also rejected the IRS’s attempt to deflect blame by pointing to the taxpayer’s failure to contact an IRS bankruptcy specialist rather than the IRS office that issued the collection letters:

It contravenes common sense to require a debtor who receives a notice from Cincinnati to direct a response to a Richmond office involved in the bankruptcy claim filed four years prior rather than responding directly to the office from which he received the communications.

The IRS then argued that its automatic collection notices should not be viewed as collection action, a contention the court rejected:

The IRS contends that these letters were non-threatening and should not be seen as an attempt to collect. This court disagrees. The letters state a monthly payment due immediately and threaten default if no payment is made. Further, none of the letters included a disclaimer that they are not an attempt to collect. This surely gives the appearance of an attempt to collect, whether sent to a layperson or a well-experienced bankruptcy attorney and his spouse. The court agrees with the Plaintiff that these letters serve no purpose other than to collect discharged personal liabilities.

IRS also argued that the automatic nature of the notices removed them from any one IRS employee, and thus should insulate the agency from sanctions designed to punish the agency for its employee’s misconduct:

The IRS is a federal agency within the executive branch and serves an extremely important mission. If employees and automated systems in the Cincinnati office are disconnected from the interactions of other offices, the resulting shortcomings should not be attributed to the affected Plaintiff, but to the agency responsible.

As to COVID, the court was sympathetic, but noted that there was plenty of time following the discharge and before the pandemic hit for IRS to get the taxpayers’ account fixed:

While COVID-19 is having a significant impact on all levels of the federal government, it does not excuse repeated attempts to collect on a Plaintiff doing everything possible to correct any miscommunications. At the time when the serious impacts of the COVID-19 pandemic reached the United States in March 2020, the Plaintiff was nearly six months post-discharge and the IRS still had not properly applied the discharge order to the couple’s federal tax accounts. Further, the IRS had already mailed the first two automated notices.

While perhaps one mistaken notice might not have led to a finding of liability, the repeated notices that lasted almost a year after discharge, combined with multiple taxpayer attempts to halt the collection action, led the court to conclude that the IRS’s actions were willful.

What Damages?

McAuliffe sought court costs and legal fees and damages relating to the unlawful collection attempts. The court noted that Section 7433 is the exclusive remedy for IRS failure to respect a discharge order, unlike that for other creditors, where the bankruptcy code provides more discretion. Under 7433(e), courts generally look to actual pecuniary damages, plus costs and possibly legal fees, but the awarding of fees under Section 7433 is controlled by Section 7430. (Note that Saltzman and Book, IRS Practice & Procedure, courtesy of Keith, has an extensive discussion of damages relating to wrongful collection).

As to legal fees, Mr. McAuliffe represented his wife in the proceeding, and did not charge her for the representation. He had previously been a party to the reopened bankruptcy case, but as the opinion notes, he dismissed himself as a party on the eve of the evidentiary hearing. He likely did so due to McPherson v US, unfavorable Fourth Circuit precedent under Section 7430, which bars recovery of legal fees for pro se litigants.

Instead, Mr. McAuliffe argued that he should be compensated because after his dismissal his representation of his wife resulted in lost business opportunities due to the time spent representing his wife. He also sought to distinguish the precedent that barred recovery from pro se litigants because following his dismissal he was technically no longer a pro se litigant.

The court found the lost opportunity argument too speculative, and in so doing noted that unlike cases more liberally awarding of fees purely under the bankruptcy code, its hands were tied:

The court realizes the annoyance and outright inconvenience that the Plaintiff and her husband may have suffered as a result of the IRS’s disregard for the discharge order (whether intentional or inadvertent), but any discretion which it would otherwise be afforded by the Bankruptcy Code is severely limited by relevant Tax Code provisions herein referenced.

As to his attempt to distinguish the adverse legal fee precedent, the court did not bite:

Put simply, McPherson is binding precedent in this circuit. While McAuliffe argues that the opinion applies only where an attorney seeks compensation for pro se representation, this conflation is misplaced. This court does not read the statute to apply solely to pro se representation, but applies it more broadly to the situation where the challenger seeks recovery of legal fees and no out of pocket legal expenses are incurred. Assuming for purposes of this analysis that the IRS’s position was not substantially justified, the Plaintiff nevertheless did not pay any out-of-pocket costs which would allow recovery of legal fees under 26 U.S.C. § 7430 and the precedent established in this circuit by McPherson.

As to other damages, McAuliffe argued that they felt pressure from the IRS’s issuance of notice of intent to levy relating to another year’s tax liability, leading them to accept the first offer on the sale of their house for an amount $15,000 less than its market value. The sale of the house occurred in 2021, a year after the IRS abated the assessment and unwound its mistaken failure to reflect the discharge. While it is likely that the IRS errors on the discharged debt may have led to a delay in a later year installment agreement, “the home sale a full year after the abatement is too distant in time and nature to attribute any possible damages to the discharge violation.”

The court did award the McAuliffe’s damages relating to interest and delinquency penalties on their 2018 liability. Despite 2018 not being before the court, the opinion notes that the mistake to respect the discharge of 2010 and 2011 liabilities led the IRS to be “uncooperative with the couple and unwilling to enter into any such agreement until approximately nineteen months after the original request was made. For eight months beyond the initial request (and more than a year past the discharge order) this uncooperativeness was attributable, in part or in whole, to the mistaken belief that the debtors still owed debts from 2010 and 2011.”

IRS argued that he 2018 debt was outside the court’s jurisdiction and subject to the Anti-Injunction Act.  The court disagreed, noting that it was not restraining the assessment or collection of the 2018 liability but finding that “any interest and missed payment penalties accrued from the initial March 2020 notice letter until the IRS’ eventual acceptance of the couple’s settlement offer are actual pecuniary damages that resulted from the IRS’s violation of the discharge order.”  The delay, according to the court, resulted in about an additional $500 in interest and delinquency penalties, which the court awarded to McAuliffe.

Conclusion

The McAuliffe opinion is interesting on a number of levels. The opinion discounts the government’s excuses for its mistakes. The court expects the multiple IRS offices involved with the case to communicate with each other. The court squarely rejects the IRS attempt to lean on the automated nature of the collection process to avoid liability, and it holds the IRS responsible for its delay when the taxpayers tried in good faith to inform the IRS that its actions were mistaken. While COVID complicates the question of fault, there were enough IRS mistakes prior to the pandemic to justify a finding of liability.

At the end of the day, McAuliffe walked away with not much in damages, and I suspect that case was brought mostly for the denied recovery of legal fees. While maybe it will not make the McAuliffes content, the opinion reflects judicial disapproval of the IRS and a shared frustration that the IRS should have done better.