The Internal Revenue Service cannot be held liable for violating the discharge injunction unless the debtor has exhausted administrative remedies, according to Chief Bankruptcy Judge Cecelia Morris of Poughkeepsie, N.Y.

On the other hand, a collection agent for the IRS is not similarly protected if the taxpayer-debtor did not exhaust administrative remedies.

Curiously, neither the IRS nor its collection agent raised Taggart v. Lorenzen as a defense. Had they done so, both may have been off the hook completely because they had a reasonable basis for contending that the taxes at issue had not been discharged. 

The Long-Overdue Taxes

The debtor didn’t file a return or pay taxes for 2002 and many other years. The IRS filed a substitute return in 2005. The debtor filed his 1040 about two years later. Subsequently, the IRS treated the debtor’s return as being accurate.

The debtor filed a chapter 13 petition in 2013, listing his tax debts. The IRS filed a proof of claim for about $23,000, asserting that some $1,300 was a priority tax debt and the remainder was an unsecured, nonpriority claim.

The court confirmed the debtor’s three-year plan that paid the priority claim in full and gave the IRS a pro rata payment on the unsecured claim. The debtor completed his payments and received a discharge in 2016. The IRS received notices of the filing and the discharge.

The IRS assigned the 2002 taxes to a collection agent. Beginning in 2017 and continuing for about two years, the collection agent sent the notices demanding payment of the 2002 tax debt. After receiving the first demand, the debtor’s counsel sent the IRS a letter explaining the automatic stay (not the discharge injunction) and demanding the cessation of collection activities.

The debtor reopened his case and filed a motion to hold the IRS and the collection agent in contempt of the discharge injunction.

Exhaustion of Administrative Remedies

Under Section 7433(d) of the IRS Code, the IRS said there could be no damages for violation of the discharge injunction under Section 524(a) of the Bankruptcy Code because the debtor had not exhausted administrative remedies within the IRS.

On the other side of the fence, the debtor argued that Section 106(a) waived the government’s sovereign immunity with regard to discharge under Section 524(a). The debtor also relied on Section 106(b), which says that the filing of a claim by a governmental unit waives immunity for any claim against the government “that arose out of the same transaction or occurrence . . . .”

Judge Morris agreed with the IRS. To give effect to both statutes, Judge Morris held that the IRS could not be saddled with contempt sanctions because the debtor had not exhausted administrative remedies.

The collection agent was not so lucky. “As a private contractor,” the agent “is not afforded the same protections as the IRS for violation of the discharge injunction,” Judge Morris said in ruling that the agent could be liable for damages.

Were the Taxes Discharged?

The IRS and the agent contended there was no contempt of the discharge injunction because the 2002 taxes were not discharged. The issue turned on the so-called one-day-late rule based on the hanging paragraph in Section 523(a).

On the one-day-late rule, the circuits are split, but the Second Circuit has not spoken.

The Third, Fourth, Sixth, Seventh, Eighth and Eleventh Circuits employ the four-part Beard test, named for a 1984 Tax Court decision. Beard v. Commissioner of IRS, 82 T.C. 766 (1984), aff’d, 793 F.2d 139 (6th Cir. 1986). Following Beard, it’s possible — but not automatic — to discharge the debt on a late-filed tax return.

The First, Fifth and Tenth Circuits hold that a tax debt never can be discharged as a consequence of the hanging paragraph in Section 523(a) if the underlying tax return was filed even one day late. To read an ABI report about a recent circuit court case on the split, click here.

After extensive analysis, Judge Morris employed the Beard test, where only the fourth prong was in question. Because the IRS had effectively conceded that the debtor’s late-filed return was accurate, Judge Morris concluded that it was an honest and reasonable attempt to comply with tax law. The 2002 tax debt was therefore discharged.

Was There a Discharge Violation?

With notice of the plan and discharge, Judge Morris found clear and convincing evidence that the collection agent violated discharge. She imposed a sanction of about $3,650 on the collection agent, including the debtor’s attorneys’ fees and $500 for each notice that violated discharge.

Briefs filed in the case indicate that neither the IRS nor the collection agent raised a potential defense under Taggart v. Lorenzen, 139 S. Ct. 1795, 1799 (June 3, 2019), where the Supreme Court held that a court “may impose civil contempt sanctions [for violating the discharge injunction] when there is no objectively reasonable basis for concluding that the creditor’s conduct might be lawful under the discharge order.”

In the case before Judge Morris, there would seem to be a reasonable basis for believing that the 2002 tax debt was not discharged because (1) the return was filed years late, (2) the circuits are split on the one-day-late rule, and (3) the Second Circuit has not taken sides on the issues.

Is Taggart a defense that a defendant is required to raise? For not having raised the issue, did the IRS and the collection agent waive the defense? Or, is Taggart an element of the contempt claim that the debtor must plead and prove?

Could the collection agent raise the defense for the first time on appeal? Must a debtor anticipate the Taggart defense and allege facts to show there could be no good faith belief that the act didn’t violate the discharge injunction? We’ll let you decide these questions.