On April 8 in the case of Bush v. United States decided by the bankruptcy court for the Southern District of Indiana the Court addressed an argument I thought the IRS had abandoned 25 years ago. At issue in the case is the interpretation of Bankruptcy Code 523(a)(7). Section 523(a) sets out the types of unsecured liabilities that Congress excepted from discharge in bankruptcy cases filed by individuals. I discussed another aspect of section 523(a)(7) in a post earlier this year. Subparagraph (a)(7) addresses the discharge of fines and penalties. The language of this subparagraph is not a model of clarity, but in a trio of circuit court cases decided 25 years ago and cited in the Bush opinion, the IRS fought about the interpretation as it applied to the fraud penalty and it lost. After losing those three cases at the Circuit Court level, the IRS gave up on the issue and issued what was then called a Litigation Guideline Memorandum saying to its employees that it would no longer litigate this issue. Yet, in the Bush case, the IRS, which was aware of the earlier cases, made the same arguments it lost 25 years ago.
The position here must reflect a shift in its litigating position or an attorney who was unaware of the government’s litigating position on this issue. I am surprised by the shift if it is a shift in position. The issue is one in which the interpretation of the courts has the support of the literal language of the statute but not the legislative history or the statutory intent. Giving up on the issue 25 years ago was difficult and apparently more difficult than I anticipated. Of course, the IRS can change its mind on this issue if it wants to do so. It did not lose the issue yet in the Supreme Court. It must be careful, however, in raising discharge arguments to monitor the cases that have this issue since a wholesale reversal of its position could cause it to keep liabilities on the books on an issue it might ultimately lose and could create problems with the discharge injunction if it continues collecting on liabilities that were discharged.
When a taxpayer files a fraudulent return, it almost always takes the IRS several years to establish fraud. Sometimes, the IRS establishes fraud after a criminal case which by its nature will take several years before the civil case follows. Sometimes the IRS establishes fraud in a civil case with no criminal component; however, taxpayers rarely concede that they committed fraud in filing a return so even these civil cases usually end up in Tax Court and otherwise take much longer than the ordinary case before fraud is established. Because of the length of time it takes to establish fraud and the importance of a fraud determination in the panoply of penalties, the language of BC 523(a)(7) makes no sense when read literally. Read literally, as the three circuit courts did 25 years ago and as Bush follows, the fraud penalty, like all other tax penalties (not counting the trust fund recovery penalty), gets discharged three years after the due date of the return. This does not seem to be the result Congress wanted nor is it a result that necessarily makes sense from a policy standpoint given the egregious behavior that underlies the determination of fraud, but this is where the language of the statute has taken the courts.
The years at issue in this case are 2009-2011. At the time of filing the bankruptcy petition in this case two of the three years, for which the taxpayers timely filed their returns, were more than three years old. The taxpayers’ returns for these years were fraudulent. The question is whether the language of the statute permits the discharge of these taxes or whether they are discharged under the language of the bankruptcy code.
As the Court in Bush discusses, subparagraph 523(a)(7) has two parts in its description of how to treat tax penalties, and, depending on whether you read these two parts as creating two separate tests that must both be met or whether you read them as requiring that only one of the tests be met, a different result attaches. The statute reads:
A discharge under section 727…. Of this title does not discharge an individual debtor from any debt –
(7) to the extent such debt is for a fine, penalty, or forfeiture payable to and for the benefit of a governmental unit, and is not compensation of actual pecuniary loss, other than a tax penalty –
(A) relating to a tax of a kind not specified in paragraph (1) of this subsection, or
(B) imposed with respect to a transaction or event that occurred before three years before the filing of the petition.
The IRS made the same arguments it made 25 years ago. It argued that the statute could be read two ways. As the majority of courts reviewing the statute have done, it could be read to discharge a penalty that meets either (A) or (B); however, as an earlier opinion in the 7th Circuit (the Circuit to which an appeal in the Bush case lies) had done, the statute could be read as interpreting (A) addressing tax penalties and (B) addressing “free-standing penalties.” Because of the confusion caused by the statute, the Court should resort to the legislative history in order to determine the correct meaning of the statute. The legislative history, according to the IRS, supports the second conclusion and excepts the fraud penalty from discharge. I thought this argument had merit 25 years ago when I argued for appeal of the cases that ultimately went the other way.
The Court here finds that the IRS argument is flawed because (B) does not limit itself to “free-standing penalties.” By its language it applies equally to tax penalties as well as free standing penalties. Therefore, the statute is not ambiguous and the Court does not need legislative history to get to the correct result. This interpretation of the statute caused the Court to determine that the fraud penalty for 2009 and 2010 were discharged by the bankruptcy. A different result, however, attaches to 2011 because the bankruptcy petition for that year was filed within three years of the due date of the return. Because the due date for the 2011 return occurred within three years of the bankruptcy petition, the fraud penalty for that year is excepted from discharge.
Will the latest loss put this issue back into the freezer for another 25 years when another generation of government lawyers looks at the statute and determines that it should not discharge fraud penalties? Will the latest loss cause the IRS to abandon the issue forever? If your client has this issue, watching whether the Bush case gets appealed will provide the short term answer.