IRS Setoff Supersedes Exemption

Posted by NCBRC - June 1, 2020

The IRS’s right to set off the debtors’ tax overpayment against their pre-existing tax debt superseded the debtors’ right to exempt the anticipated refund. Copley v. U.S.A., No. 18-2347 (4th Cir. May 12, 2020).

When the Copleys filed for chapter 7 bankruptcy they listed a debt to the IRS of over $13,500. They also claimed their anticipated tax refund as exempt under Virginia’s exemption for “money and debts due the householder not exceeding $5,000.” They subsequently filed their tax returns which showed that their withheld income exceeded the amount they owed by over $3,000. Instead of sending the Copleys a refund, however, the IRS notified them that it had used the overpayment to set off the pre-existing tax debt. The debtors filed a complaint in the bankruptcy court seeking an order requiring the IRS to turn over the tax refund to the debtors. The bankruptcy court found that the refund was part of the bankruptcy estate and that the exemption superseded IRS’s right to set-off. The district court affirmed.

The IRS argued on appeal that the tax refund never became part of the bankruptcy estate and therefore could not have been exempted from collection. The IRS maintained that while the Copleys had a tax overpayment they were not entitled to a refund of that amount because the excess tax payment in their most recent tax return went directly to the set-off of pre-existing liability and never entered the bankruptcy estate. The circuit court disagreed. It found that the bankruptcy estate is defined broadly to encompass a debtor’s interest in property even if that interest is subject to dispute. Here, when the Copleys filed their bankruptcy petition, they had not yet filed their tax return. Due to the timing, the IRS could not have taken any of the necessary steps to effectuate a setoff until after the debtors’ interest in the refund had already entered the estate. The IRS’s potential defense of setoff did not prevent the interest from entering the estate.

The circuit court went on to address whether the debtors’ claimed exemption in the anticipated refund prevented the IRS from exercising its right of setoff. Section 522(c) provides that exempt property may not be used to satisfy “any” pre-petition debt, while section 6402(a) of the IRC provides that the IRS may offset “any overpayment” against a taxpayer’s pre-existing tax debt. The court resolved this apparent conflict through the language of section 553(a), which provides in part: “this title does not affect any right of a creditor to offset a mutual debt owing by such creditor to the debtor that arose before the commencement of the case under this title against a claim of such creditor against the debtor that arose before the commencement of the case.”

The court found that section 553(a) encompassed the exemptions listed in section 522, requiring the court to read the language of section 522 in such a way that it would not affect the IRS’s right of setoff. The court went on to find that section 6402(a) unambiguously creates a right of setoff under the circumstances present in this case. In sum, the court stated: “[T]he plain text of 11 U.S.C. § 553(a) prevents us from reading an implicit exception into the offset statute based on the language of 11 U.S.C. § 522(c).”

The court rejected the Copleys’ argument that forwarding the bankruptcy goal of providing a fresh start to deserving debtors mandates a different outcome. While the court agreed that the fresh start was one of bankruptcy’s purposes, paying outstanding debts to the extent possible was another.

The court also disagreed with the debtors’ contention that its decision would render section 522(c) superfluous. Rather, the court found that section 553(a) created a statutory exception to section 522(c) allowing it to apply according to its terms where that exception does not apply.

Finally, the debtors argued that the bankruptcy court had discretion under 553(a) to deny setoff. The court disagreed, finding that the discretion to deny setoff was limited to circumstances where the right to setoff was questionable under non-bankruptcy law. Here, sections 553(a) and IRC section 6402(a) clearly established the IRS’s right to setoff and the bankruptcy court lacked discretion to disregard that right.

Copley 4th Cir May 2020

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