Tuesday, December 31, 2013
A married couple was not allowed to take losses from a cutting horse farm operated by the wife because she did not engage in the activity for profit within the meaning of Code Sec. 183(a). The facts and circumstances showed the farm was not run as a business activity. Because the horse farm had not made a profit in a single one of the 13 years it had operated, and the couple had substantial income from the investments of the husband, it was not operated for profit.—C
The couple was not subject to the accuracy-related penalty because they showed good faith and reasonable cause for the substantial understatement of tax resulting from the denial under the hobby-loss rules of deductions they had claimed relating to the wife’s horse-breeding activity. The taxpayers hired a certified professional accountant to prepare their returns, and they reasonably relied on her advice; because she had signed all their returns for the history of the horse farm, she knew its financial history. Moreover, the taxpayers operated the farm in a professional manner and took their activity seriously.
Travis A. Mathis and Bettina C. Jary-Mathis v. Commissioner.
U.S. Tax Court, Dkt. No. 21704-10, 24596-11, TC Memo. 2013-294, December 30, 2013.
James Frederick Martens, Kelli H. Todd, and Jeffrey S. Taylor, for petitioners; Roberta L. Shumway and Bryan J. Dotson, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
GOEKE, Judge: Petitioners owned a cutting horse farm in Florence, Texas. They continued to operate the farm despite sustaining significant losses for each of the 13 years of its existence. Respondent audited petitioners' Forms 1040, U.S. [*2] Individual Income Tax Return, for the years 2006 to 2008. Respondent determined petitioners were not operating the farm for profit. Consequently, they issued a notice of deficiency denying the related deductions and determining a deficiency for each of those years. Respondent also imposed accuracy-related penalties associated with the resulting deficiencies. The issues for decision are:
(1) whether petitioners engaged in their cutting horse activity from 2006 to 2008 for profit within the meaning of section 183(a). 1 We hold that they did not; and
(2) whether petitioners are liable for accuracy-related penalties under section 6662(a) for 2006, 2007, and 2008. We hold that they are not.
FINDINGS OF FACT
. Section 183 For-Profit Requirement
Section 183 limits the section 162 trade or business expense deductions a taxpayer may claim for expenses attributable to an activity not engaged in for profit. Taxpayers may not deduct such expenses to the extent they exceed income generated by the activity less deductions attributable to the activity allowable without regard to whether the taxpayer engaged in the activity for profit. Sec. 183(b).
Taxpayers engage in an activity for profit when they entertain an actual and honest profit objective in engaging in the activity. Dreicer v. Commissioner, 78 T.C. 642, 645 (1982), aff'd without opinion, 702 F.2d 1205 (D.C. Cir. 1983); sec. 1.183-2(a), Income Tax Regs. Whether the requisite profit objective exists is [*8] determined by looking at all the surrounding facts and circumstances. Keanini v. Commissioner, 94 T.C. 41, 46 (1990); sec. 1.183-2(b), Income Tax Regs. We give greater weight to objective facts than to a taxpayer's mere statement of intent. Thomas v. Commissioner, 84 T.C. 1244, 1269 (1985), aff'd, 792 F.2d 1256 (4th Cir. 1986); sec. 1.183-2(a), Income Tax Regs. Evidence from years after the years in issue is relevant to the extent it creates inferences regarding the taxpayer's requisite profit objective in earlier years.E.g., Foster v. Commissioner, T.C. Memo. 2012-207; Bronson v. Commissioner, T.C. Memo. 2012-17.
Section 1.183-2(b), Income Tax Regs., provides a list of factors to consider in evaluating a taxpayer's profit objective: (1) the manner in which the taxpayer carried on the activity; (2) the expertise of the taxpayer or his or her advisers; (3) the time and effort expended by the taxpayer in carrying on the activity; (4) the expectation that the assets used in the activity may appreciate in value; (5) the success of the taxpayer in carrying on other similar or dissimilar activities; (6) the taxpayer's history of income or loss with respect to the activity; (7) the amount of occasional profits earned, if any; (8) the financial status of the taxpayer; and (9) whether elements of personal pleasure or recreation are involved. No single factor controls. Golanty v. Commissioner, 72 T.C. 411, 426 (1979), aff'd without [*9] published opinion, 647 F.2d 170 (9th Cir. 1981). After careful consideration of these factors, we find that petitioners did not engage in their cutting horse activity with a profit motive. We present our analysis below.
A. Manner in Which the Taxpayer Carries on the Activity
The fact that the taxpayer carries on an activity in a businesslike manner and maintains complete and accurate books and records may indicate a profit motive. Sec. 1.183-2(b)(1), Income Tax Regs. Characteristics of a businesslike operation include the preparation of a business plan and, in the case of horse breeding and sales, a consistent and concentrated advertising program. Bronson v. Commissioner, T.C. Memo. 2012-17. The regulations further provide that a taxpayer's change in operating methods or adoption of new techniques to improve profitability may indicate an overall profit motive. Sec. 1.183-2(b)(1), Income Tax Regs.
Petitioners maintained complete and accurate books for their cutting horse activity. Their bookkeeper prepared financial reports, and Mrs. Jary-Mathis reviewed them monthly. The reports provided Mrs. Jary-Mathis an accurate account of the farm's financial performance.
Petitioners did not create a business plan when they started La Brisa Farm in 1995, but they did when the farm's focus shifted to breeding in 2000. The [*10] business plan indicates that petitioners planned to promote their horses “so effectively that customers will be willing to pay a premium”. Petitioners have maintained a consistent advertising program. The farm frequently displays its horses at shows and has advertised in print publications and online. Mrs. Jary-Mathis also marketed her horses by talking with industry insiders.
Petitioners argue that the farm's shift in focus from training to breeding represents a change in operating method that indicates a profit motive. We find that petitioners changed their focus not to improve profitability but because they could not keep top-level trainers. The best cutting horse trainers want to demonstrate their skills by training and riding horses from a variety of farms. Because they could not keep good trainers at La Brisa Farm, petitioners decided to focus on breeding instead.
On balance, this factor favors petitioners. They maintained complete and accurate records, created a business plan, marketed their horses, and generally ran the farm in a professional manner.
B. The Expertise of the Taxpayer or Her Advisers
The taxpayer's expertise, research, and extensive study of an activity, as well as his or her consultation with experts, may indicate a profit motive. See sec. 1.183-2(b)(2), Income Tax Regs. Mrs. Jary-Mathis grew up around ranching and [*11] learned about cutting horses when she was in high school. When she began her own cutting horse operation, she had help from experienced trainers. Since she started La Brisa Farm, Mrs. Jary-Mathis has frequently discussed training and breeding strategies with prominent figures in the cutting horse industry. She continually performs online research to identify the best horses in the country, and she has attended seminars to learn more about the cutting horse business.
Mrs. Jary-Mathis has developed expertise in breeding quality cutting horses, but she lacks business expertise. Mrs. Jary-Mathis attended a seminar on ranching for profit, but that does not make her an expert. Moreover, she attended the seminar long after she started the activity. Petitioners' failure at the outset to consult experts on the financial aspects of running a cutting horse farm indicates that they lacked a profit motive. See Burger v. Commissioner, 809 F.2d 355, 359 (7th Cir. 1987), aff'g T.C. Memo. 1985-523; Smith v. Commissioner, T.C. Memo. 1997-503, aff'd without published opinion, 182 F.3d 927 (9th Cir. 1999).
C. The Time and Effort Expended by the Taxpayer in Carrying On the Activity
The taxpayer's devotion of much of his or her personal time and effort to carrying on an activity may indicate a profit motive, particularly if the activity [*12] does not involve substantial personal or recreational aspects. Sec. 1.183-2(b)(3), Income Tax Regs.
Mrs. Jary-Mathis devotes considerable time and effort to La Brisa Farm. She typically spends 40 hours a week on the cutting horse activity and 60 hours a week during the top cutting events. Although Mrs. Jary-Mathis works hard, her work involves substantial personal and recreational aspects. She works with cutting horses, which have been her passion since she was young. She spends time with her daughter at horse shows, and she derives a sense of personal pride from owning high-quality cutting horses. On balance, this factor weighs in petitioners' favor, but the personal and recreational aspects of the activity limit its effect on our overall analysis.
D. The Expectation That Assets Used in the Activity May Appreciate in Value
An expectation that assets used in the activity will appreciate in value may indicate a profit motive even if the taxpayer derives no profit from current operations. Sec. 1.183-2(b)(4), Income Tax Regs. However, we may infer a profit objective from such expected appreciation only when the appreciation exceeds operating expenses and would be sufficient to recoup the accumulated losses of [*13] prior years. Foster v. Commissioner, T.C. Memo. 2012-207; see Golanty v. Commissioner, 72 T.C. at 427-428.
Mrs. Jary-Mathis testified that she expects her horses to appreciate in value as her broodmares produce successful foals. However, petitioners have failed to present evidence that the appreciation will recoup the accumulated losses. Petitioners have reported over $9 million in losses, and the highest price they have ever received for a horse is $65,000. Petitioners' expert appraised La Brisa Farm's entire horse inventory at $1,252,500 as of December 31, 2008. Any appreciation on petitioners' horses only minimally offsets the very large losses petitioners have sustained since beginning their cutting horse activity.
Petitioners also provided some evidence that the La Brisa Farm property has increased in value, but this does not indicate that they had a profit motive for their cutting horse activity. Petitioners did not purchase the property for investment; they purchased it to breed and train cutting horses. We must evaluate any profit motive petitioners had in operating the farm separately from any profit motive they had in purchasing the land. See sec. 1.183-1(d)(1), Income Tax Regs. (providing that the farming and holding of land will ordinarily be considered a single activity only when the taxpayer engages in the farming activity to offset the carrying costs of the land). Although the land's appreciation would be relevant to petitioners' [*14] motive in holding the land, it is not relevant to their motive in operating the cutting horse farm. Even if the land's appreciation were relevant to petitioners' profit motive in operating the cutting horse farm, they have not presented sufficient evidence that the appreciation offsets the farm's substantial losses. The evidence in the record concerning appreciation in the farm's assets fails to persuade us that future profits motivated petitioners to continue the cutting horse activity.
E. The Success of the Taxpayer in Other Similar Activities
Section 1.183-2(b)(5), Income Tax Regs., provides: “The fact that the taxpayer has engaged in similar activities in the past and converted them from unprofitable to profitable enterprises may indicate that he is engaged in the present activity for profit, even though the activity is presently unprofitable.” None of petitioners' past activities provides evidence of a profit motive here.
F. Taxpayer's History of Income or Losses
A history of continued losses with respect to an activity may indicate that the taxpayer lacked a profit motive. See sec. 1.183-2(b)(6), Income Tax Regs. Although a series of losses during the initial or startup stage of an activity may not necessarily indicate a lack of profit motive, a record of large losses over many [*15] years is persuasive evidence that the taxpayer did not have such a motive. Golanty v. Commissioner, 72 T.C. at 426; Foster v. Commissioner, T.C. Memo. 2012-207.
Petitioners realized no profits from La Brisa Farm in 13 years. Petitioners claim that they engaged in two separate activities during that period: (1) training from 1995 to 2000 and (2) breeding from 2000 to present. They argue that the breeding operation remained in its startup phase during the years at issue, so the losses during those years do not indicate the absence of a profit motive. We find that the 2000 change was not significant enough to constitute the start of a new activity. Petitioners have bred and trained horses on their farm throughout the entire period. They focused more on breeding after 2000 and moved the training operation offsite, but these changes do not amount to a change in activity. Accordingly, we decline to “reset the clock” as of 2000 simply because petitioners shifted their focus. The startup period for petitioners' cutting horse activity passed before respondent conducted his audit, and the history of losses strongly indicates petitioners lacked a profit motive.
Petitioners reported smaller Schedule F losses for the years following those respondent audited. They cite the diminishing losses as a sign that the farm is nearing profitability. However, the smaller net losses did not result from increased [*16] sales, only from lower reported expenses. Petitioners reported lower expenses only after they received notice of the audit, which indicates that the audit, not a desire to earn profits, may have triggered the reductions. Accordingly, we give little weight to the decline in expenses petitioners reported in determining whether they had a profit motive.
The current and expected losses of an activity should not be of such a magnitude that an overall profit going forward would not be possible. Bessenyey v. Commissioner, 45 T.C. 261, 274 (1965), aff'd, 379 F.2d 252 (2d Cir. 1967). Petitioners have accumulated over $9 million in losses from their cutting horse activity. It is unrealistic to expect that petitioners would not continue to accumulate significant losses. They have presented no convincing evidence that future profits could possibly offset these losses. Accordingly, this factor weighs heavily against finding a profit motive.
G. Amount of Occasional Profits
The amount of profits in relation to the amount of losses incurred may provide evidence of the taxpayer's intent. Sec. 1.183-2(b)(7), Income Tax Regs. Petitioners have never earned a profit from the cutting horse activity, yet they continue to operate the farm. This indicates that they are running the farm for personal rather than business reasons.
[*17] H. Taxpayer's Financial Status
Substantial income from sources other than the activity may indicate that the activity is not engaged in for profit. Sec. 1.183-2(b)(8), Income Tax Regs. A taxpayer with substantial income unrelated to the activity can more readily afford a hobby. Foster v. Commissioner, T.C. Memo. 2012-207. This is particularly true if the losses from the activity might generate substantial tax benefits. Golanty v. Commissioner, 72 T.C. at 429. Petitioners' substantial investment income has allowed them to continue the cutting horse operation despite 17 consecutive years of substantial losses. Petitioners' cutting horse activity also generated tax savings in the form of net losses that offset petitioners' investment income. This factor weighs against finding a profit objective.
I. Elements of Personal Pleasure or Recreation
The presence of personal motives and recreational elements in carrying on an activity may indicate that the activity is not engaged in for profit. Sec. 1.183-2(b)(9), Income Tax Regs. Mrs. Jary-Mathis enjoys working with horses and derives substantial personal satisfaction from her cutting horse operation. She enjoys watching the young horses and often brings them to her personal farm to watch them grow. However, running a large-scale breeding operation takes many [*18] hours of hard work, and Mrs. Jary-Mathis has sacrificed family and personal time to promote her horses. This factor weighs slightly against a profit motive.
After weighing all the facts and circumstances in light of the relevant factors, we conclude that petitioners did not engage in their cutting horse activity with the requisite profit objective. Mrs. Jary-Mathis is determined to be a successful horsewoman. She wants to build a reputation as a producer of top-level cutting horses. However, she has pursued this goal independently of any desire to earn profits. She has continued training and breeding cutting horses for 17 years without ever approaching profitability, yet she has never seriously considered discontinuing operations. Accordingly, we sustain respondent's determination that petitioners did not engage in the cutting horse activity for profit.
III. Accuracy-Related Penalties
Respondent determined that petitioners were liable for an accuracy-related penalty pursuant to section 6662(a) for each of the tax years at issue. Section 6662(a) and (b)(1) and (2) imposes a penalty of 20% on any underpayment attributable to, among other things, (1) negligence or disregard of rules or regulations; or (2) any substantial understatement of income tax. An understatement is substantial if it exceeds the greater of $5,000 or 10% of the [*19] income tax required to be shown on the return for the taxable year. Sec. 6662(d)(1)(A).
The Commissioner bears the burden of production with respect to this penalty. Sec. 7491©. The Commissioner satisfies the burden by presenting sufficient evidence supporting the relevant penalty. Higbee v. Commissioner, 116 T.C. 438, 446 (2001). Respondent determined that petitioners underpaid their income tax by $320,927, $376,318, and $491,571 for the years 2006, 2007, and 2008, respectively. These amounts exceed the “substantial understatement” threshold for each year in question. Thus, respondent has carried his burden of demonstrating that petitioners substantially understated their income tax.
Pursuant to section 6664(c)(1), the accuracy-related penalty under section 6662 does not apply to any portion of an underpayment for which a taxpayer establishes that he or she: (1) had reasonable cause, and (2) acted in good faith. A taxpayer's failure to comply with section 183 does not preclude a reasonable cause and good faith defense. See, e.g., Rodriguez v. Commissioner, T.C. Memo. 2013-221, at *57. Whether a taxpayer has acted with reasonable cause and in good faith depends on the facts and circumstances of the case. Relevant factors include the taxpayer's efforts to assess the proper tax liability, the taxpayer's knowledge and [*20] experience, and the extent to which the taxpayer relied on the advice of a tax professional. Sec. 1.6664-4(b)(1), Income Tax Regs.
Petitioners hired a certified public accountant to prepare their returns. Because the return preparer had signed all of their returns since 1999, she knew the farm's financial history. Petitioners submitted complete and accurate books and records to their accountant and relied on her to properly prepare their returns. Although we find that petitioners lacked a profit motive, we acknowledge that they operated the farm in a professional manner and took their activity seriously. We are persuaded that petitioners had reasonable cause and acted in good faith. Accordingly, we find they are not liable for accuracy-related penalties.
To reflect the foregoing,
Decisions will be entered for respondent as to the deficiencies and for petitioners as to the accuracy-related penalties under section 6662(a).
Unless otherwise indicated, all section references are to the Internal Revenue Code in effect for the years at issue, and all Rule references are to the Tax Court Rules of Practice and Procedure.
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Posted by www.irstaxattorney.com at 8:59 AM
Monday, December 30, 2013
The IRS engaged in unauthorized collection actions when it sought to collect tax debts that had been discharged in the taxpayer’s Chapter 7 bankruptcy. The IRS was subject to the same standards as any other creditor and, therefore, its claim that is acted in good faith was irrelevant. In addition, the debtor’s cause of action accrued when the IRS issued its levy notices, not when it first asserted that his tax debts had not been discharged. Thus, his suit was timely because it was filed less than two years after the levy notices were issued.
In re William C. Murphy, Debtor. William C. Murphy, Plaintiff v. United States Department of the Treasury, Internal Revenue Service, Defendant.
U.S. Bankruptcy Court, D. Maine; 05-22363, December 20, 2013.
Haines, U.S. Bankruptcy Judge:
For chapter 7 debtors, a discharge order relieving them of pre-petition personal debt and providing them a “fresh start” is, when earned, the deserved result. Their discharge is protected by a statutory precept broadly enjoining creditors from commencing or continuing actions to collect, recover, or offset discharged debt. This discharge injunction is enforceable by contempt. A creditor willfully violates the injunction, and can be called to answer for it, when, knowing of the debtor's discharge, it intentionally undertakes action to collect discharged debt. All this is plain. The question posed by this case is whether the Internal Revenue Service is held to the same standard as any other creditor when a discharged debtor invokes 26 U.S.C. §7433, asking the bankruptcy court to award damages on account of IRS employees' willful violation of the discharge injunction.
In this case, the answer is “yes.” The IRS is liable for damages occasioned by the intentional acts of its agents who were aware of William Murphy's discharge. On cross motions for partial summary judgment seeking a determination of liability, I conclude that the IRS is liable for damages arising from violations of the injunction protecting Murphy's fresh start. The case will be set for trial on damages.
William Murphy filed for chapter 7 relief on October 13, 2005. He scheduled federal income tax obligations for tax years 1993, 1994, 1996, 1997, 1998, 2000, and 2001among his debts. Murphy received his discharge on February 14, 2006. As with all chapter 7 discharges, Murphy's discharge was not absolute. Consistent with §§523 and 727, 1 it was subject to exceptions - some self-executing and some not. More specifically, Murphy's discharge order stated that debts for “most” taxes were not discharged. 2
Following Murphy's discharge, the IRS informed him that it considered the pre-petition tax obligations he had scheduled to be excepted from discharge. He was told that collection efforts would ensue.
Murphy then reopened his case 3 and filed an adversary action, 4 seeking a determination that the scheduled tax obligations were comprehended by his discharge, together with an award of damages occasioned by the IRS's post-discharge collection activities.
In the course, Murphy and the IRS were required to file a joint pretrial scheduling order, 5 but they could not agree on fundamental issues, including the state of the pleadings and burdens of proof. I determined the legal and factual issues to be as follow:
As articulated by Murphy:
1. Did the discharge Murphy received on February 14, 2006, discharge his income tax obligations for the tax years 1993, 1994, 1996, 1997, 1998, 2000, and 2001?
2. Did the IRS violate the discharge injunction?
3. Were any of the tax obligations identified above excepted from the discharge pursuant to Section 523(a)(1)(B) for failure to file a return?
4. Were any of the tax obligations identified above excepted from the discharge pursuant to Section 523(a)(1)(C) for filing a fraudulent return?
5. Were any of the tax obligations identified above excepted from the discharge pursuant to Section 523(a)(1)(C) for willfully attempting to evade or defeat such tax?
As expanded upon by the IRS:
6. Were any of the tax obligations identified above excepted from the discharge pursuant to §523(a)(1)(B) because a tax return was filed late and filed after two years before the date of the filing of the petition?
7. Were any of the tax obligations identified above excepted from the discharge pursuant to Section 523(a)(1)(C) for willfully attempting in any manner to evade or defeat such tax? 6
After conferring with counsel, I entered a pretrial scheduling order, and added the following:
IMPORTANT ADDITIONAL NOTE: The court considers that the Plaintiff [Murphy] bears the burden of proving a discharge issued. The Defendant [IRS] bears the burden of proving, by a preponderance, the applicability of a discharge exception to the debts at issue. Objections to this allocation must be made, if at all, by motion filed within 14 days of this date. 7
The IRS made no complaint and the case proceeded. But the IRS did not budge from its position that Murphy was tasked with proving that none of §523(a)(1)'s discharge exceptions applied to his prepetition tax debts. It refused to identify any specific provision of §523(a)(1) to support its assertion that the debts survived discharge. 8 As the case moved forward, Murphy was forced to obtain an order compelling discovery for even the most obviously pertinent information in the IRS's files.9
Murphy's prayer for damages was dismissed, without prejudice, by stipulation. 10 And the parties agreed the count seeking injunctive relief was unnecessary, as the IRS had agreed to stand still until all other issues were put to rest. 11 Murphy moved for summary judgment, asking for a final determination that his discharge embraced the tax debt and for relief addressing the way in which post-discharge tax payments had been applied by the IRS. In the face of IRS opposition that fell far short of applicable substantive and procedural standards, 12 summary judgment entered for Murphy as follows:
This matter came before the Court on the Motion for Summary Judgment filed by the plaintiff, William C. Murphy. Upon notice and after hearing, this Court finds that there are no genuine issues of material fact in dispute and that Murphy is entitled to judgment as a matter of law. Accordingly, this Court hereby grants judgment in favor of Murphy as follows:
The summary judgment order concluded the adversary proceeding finally. The IRS did not appeal. It has neither sought nor obtained relief from the judgment.
Murphy next pursued an administrative claim for damages. 14 Meeting with no success there, he initiated this action under 26 U.S.C. §7433(c)(3), which entitles a discharged debtor to petition the bankruptcy court for damages when “any employee of the Internal Revenue Service willfully violates any provision of section … 524 of Title 11.”
III. The Summary Judgment Standard
Summary judgment is called for when there is “no genuine issue as to any material fact and the moving party is entitled to judgment as a matter of law.” Gerald v. Univ. of P.R., 707 F.3d 7, 16 (1st Cir.2013) (quoting Martínez-Burgos v. Guayama Corp., 656 F.3d 7, 11 (1st Cir.2011)); see Fed.R.Civ.P. 56(a). “The presence of cross-motions for summary judgment neither dilutes nor distorts this standard of review.” Mandel v. Boston Phoenix, Inc., 456 F.3d 198, 205 (1st Cir.2006); see Atwater v. Chester, __ F.3d __, 2013 WL 5290019 (1 st Cir. Sept. 20, 2013); Fed. R. Civ. P. 56.
Our local rules spell out formal requirements for summary judgment practice in exquisite detail. See D. Me. L. Bankr. R. 7056-1, D. Me. L. R. 56. Notably,
(b) Supporting Statement of Material Facts. A motion for summary judgment shall be supported by a separate, short, and concise statement of material facts, each set forth in a separately numbered paragraph(s), as to which the moving party contends there is no genuine issue of material fact to be tried. Each fact asserted in the statement shall be simply and directly stated in narrative without footnotes or tables and shall be supported by a record citation ….
Although the parties' submissions, more particularly those of the IRS, fail to abide by the requirements of the rules, 15 I can navigate the morass. The question of liability, which is all that is before me today, is not so complex as the IRS would have it.
IV. The Statutes
Murphy argues that the IRS's post discharge collection activity is actionable in this court under §7433 of Title 26 U.S.C.:
§7433. Civil damages for certain unauthorized collection actions
(a) In general
If, in connection with any collection of Federal tax with respect to a taxpayer, any officer or employee of the Internal Revenue Service recklessly or intentionally, or by reason of negligence, disregards any provision of this title, or any regulation promulgated under this title, such taxpayer may bring a civil action for damages against the United States in a district court of the United States. Except as provided in section 7432, such civil action shall be the exclusive remedy for recovering damages resulting from such actions.
In any action brought under subsection (a) or petition filed under subsection (e), upon a finding of liability on the part of the defendant, the defendant shall be liable to the plaintiff in an amount equal to the lesser of $1,000,000 ($100,000, in the case of negligence) or the sum of—
(c) Payment authority
Claims pursuant to this section shall be payable out of funds appropriated under section 1304 of title 31, United States Code.
(e) Actions for violations of certain bankruptcy procedures
(1) In general
If, in connection with any collection of Federal tax with respect to a taxpayer, any officer or employee of the Internal Revenue Service willfully violates any provision of section 362 (relating to automatic stay) or 524 (relating to effect of discharge) of title 11, United States Code (or any successor provision), or any regulation promulgated under such provision, such taxpayer may petition the bankruptcy court to recover damages against the United States.
(2) Remedy to be exclusive
26 U.S.C. §7433 (emphasis supplied).
The operative portion of Code §524 (the entirety of which 26 U.S.C. §7433(e)(1) incorporates) reads:
(a) A discharge in a case under this title -
* * *
(2) operates as an injunction against the commencement or continuation of an action, the employment of process, or an act, to collect, recover or offset any … debt [discharged under section 727 …] as a personal liability of the debtor, whether or not discharge of such debt is waived;
* * *
11 U.S.C. §524(a)(2).
The IRS contends that it is not liable to Murphy for two reasons. First, it asserts that his complaint came too late - that it is barred by the two-year limitation set out in 26 U.S.C. §7433(d)(3). Second, it urges that its post-petition actions did not constitute “willful violation” of 11 U.S.C. §524's injunction within the meaning of 26 U.S.C.§7433. It is wrong on both counts.
After pursuing (and exhausting) his administrative remedies as required by 26 U.S.C. §7433(c)(1), Murphy filed this complaint for damages on February 18, 2011. Thus, suit was initiated within two years of the IRS's levy notices issued February 20, 2009. It is, therefore, timely.
1. Accrual of Cause of Action
The IRS asserts that Murphy's right of action accrued well before the February 20, 2009, levy notices issued. It contends that Murphy's cause of action accrued when, notwithstanding Murphy's former counsel's insistence that the tax debt was discharged, it insisted that the liabilities were excepted from the discharge. It further insisted that it was Murphy's burden to file an action to determine their status. Charitably characterized, the IRS's position is simply wrongheaded.
The earliest that Murphy could have become aware that the IRS was actually initiating post-discharge collection action was the date the IRS levied against him: February 20, 2009. That was the triggering event. It was at that point that the IRS's stated intention manifested as action inimical to Murphy's rights. Thus, if Murphy's complaint was filed on February 18, 2011, he initiated action within 26 U.S.C. §7433(d)(3)'s two year limitation period. 16
This is not a novel concept. For example, if neighbors disagree on the location of a boundary line, a cause of action for trespass does not accrue when first they argue, or even when one or the other pays a surveyor (or a title attorney) to investigate. The right of action comes into being upon action ( e.g., wrongful possession or exclusion), not upon mere disagreement. Similarly, Murphy's claim did not accrue when the IRS - no matter how insistently - took issue with him. It accrued when he became aware that all the elements of a cause of action for violation of the discharge injunction were present. 26 C.F.R. §301.7433-1(g) (a cause of action accrues when the taxpayer has had a reasonable opportunity to discover all essential elements of a possible cause of action).
2. Date of Filing
The IRS asserts that, although the complaint was stamped as “filed” when the bankruptcy court received it on February 18, 2011, it was not docketed until February 28, 2011, when Murphy's bankruptcy case was formally reopened. In its view, the date that counts is the formal docketing date. In federal practice, complaints are “filed” when received by the clerk's office and date-stamped. See Desroches v. U.S. Postal Service, 631 F.Supp. 1375, 1381 (D.N.H.1986). To rule otherwise would “unfairly penalize punctual plaintiffs for unavoidable delays in processing complaints” by the clerk's office. Id. “[T]he reopening of a case is a ministerial act which allows the file to be retrieved so the court can receive a new request for relief; the reopening, by itself, has no independent legal significance ….” In re Anderson, 2011 WL 5830599 (Bankr.D.Mass.)(Nov. 21, 2011).
Murphy's complaint was filed, and this action was initiated, on February 18, 2011, within two years following issuance of the first post-discharge levy notices. The fact that his bankruptcy case was not reopened, and the complaint was not lodged on the docket until February 28, 2011, is of no moment. 17
B. Willful Violation
1. The IRS's “Good Faith” Model
The best way to appreciate the IRS's view of the case is the “Overview and Background” section of its memorandum in support of summary judgment:
In view of the extensive statement of material facts being filed herewith pursuant to District Court Local Rule 56(b) [SMF], we provide only a brief capsulization here of the factual predicate for the government's insistence that no IRS employees willfully violated BC [Bankruptcy Code] §524 within the meaning of IRC [Internal Revenue Code] 7433(e). The SMF and the exhibits attached to it, along with the Declaration of Walter Boguslawski and the exhibits attached thereto, confirm that the IRS and the former Assistant United States Attorney (“former AUSA”) assigned to the Chapter 7 case: (I) repeatedly informed the debtor and his representatives of their position that the taxes were excepted from discharge; (ii) repeatedly told them that the debtor, if he disagreed, should file a proceeding to determine dischargeability (and that the IRS was not required to do so); and (iii) gave the debtor ample warning that the IRS was going to levy to collect the liabilities of he did not commence such a proceeding. Despite the fact that this was conveyed as early as 2006 and consistently thereafter until the IRS actually issued levies on February 20, 2009, the debtor elected not to file an adversary complaint to determine dischargeability until August of 2009 - six months after the levies (and almost five months after their release) - whereupon the IRS immediately consented to a preliminary injunction pending the Court's determination of dischargeability.
Moreover, this is not a case in which the IRS's theory of a discharge exception was based on a novel legal theory or wild speculation as to unknown facts. Instead, the IRS records and internal communications reflect that it initially notified the debtor of intent to levy only on any premise of nondischargeability with the concurrence of counsel (the former AUSA) after an investigation that included a considerable factual record of support for its view that the debtor had willfully attempted to defeat collection of the tax within the meaning of BC §523(a)(1)(C). Indeed, the facts as viewed by the IRS met virtually all of the indicia reflected in established court precedents. [Footnote omitted.] 18
The IRS's position is that, as far as tax collection and §523(a)(1)(C) goes, it retains the authority to make up its mind whether tax obligations are discharged, that it may act unilaterally on the basis of its conclusions, and that it encounters no risk in doing so, as long as it has a “good faith” or “reasonable” basis for its conclusion. According to it, what matters for purposes of Murphy's 26 U.S.C. §7433 action is only that the “IRS employees involved reasonably believed that the taxes were excepted from discharge after having investigated the facts relevant to that issue in good faith.” 19
To evaluate the IRS's position, the first step is to consider the regime under which most creditors' post-discharge conduct is considered. The next step is to consider whether there is something about the pertinent statutory model that requires claims against the IRS based on alleged violations of the discharge injunction be considered differently.
2. The Generally Applicable Discharge Injunction Violation Model
“Generally, a discharge in bankruptcy relieves a debtor from all pre-petition debt, and §524(a) permanently enjoins creditor actions to collect discharged debts.”Bessette v. AVCO Fin. Serv., 230 F.3d 439, 444 (1 st Cir. 2000) ( citing National Ins. Co. of North America v. NGC Settlement Trust & Asbestos Claims Management Corp. (In re National Gypsum Co.), 118 F.3d 1056, 1062 n. 13 (5th Cir.1997); Hardy v. United States (In re Hardy ), 97 F.3d 1384, 1388-89 (11th Cir.1996); In re Getzoff, 180 B.R. 572, 573 (9th Cir.B.A.P. 1995)). Although §524 does not expressly set forth a private right of action, a bankruptcy court properly may enforce §524(a)'s discharge injunction by invoking its equitable powers under §105(a) as necessary or appropriate to assure its efficacy. Id at 445-46.
A creditor violates the injunction when, with knowledge of the discharge, it intends to take an action, and that action is determined to be an attempt to collect a discharged debt. Pratt v. GMAC, 462 F.3d 14, 21 (1 st Cir. 2006).
To run afoul of the discharge injunction, a creditor need not expressly attempt to collect a discharged obligation. It need not subjectively intend to violate the injunction. It is enough that its conduct objectively functions to coerce payment of discharged debt. Id at 19-21. This is true even where the creditor mistakenly believes it is doing nothing more than enforcing rights that survived discharge. Id at 20 (creditor that insisted on enforcing lien rights in a manner that was coercive where such action was without independent economic value to it). Knowledge of the discharge, plus “general intent” to do the prohibited act constitutes the violation. Id at 21, see also, McComb v. Jacksonville Paper Co., 336 U.S. 187, 69 S.Ct. 497 (1949), (stating: “The absence of willfulness does not relieve from civil contempt. […] Since the purpose is remedial, it matters not with what intent the defendant did the prohibited act. […] An act does not cease to be a violation of a law and of a decree merely because it may have been done innocently. The force and vitality of judicial decrees derive from more robust sanctions.”) See also, In re Hardy, 97 F.3d 1384 at 1390; Kight v. Dept. of Treas./Internal Rev. Svc. (In re Kight), 460 B.R. 555, 565 (Bankr.M.D. FL. 2011); Matthews v. United States (In re Matthews), 184 B.R. 594, 598 (Bankr.S.D.AL. 1995).
In Murphy's 2009 action, the IRS was invited to demonstrate that Murphy's pre-petition tax obligations escaped discharge. It declined the invitation. Final judgment entered against it. That judgment put aside the question of damages, but determined that the scope of Murphy's discharge encompassed his tax debt and ordered remedial measures to rectify one aspect of the IRS's wrongful conduct: reversing its crediting of post-bankruptcy payments from discharged obligations to post-petition obligations.
Thus, it has already been finally determined that (1) the tax debt was discharged; (2) the IRS knew of the discharge; and (3) with knowledge of the discharge, it took action violative of the discharge injunction. Thus, if this were a case with any defendant other than the IRS, sanctions - including compensatory sanctions - would issue.
3. The Model for Considering IRS Liability - 26 U.S.C. §7433
So, is there something in the law that provides the IRS with defenses (to a damages claim) that are not available to other creditors? The only way the IRS can avoid liability for damages is if the words “willfully violates” in 26 U.S.C. §7433(e) mean something different than they do in applications of Bankruptcy Code §524 (discharge injunction violations as enforced via §105 in First Circuit case law, supra). Alleged violations of §362's automatic stay are scrutinized under the same model. See Fleet Mortg. Group, Inc. v. Kaneb (In re Kaneb), 196 F.3d 265, 268 (1 st Cir. 1999).
Certainly, as the IRS stresses, a private party may not sue the United States for damages absent a waiver of sovereign immunity. See United States v. Nordic Village, Inc., 503 U.S. 30, 33. 112 S.Ct. 1011, 117 L.Ed.2d 181 (1992). Therefore, Murphy may not sue the IRS for damages associated with violations of his discharge injunction unless there is a specific statutory waiver that will support any such award. See United States v. Mitchell, 463 U.S. 206, 212, 103 S.Ct. 2961, 2965 (1983). Clearly, 11 U.S.C. §106 and 26 U.S.C. §7433 create such a waiver.
Under §106, sovereign immunity is abrogated for a governmental unit with respect to several sections of the Bankruptcy Code, including §524. 20 That waiver of immunity is not without limits. For example, a bankruptcy court may not award punitive damages against a governmental unit. 11 U.S.C. §106 (a)(3). A bankruptcy court, may, however, issue a judgment for money damages against the government based on a violation of §524. It may only do so in compliance with applicable nonbankruptcy law. 11 U.S.C. §106 (a)(4).
Title 26 §7433, entitled “Civil damages for certain unauthorized collections actions,” provides applicable nonbankruptcy law governing a private party's claim for damages from the IRS for violations of the discharge injunction. See 26 U.S.C. §7433, supra. In 1998, Congress amended 26 U.S.C. §7433 by adding subsection (e), which provides: “If, in connection with any collection of Federal Tax with respect to a taxpayer, any officer or employee of the Internal Revenue Service willfully violates any provision of section 362 or 524 of title 11, United States Code … such taxpayer may petition the bankruptcy court to recover damages against the United States.” The subsection continues: “Notwithstanding section 105 of such title 11, such petition shall be the exclusive remedy for recovering damages resulting from such actions.” 26 U.S.C. §7433 (e)(2)(A). This procedure is exactly what Murphy has invoked.
The only way the IRS can avoid liability is if 26 U.S.C. §7433 imposes a novel standard governing the IRS's post-discharge conduct. The IRS asserts that the words “willfully violates” in 26 U.S.C. §7433(e) mean something different, something more forgiving, than they do in accepted applications of Bankruptcy Code §§105 and 524 in the First Circuit. However, I cannot see how that is possible. Title 26 §7433 employs the term “willfully violates,” the same term employed in the Bankruptcy Code and in controlling case law. The identical language appears without qualification.
Title 26 §7433 outlines the process for pursuing damages against a sovereign entity which would otherwise be immune. It can not reasonably be viewed as setting out a unique, more demanding, standard for determining liability. Indeed, the scant legislative background for 26 U.S.C. §7433's enactment (as a component of a bill denominated the “Taxpayers' Bill of Rights”) indicates that Congress' intention was that, insofar as honoring a debtor's discharge was concerned, the IRS should be treated no differently than any other creditor. See, 144 Cong. Rec. S7621-05, S7623.
Thus, the IRS is liable for violating Murphy's discharge injunction via §§106 and 524. A money judgment may enter pursuant to 26 U.S.C. §7433. See, e.g., Kovacs v. United States, 614 F.3d 666, 672-73 (7th Cir. 2010); In re Kight, 460 B.R. 555, 565; Jacoway v. Dep't of Treas. (In re Graycarr, Inc.), 330 B.R. 741, 747 (Bankr.W.D.Ark.2005); In re Lowthorp, 332 B.R. 656 (Bankr.M.D.Fla2005). Cf. Duby v. United States, 451 B.R. 664 (1 st Cir. B.A.P. 2011) (discussing whether emotional distress damages are available against the United States after a finding of a violation of the discharge injunction via §106) ( citing United States v. Rivera Torres (In re Rivera Torres), 432 F.3d 20 (1st Cir.2005)); In re Hardy, 97 F.3d at 1391 (attorney's fee awards made via §106 must be consistent with the limitations established by 26 U.S.C. §7430).
If any doubt remains that the IRS's “good faith” defense is not appropriate for determining liability under §524, one need only look to 26 U.S.C. §7430. That section addresses potential attorney's fee awards in cases where the IRS is determined to have violated the discharge injunction. Generally, a bankruptcy court may award the plaintiff its fees if the plaintiff is the prevailing party as defined by 26 U.S.C. §7430 (c)(4). A party does not “prevail” if the IRS establishes that its position was “substantially justified”. 26 U.S.C. §7430 (c)(4)(B). The section, therefore, acknowledges that liability under the Code may flow from good faith actions of the IRS, but that “substantial justification” may mitigate the damages available to the aggrieved party. The IRS has festooned the record with extensive information and argument that is immaterial to the issue of liability, but which may have pertinence to damages and their mitigation.
The chapter 7 discharge is peppered with exceptions. Most are self-executing, 21 a few are not. 22 Creditors who continue collection efforts post-discharge are betting that an exception applies. But they do so at their peril. If they are wrong, their intended acts (innocent or not) will buy them trouble. Any other paradigm - such as the one the IRS has put forward here - would render the fresh start fragile. Debtors, rather than starting fresh, would be burdened with fending off any manner of post-discharge collection attempts, all justified by the assertion of a “good faith” belief that a discharge exception applied.
The Bankruptcy Code's discharge injunction ensures a chapter 7 discharge's efficacy. The IRS, in this realm, is but another creditor. It enjoys no special status; it is due no special favor. 23
Partial summary judgment will enter determining the issue of liability for Murphy, and against the IRS. The matter will proceed to trial. A separate order will issue forthwith.
In re: William C. Murphy, Debtor. William C. Murphy, Plaintiff v. United States Department of the Treasury, Internal Revenue Service, Defendant.
UNITED STATES BANKRUPTCY COURT DISTRICT OF MAINE. Chapter 7. Case No. 05-22363. Adv. Proc. No. 11-2020. Dated: December 20, 2013.
HAINES, U.S. Bankruptcy Court District of Maine:
For the reasons set forth in the Memorandum of Decision dated December 20, 2013, the plaintiff's cross-motion for partial summary judgment on the issue of liability isGRANTED. This case will be set for further pretrial and trial on damages.
/s/ James B. Haines, Jr.
Hon. James B. Haines, Jr.
Judge, U.S. Bankruptcy Court
District of Maine
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