What to Do When the IRS Refuses to Recognize a Bankruptcy Discharge

Published Categorized as Bankruptcy Tax, IRS Debts, Tax Procedure
Ex-spouse’s Defense For Tax Discharged In Bankruptcy
Ex-spouse’s Defense For Tax Discharged In Bankruptcy

What happens if the IRS fails to recognize a bankruptcy discharge for taxes? What can taxpayers do if the IRS violates the law in trying to collect a discharged tax debt?

These are important questions that have a significant impact on taxpayers’ rights and financial well-being. Fortunately, there is a remedy.

In the recent case of Kuhl v. United States, No. 05-6570-BK (2nd. Cir. 2006), the court addressed this issue. The case provides an opportunity to consider the available remedies. It also shows taxpayers who find themselves in a similar situation may respond to this situation.

Facts & Procedural History

The taxpayer, Barbara Ann Kuhl, filed joint tax returns with her husband, Paul, from 1981-1990. In March 1993, during their divorce proceedings, the couple filed a joint tax return for the 1991 tax year, bearing both names and signatures. However, Mr. Kuhl later told an IRS auditor that he had not signed the 1991 return himself. As a result, the IRS assessed a deficiency against the taxpayer for the 1991 tax year.

In February 2000, the taxpayer filed for Chapter 7 relief in the Eastern District of New York, and an order of discharge was issued in May 2000, relieving her of specified liabilities pursuant to 11 U.S.C. §?524, which grants relief as against the IRS in respect to years in which a return was filed. Despite this, the IRS garnished the taxpayer’s wages in February 2003 to satisfy alleged outstanding tax liabilities, including the 1991 tax deficiency. The IRS claimed that the nominally joint return filed for 1991 did not constitute a proper return within the meaning of 11 U.S.C. §?524.

On March 29, 2003, the taxpayer sent a letter protesting the garnishment to the IRS office in Fresno, California, stating that she had filed for bankruptcy and enclosing copies of the Bankruptcy Discharge Papers. The taxpayer also requested that the IRS release the levy sent to her employer requesting a salary garnishment. However, the taxpayer did not receive a response from the IRS.

In May 2003, the taxpayer moved to reopen her bankruptcy case in order to discharge the assessment. She also sought compensatory damages, attorneys’ fees, and costs for the IRS’ willful violation of the discharge order.

Start With the Administrative Remedy

A discharge in bankruptcy operates as an injunction against the collection of any discharged debts. ?This includes tax debts that are discharged in bankruptcy. This rule is found in 11 U.S.C. §?524(a)(2).

If the IRS tries to collect taxes that are discharged in bankruptcy, the starting point is to pursue and exhaust the available administrative remedies. The regulations explain what these remedies include.

According to Reg. §?301.7430-1, if a taxpayer’s rights under the Bankruptcy Code have been willfully violated, as is in this case, the taxpayer is to submit an administrative claim to the IRS. Subsection (e)(1) of the regulation specifies that the taxpayer must send the administrative claim to the IRS office where the taxpayer’s most recent tax return was filed, or to the IRS office that issued the notice of the alleged violation.

The IRS then has six months to respond to the administrative claim, either by paying the requested amount or denying the claim. If the IRS denies the claim or fails to respond within six months, the taxpayer may file a civil suit seeking damages for the willful violation of the Bankruptcy Code’s discharge provisions.

Bankruptcy Litigation

Generally, taxpayers cannot sue the Federal government. This includes suing the IRS. To do so, the taxpayer has to find a statute or court case that authorizes the suit.

Congress has conditionally waived sovereign immunity for the IRS’s willful violation of such a discharge. This is set out in Section 7433(e) of the tax code (“after exhausting administrative remedies, the taxpayer may petition the bankruptcy court for damages.”). The statute even allows damages to be paid under Section 7430 of the tax code.

Section 7430 in turn allows recovery of attorneys’ fees provided that “the prevailing party has exhausted the administrative remedies available to such party within the Internal Revenue Service.” Failure to exhaust such remedies deprives the federal court of jurisdiction over the suit. ?

The taxpayer followed this process in this case. Once the IRS failed to respond to her, Ms. Kuhl reopened the bankruptcy proceeding to have the bankruptcy court enter an order declaring that the tax liabilities were in fact discharged.  The IRS initially appealed the discharge.  The court did not buy the IRS’s invalid tax return argument.   The litigation focused on whether the IRS attorneys were subject to sanctions and had to pay the taxpayer’s attorneys fees, given that the government had violated the law in trying to collect a discharged tax debt. 

The Takeaway

As this case shows, if the IRS refuses to recognize that taxes are discharged in bankruptcy, the taxpayer should start by pursuing the available administrative remedies as outlined in the regulations. The taxpayer should submit an administrative claim to the IRS and wait for a response. If the IRS fails to respond or denies the claim, the taxpayer can file a civil suit seeking damages for the willful violation of the Bankruptcy Code’s discharge provisions. Ultimately, if the IRS violates the law in trying to collect a discharged tax debt, the taxpayer may be entitled to damages and attorneys’ fees.

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