In a case from Virginia, the superiority of the IRS’s right to set off was reaffirmed.
The IRS has the right to set off the debtors’ tax overpayment against pre-existing tax debt which is superior to the debtors’ right to exempt the anticipated refund. Copley v. U.S.A., No. 18-2347 (4th Cir. May 12, 2020).
The debtors filed for chapter 7 bankruptcy and listed a debt to the IRS of over $13,500. They claimed their anticipated tax refund as exempt under Virginia’s exemption for “money and debts due the householder not exceeding $5,000.”
They were due over $3000 after they filed their tax returns. Instead of refunding the overpayment, 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 turn over of the tax refund.
The bankruptcy court agreed that the refund was (1) part of the bankruptcy estate and (2) the bankruptcy exemption superseded the IRS’s right to set-off. The district court affirmed.
On appeal, the IRS argued that the tax refund was not part of the bankruptcy estate. The excess tax payment went directly to the set-off of pre-existing liability. It never became part of bankruptcy estate. Thus it could not be exempted.
The circuit court disagreed. The bankruptcy estate definition is broad and includes the debtor’s interest in the property even if that interest is in question. Therefore, the debtors’ interest in the refund was part of the estate.
The circuit court addressed the debtors’ claim that the exemption in the anticipated refund prevented the IRS from exercising its right of setoff by analysing several conflicting statutes.
First, 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.
Faced with the conflicting sections, the court turned to 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.”
In plain english, section 553(a) means that if you owe Bank A $100.00 and you file bankruptcy. After the case is filed, it turns out you Bank A actually owes you $200. Then Bank A can deduct the $100 you owe before giving you your money. This commonly applies to IRS and banks.
It found that section 553(a) covered the exemptions listed in section 522, by exempting the entire title from changing the right of setoff which meant section 522 did not affect the IRS’s right of setoff.
Finally, the court found that section 6402(a) creates a right of setoff under the circumstances present in this case.
If you have a bankruptcy or tax debt related question feel free to contact me at 410-849-9529.
