Over a comprehensive dissent, the First Circuit ruled that the Internal Revenue Service intentionally violates the discharge injunction when an IRS employee knows there was a discharge but nonetheless “takes an intentional action” later found to violate the discharge, even if the IRS had a good faith belief that its action did not violate the discharge.
The First Circuit’s June 7 opinion represents a stark split with a decision handed down by the Ninth Circuit less than seven weeks ago: Lorenzen v. Taggart (In re Taggart), 888 F.3d 438 (9th Cir. April 23, 2018), petition for panel rehearing and rehearing en banc filed June 6, 2018. Although the First Circuit dissent cited Taggart, the majority did not.
The First Circuit’s dissent underscores an arguably longstanding circuit split on the question of whether good faith is a defense to an alleged violation of the discharge injunction.
The majority opinion for the First Circuit, holding that good faith is not a defense to contempt, was written by Circuit Judge Norman H. Stahl. Joining the majority opinion was retired Supreme Court Associate Justice David H. Souter, sitting by designation. The dissent was by Circuit Judge Sandra L. Lynch.
The Facts in the First Circuit
The debtor filed a chapter 7 petition and received a discharge. The IRS was aware of the discharge.
Among his $600,000 in total debt, the debtor owed the IRS about $550,000 in taxes. The IRS had a good faith basis for believing that the taxes were not dischargeable under Section 523(a)(1)(C) because the debtor, allegedly, had willfully attempted to evade payment of the taxes. The IRS therefore took the position that the tax debt was not automatically discharged under Section 523(c)(1). Thus, the IRS did not object to the dischargeability of the debt before the debtor received his general discharge.
After entry of the general discharge, the IRS repeatedly notified the debtor of its belief that the taxes were not automatically discharged. After the IRS eventually levied against an account receivable owing to the debtor, he filed an adversary proceeding in bankruptcy court seeking a declaration that the debt indeed had been discharged. Allegedly because of mental infirmities afflicting the assistant U.S. Attorney (AUSA) who represented the IRS, the government presented insufficient evidence, leading the bankruptcy judge to grant summary judgment declaring that the taxes were discharged. The IRS did not appeal the ruling that the debt was discharged.
The debtor later filed a complaint against the IRS under 26 U.S.C. § 7433(e), seeking sanctions for willful violation of the discharge injunction by issuing levies against his assets. In defense, the IRS argued there was no willful violation because the government reasonably believed that the debt was not discharged.
The bankruptcy judge found a willful violation and ruled in favor of the debtor. On appeal, the district court remanded for the bankruptcy court to consider the AUSA’s mental impairment.
On remand, the IRS and the debtor reached a partial settlement narrowing the issues. To avoid extensive litigation over the AUSA’s mental impairment and whether his impairment would give the government a defense, the IRS agreed that the debtor could have $175,000 in damages if an appellate court ultimately were to rule that a reasonable belief that the debt was excepted from discharge was not a defense to contempt.
The bankruptcy court decided that good faith was not a defense and ruled against the IRS. The district court affirmed, and the IRS appealed.
The Majority Opinion
Given the stipulation limiting the issue on appeal, Judge Stahl said the appeals court would decide whether the IRS’s good faith belief meant there was no willful violation of the discharge injunction under Section 7433(e).
Adopted in 1998, Section 7433(e) allows a taxpayer to recover damages from the U.S. if the IRS, in connection with the collection of taxes, “willfully violates any provision of” the automatic stay under Section 362 of the Bankruptcy Code or Section 524 and its injunction barring the collection of discharged debt.
Judge Stahl said that the statute defines neither “willfully” nor the phrase “willfully violates.” To find a meaning for the terms, he surveyed the definition given those words by the circuit courts when the statute was adopted in 1998.
Although the dissenter disagreed about unanimity among the courts of appeals, Judge Stahl said that the circuit courts agreed that the “phrase ‘willful violation’ had an established meaning in the context of violations of the automatic stays [sic] as of 1998: a creditor willfully violated the automatic stay if it knew of the automatic stay and took an intentional action that violated the automatic stay. A good faith belief in a right to the property was not relevant to determining whether the creditor’s violation was willful.”
Judge Stahl next concluded that Congress intended to give the same meaning to violations of the discharge injunction, in part because “the plain language of Section 7433(e) does not distinguish between” violations of the automatic stay and discharge.
Although Judge Stahl said he was relying “primarily” on what Congress understood “willful violation” to mean in 1998 on adopting Section 7433(e), he said that later First Circuit decisions hewed to the same definition for violations of both the automatic stay and the discharge injunction.
Although the dissenter disagreed, Judge Stahl said that his definition of “willful violation” did not entail an overbroad interpretation of the wavier of sovereign immunity in Section 7433(e).
The IRS contended that Judge Stahl’s interpretation would force the government to seek a declaration about the dischargeability of debts for tax fraud, even though Section 523(a)(1)(C) excepts them from discharge automatically.
Judge Stahl rejected the argument, finding “policy considerations” against “allowing the IRS to attempt to collect purportedly discharged debts without facing potential consequences.” He said the IRS had several alternatives.
First, the IRS could have filed an objection to the dischargeability of the debt, although it was not required to do so before the entry of the general discharge. Second, the IRS could have filed an adversary proceeding and sought a declaration about dischargeability before beginning collection activity.
Third, the IRS could have attempted to collect the debt, as it had done in the case at bar, and gamble that the bankruptcy court would find for the government and rule that the taxes were not discharged.
The Dissent
In dissent, Judge Lynch said that her panel was handing down the first circuit court opinion construing “willfully violates” in Section 7433(e). The majority, she said, “gets this one wrong.”
Judge Lynch said her circuit was the first to deprive the government of sovereign immunity when acting “on a reasonable and good faith belief.” In Section 7433(e), she found no indication of a waiver of immunity “where the IRS acts reasonably and in good faith,” even if the belief turns out to be erroneous.
Rather than following circuit law, Judge Lynch would have adopted the approach of the Supreme Court where she said the justices held in the context of Section 523 that a willful injury includes only acts that “were specifically intended to cause injury, not all intentional acts that resulted in injury.”
Of special significance, Judge Lynch disagreed with the majority’s statement that the circuits were in agreement before 1998. Although the majority opinion reflected the holding of seven circuits, she said that the First, Fifth and Sixth Circuits would allow a good faith defense to an alleged willful stay violation. Where she said the “majority attempts to deny the existence of this circuit split,” Judge Lynch said that those three circuits “had held that the mere knowledge of a stay was insufficient to show a ‘willful violation.’”
In addition to older authority from those three circuits, she cited Taggart, decided by the Ninth Circuit on April 23. She read the Ninth Circuit as allowing a good faith defense. “Indeed,” she said, “the Ninth Circuit does not even impose a reasonableness requirement.” For ABI’s discussion of Taggart, click here.
Judge Lynch placed significant reliance on Section 523(a)(1)(C), which does not “require the IRS to first obtain a judicial determination that an exception to discharge applies.” The subsection, she said, “means that Congress chose not to require that the IRS seek a pre-collection determination from the bankruptcy court.” [Emphasis in original.]
“Given that Congress created this exception to discharge and did not require the IRS to seek a pre-collection determination that the tax debts are not dischargeable, there is no reason to say that the IRS should incur the risk of having damages found against it even if it acted on a reasonable and good faith belief,” Judge Lynch said.
Are There Grounds for Certiorari?
The First Circuit’s decision and Taggart are very much at odds. The Ninth Circuit permits a good faith defense to a discharge violation, while the First Circuit does not.
Should the losing parties in either circuit petition for certiorari, they surely will claim there is a circuit split. However, the majority on the First Circuit found no circuit split, although the dissenter did.
By ruling on Section 7433(e), the First Circuit was not construing the same statute as the Ninth. If a certiorari petition is based on divergent opinions by the two circuits just seven weeks apart, the justices might shy away from granting the petition because the underlying statutes are not the same.
However, there surely is a lack of clarity about the availability of a good faith defense when a panel of the First Circuit cannot agree on whether there is a circuit split. The Supreme Court might decline to grant certiorari until there is a decision more starkly raising a circuit split. Taggart might become a better vehicle for certiorari after the Ninth Circuit disposes of the pending petition for rehearing and rehearing en banc.
Although the dissent in the First Circuit says there is a circuit split about the good faith defense generally, the dissenter also said her panel was the first appeals court to rule on Section 7433(e). Even though the underlying issue is applicable to Sections 362 and 524 of the Bankruptcy Code, the Supreme Court might not be inclined to grant certiorari to the First Circuit and review the first decision on Section 7433(e).
All things considered, Taggart therefore might be the better vehicle for certiorari. The debtor in Taggart contends that the Ninth Circuit’s opinion represents a split with the Fourth and Eleventh Circuits on the availability of a good faith defense.
If there is a petition for certiorari in Taggart, the Supreme Court may request the opinion of the U.S. Solicitor General on whether to grant or deny the petition, known as a CVSG for “consider the views of the Solicitor General.” A CVSG would allow the government to weigh in on the existence of a split (or not) and presumably urge the justices to review the case.
Given the outcome in the First Circuit, the government well may urge a grant of certiorari in Taggart, especially if certiorari to the First Circuit is less likely.
Either case would enable the Supreme Court to rule on a fundamental, recurring issue in bankruptcy law: Does good faith allow a creditor to escape the consequences of an intentional violation of the principal relief a debtor obtains through bankruptcy?