Bankruptcy is often a last-ditch effort for individuals who feel as though there’s no way out of a bad financial situation. Making the choice to file often comes with a litany of challenging emotions like fear, guilt, and anxiety, but virtually all filers feel as though most of their debt struggles will be minimized or eliminated after a successful petition. For most who choose Chapter 7 bankruptcy, this is probably true. However, when the IRS comes to call, nothing is ever as simple as it seems.

The First Circuit opinion in IRS v. Murphy centered on this exact concept: what happens when the IRS seeks to collect on its past-due obligations when a bankruptcy discharge is involved?

What Is Chapter 7 Bankruptcy?

Chapter 7 bankruptcy is a form of bankruptcy filing in the U.S. for eligible individuals in order to ease the burden of insurmountable debt. Also known as a liquidation bankruptcy, Chapter 7 bankruptcy involves the liquidation of selected assets by an appointed trustee in order to pay back some or all creditors. Not all property is seized and sold; some assets, like retirement accounts, can be legally maintained.

Chapter 7 is the most common form of bankruptcy in the United States, with, 8.7 million petitions filed between 2005 and 2017. To qualify, applicants must be able to:

• Provide full financial records
• Undergo credit counseling with an approved counselor
• Pass a means test that indicates sufficient assets to pay off a meaningful portion of current debt; those that cannot may have to instead file for Chapter 13 bankruptcy
• Meet with creditors to discuss the veracity of the pending case
• Consent to a seizure of non-exempt assets as determined by both state and federal law
• Take a financial management course to hopefully improve future behavior

If these steps can be met and there is no objection from creditors or the trustee, a discharge will be granted. This means that all dischargeable debts will be effectively eliminated, giving filers a fresh start to their finances.

Murphy, Bankruptcy, and the IRS: A Perfect Storm

The case of IRS v. Murphy started in a similar manner to the steps above: William C. Murphy, a U.S. citizen with an apparent disinterest in abiding by Internal Revenue Service policy and procedure, filed for Chapter 7 bankruptcy on October 13th, 2005. In his petition, Mr. Murphy listed over $600,000 in debt, the vast majority of which was due to the IRS for unpaid taxes dating back to 1998. The bankruptcy court, agreeing with Mr. Murphy’s self-assessed inability to pay his liabilities in full, granted a discharge on February 14th, 2006. It is important here to note that the IRS was anything but ignorant of this ongoing process; as the steps to a successful bankruptcy indicate, a meeting of creditors is required for debt to be successfully discharged. Further, the IRS was notified of the discharge on February 16th.

The language used in the discharge was completely standard, reading as such: “The debtor is granted a discharge under section 727 of title 11, United States Code.” The back of this discharge order then went on to clarify that the “discharge prohibits any attempt to collect from the debtor a debt that has been discharged.”

Under normal circumstances, this would be the conclusion of a bankruptcy case. However, when the IRS is involved, it isn’t unusual for events to transpire that deviate strongly from the norm.

The Discharge That Never Ends

For the three years that followed Mr. Murphy’s supposedly-successful discharge, the IRS continued to maintain that the debts were not, in fact, discharged. Their reasoning? Bankruptcy Code § 523(a)(1)(C), which states that tax debt is not dischargeable if “the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat such tax.” In 2009, these beliefs were reinforced by several levies, which led to Mr. Murphy’s lawsuit against the IRS.

Assistant U.S. Attorney Frederick Emery, Jr. represented the IRS – or, perhaps it’s more appropriate to say that he was supposed to. Bafflingly, despite apparent evidence that there was potential fraud in Mr. Murphy’s tax history, Mr. Emery did not present any of it at trial. In fact, little evidence of any kind was offered, leading to an easy judgment in favor of Mr. Murphy. In a bizarre turn of events, Mr. Emery was subsequently diagnosed with an aggressive form of dementia, of which he was likely suffering during the trial.

Inspired by the verdict of the courts, Mr. Murphy persevered in his case against the government, filing a complaint under Internal Revenue Code § 7433(e) to seek damages for the “willful violation” of the injunction granted as a part of the discharge in his bankruptcy case. After some further unpleasant back and forth, the IRS conceded that the bankruptcy discharge did indeed include Mr. Murphy’s back taxes and agreed to the amount of damages suffered, regardless of the competence issues brought to light by Mr. Emery’s shocking diagnosis. The only question remaining? The IRS’s so-called willful violation.

Willfully or Not Willfully: That Is the Question

So, did the IRS willfully violate the discharge? The IRS said no, claiming that all attempts to collect on the discharged debt were made in good faith under the assumption that the tax debts were not dischargeable. The court, however, disagreed, determining that a willful violation on the part of the IRS occurs when an employee knows of the discharge order and takes intentional action to violate it anyway. This determination was carried up to the Court of Appeals, which also sided with Mr. Murphy, overruling the IRS’ good faith argument.

While a seemingly clear resolution – the IRS knew about the discharge and still chose to willfully pursue debts the agency no longer had the right to collect – the legal ramifications are much stronger. While it’s true that the IRS knowingly and intentionally acted in opposition to the discharge order, they did not deliberately cause a violation – a matter that should have been clear based on the ruling of Kawaauha v. Geiger. Instead, the Court ignored the definition of willful as defined in the proceedings of Kawaauha, effectively stripping the IRS of its ability to exercise a good faith defense. Instead of taking immediate action to collect debts deemed collectible, this ruling indicates that the IRS must first take the case to court to prove that the debt is in fact still owed, even though this is not a requirement under Bankruptcy Code § 523. Instead of being compared to debts included in Bankruptcy Code § 523(c)(1) that were deemed by Congress to be automatically dischargeable unless determined otherwise by a judge, tax debt now seemingly stands in a class of its own, complete with more hoops than a small circus. What this means for the future of collection efforts by the IRS remains to be seen.