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

Posted on June 6, 2022

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.

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.

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