The Internal Revenue Service (IRS) has achieved a significant result in recent
decisions by allowing the Service to set off tax refunds against discharged tax
obligations. More important is the Fifth Circuit's recent decision substantiating this
new line of cases, In re Luongo, 2001 WL 811766
, __ F.3d __ (5th
Cir. July 18, 2001). The Fifth Circuit's holding in Luongo
is the first
appeals court decision supporting the IRS's argument that its right of setoff under
§553 trumps the effect of discharge under §524.
At issue in these cases is the ability of the debtor to retain tax refunds
post-discharge. Debtors had successfully argued that a debtor should retain his or
her tax refunds post-discharge whether the case be a chapter 7, 11 or 13
bankruptcy. As discussed below, the courts had premised their findings on three bases
to allow the debtor to retain his/her tax refunds.
To fill in some background, §553 of the Bankruptcy Code addresses setoff in
the bankruptcy context. Section 553 provides, in relevant part, that:
except as otherwise provided in this section and in §§362 and 363 of this
title, this title does not affect any right of the 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 Supreme Court has previously noted that §553 does not create a federal right
of setoff; it only preserves whatever right of setoff that exists otherwise. In re
Bourne, 262 B.R. 745, 747 (Bankr. E.D. Tenn. 2001), citing
Citizens Bank of Maryland v. Strumpf, 516 U.S. 16 (1995). "Section
553 preserves the right of setoff where there are mutual, pre-petition obligations
owing between the debtor and the creditor, and a right to setoff the obligations
exist[s] under non-bankruptcy law." Id. at 749 (citation omitted).
The Supreme Court has previously noted that
§553 does not create a federal right of
setoff; it only preserves whatever right of
setoff that exists otherwise.
In addition to the right of setoff under §553, the United States through the
Department of Treasury (IRS) possesses a right of setoff pursuant to 26 U.S.C.
§6402(d), which provides, in relevant part:
upon receiving notice from any federal agency that a named person owes a past
due legally enforceable debt [other than past due support subject to the provisions
of subsection (c)] to such agency, the Secretary shall (A) reduce the amount
of any overpayment payable to such person by the amount of such debt, (B)
pay the amount by which such overpayment is reduced under subparagraph (A) to
such agency, and (C) notify the person making such overpayment that such
overpayment has been reduced by amount necessary to satisfy such debt.
Section 6402, known as the federal intercept statute, was enacted to allow the
IRS to offset a tax refund against any debt that the taxpayer may owe a federal
agency. Id. at 749, citing Bosarge v. United States Dep't. of Educ., 5
F.3d 1414, 1417 (11th Cir. 1993), cert. denied, 512 U.S.
1226 (1994). As such, the United States through the IRS may set off tax
refunds against unpaid tax liabilities or against other unpaid government obligations such
as student loans or defaulted government insured loans.
The issues pertaining to the IRS's ability to collect tax refunds post-discharge
usually track the following scenario. The debtor files for bankruptcy listing unpaid tax
liabilities that may be comprised of secured, unsecured priority and unsecured general
tax obligations. The debtor lists a potential tax refund as exempt in Schedule C.
The debtor receives a discharge. After the discharge, the debtor anticipates receiving
the tax refund. The IRS learns of the refund and sets off the refund against unpaid
tax obligations, most notably the discharged unsecured general obligation.2 The debtor
cries foul, and litigation ensues.3
Cases supporting the debtor's argument that the tax refund should not be subject
to setoff follow three arguments. First, the courts find that the debtor's right to
exempt the tax refund prevails over the government's right of setoff. See, e.g.,
In re Jones, 230 B.R. 875, 880 (M.D. Ala. 1999). These courts
have found that to allow otherwise would render the debtor's ability to exempt property
a nullity and impermissibly elevate a right of setoff over an exemption statute.
Second, the courts find that the debtor's entitlement to a fresh start would be
frustrated and diminished by the collection of discharged obligations. Id. Further,
the paramount intent of Congress is to ensure that a debtor discharged from bankruptcy
receives a discharge that is as broad as possible.
Third, the courts find that the legislative history to §522 supports the
conclusion that setoff should not abrogate a right of exemption under §522(c).
Id. Courts examining this argument have noted that the original Senate Bill
2266's version of §522(c) contained a provision that would have allowed exempt
property to remain liable for discharged taxes. In re Martinez, 258 B.R.
364, 366 (Bankr. W.D. Tex. 2000). The Senate version was rejected,
thereby indicating that Congress did not intend that exempt property be liable for
discharged taxes. Id. (citations omitted).4
Luongo and the Emerging Minority View
The Fifth Circuit in Luongo used a three-tiered analysis in finding that the IRS'
setoff in that case was proper. First, it had to determine whether the bankruptcy
court had jurisdiction. Luongo had filed chapter 7 and sought a §505 determination
of her tax liability and right to her tax refund. The IRS argued unsuccessfully that
only the chapter 7 trustee could seek a refund on behalf of the estate, not the
debtor. Luongo, 2001 WL 811766, *2. The IRS also argued that the
bankruptcy court should have abstained from hearing the matter because there was no
apparent benefit conferred on the unsecured creditors even if the debtor was successful
in her arguments, because the refund would be paid to the debtor, not the estate.
Id. at *3. The Fifth Circuit rejected this argument, stating that a court in
considering abstention should not only consider the impact on the administration of the
estate and creditors, but on the debtor as well. Id.5 Finally, the debtor argued
that if the IRS were permitted to exercise its right of setoff, it would violate
the debtor's discharge under §524, and also that the tax refund was exempt under
§522(c). The debtor did not argue that permitting the setoff rendered §522(f)
a nullity, the setoff violated her fresh start, and the legislative history of
§522(c) suggested that Congress did not intend to have the IRS collect tax
refunds against discharged taxes.
The Fifth Circuit instead focused on the apparent conflict between
§524(a)(2)'s prohibition of offsets6 and §553's recognition of setoff rights.
Luongo, 2001 WL 811766, *4. In doing so, the Fifth Circuit found that
a discharge in bankruptcy does not bar a creditor from asserting its right of setoff.
Id. (citations omitted). The Fifth Circuit noted §553's clear statement that
bankruptcy does not affect any right of a creditor to offset. The Fifth Circuit
interpreted this statement to allow a discharged debt to be set off upon compliance
with the terms and conditions of §553, notwithstanding §524's post-discharge bar.
Id.7 Moreover, the court noted the injustice in requiring a creditor to file a
claim for satisfaction of a debt while compelling the same creditor to pay the full
amount of its debt to the estate. Id. at *6. The court also theorized that in
setoff actions involving taxes, an inequity could arise where the debtor could shelter
assets from creditors by making substantial overpayments to the IRS during a given tax
year. The debtor could then withhold the filing of his/her tax return until after
filing bankruptcy and receiving a discharge. The debtor could then seek a refund
post-discharge unfettered by the IRS's right of setoff.8
The Fifth Circuit did reject the debtor's argument that the refund was exempt
property, but not for the same reasons as other courts have found that the exemption
right trumps a right of setoff.9 Instead, the Fifth Circuit found that §522
would only be implicated where it could be demonstrated that the refund exceeded the
tax liability, thereby resulting in a residual amount of money that would become
property of the estate. Id. at *8. The Fifth Circuit held that under 26
U.S.C. §6402(a), the debtor is generally entitled to a refund to the extent
that the overpayment exceeds the tax liability. If there is not entitlement to a
refund because the refund does not exceed the tax liability, the refund does not
become property of the estate because the debtor is not entitled to a refund.
Id.10 Further, the Fifth Circuit found that the tax refund could be applied
against discharged taxes.
Recent bankruptcy court decisions have directly confronted the majority view. For
example, the court in In re Bourne, 262 B.R. 745, 755 (Bankr.
E.D. Tenn. 2001), noted that the argument that applying §553 over §522
would nullify §522 could equally apply to an argument that applying §522 over
§553 would nullify §553. Further, enforcing a creditor's right of setoff does
not compromise the debtor's right to exemptions, but limits the effect on a claim of
exemptions by a creditor that has a valid right of setoff. Id.
As to the rationale that a right of setoff compromises the debtor's fresh
start, the Bourne court found that the Bankruptcy Code does not always defer to
the fresh-start principle, noting the 18 exceptions to discharge in §523. Id.
As such, just as the fresh-start provision must yield to specific provisions to
the Code, it must bow to the provisions of §553. Id. (citation omitted).
The court further found that validating the right of setoff over discharge would
comport with the recognition that setoff is afforded special status under the Code.
The reliance on the legislative history of §522 has also been placed in
question. The conclusion that the failure to enact the Senate bill version of
§522(c), which would have allowed exempt property to be used to pay discharged
taxes, is misplaced. Martinez, 258 B.R. at 366. As was noted by the
bankruptcy court in Martinez:
Congress did not act to prohibit the setoff in question [IRS setoff against
exempt property], and debate over approval of a provision to explicitly allow
setoff in these circumstances does not clearly evince Congressional intent. In
any event, the courts are governed by the plain meaning of the statute, rather
than cloudy legislative history.
Application to Specific Chapters of the Code
As noted herein, the Luongo and Davidovich decisions strengthen a creditor's right
of setoff post-discharge in chapter 7 cases. Chapter 11 is less clear. The Third
Circuit did not uphold the General Service Administration's right of setoff
post-discharge in a confirmed chapter 11 case absent a retention of the right in the
confirmed plan. In re Continental Airlines, 134 F.3d 536 (3rd Cir.),
cert. denied, 525 U.S. 929 (1998); but, see De Laurentiis, 963
F.2d at 1278.
The chapter 13 context provides a more interesting scenario. Debtors have argued
that a confirmed chapter 13 plan that does not provide a right of setoff binds the
creditor to the terms of the plan. Section 1327(a); United States v. Norton,
717 F.2d 767, 774 (3rd Cir. 1983). A majority of courts have
held that a confirmed plan does not extinguish a right of setoff, observing that in
the chapter 11 context, if §1141 were allowed to trump §553 unless written
into the plan, §553 would be rendered meaningless. In re Sedlock, 219 B.R.
207, 209 (Bankr. N.D. Ohio 1998); United States v. Munson (In re
Munson), 248 B.R. 343, 346, fn.2 (C.D. Ill. 2000) (noting
that if Congress intended to depart from common law by allowing §1327 to
predominate over §553, it could have explicitly done it).
1 The views expressed in this article are Mr. Gargotta's and do not necessarily reflect the views of the Department of Justice or
the Internal Revenue Service (IRS). Return to article
2 The IRS, as a general rule, would not set off the refund against its secured claim because the IRS can pursue collection of
the claim against the debtor's property, nor would it apply it against the priority component of its claim because its priority claims are
non-dischargeable. Return to article
3 Two other aspects of tax-refund litigation are generally not at issue. First, many of the decisions report that the requirements
for setoff are that no exceptions exist under §553(a), that the debts owing both to the debtor and creditor both arose pre-petition,
and that the debts are mutual or reciprocal obligations either met or stipulated to by the parties. Second, the refund arises at the end
of the tax year to which the refund relates. Matter of Midland Indus. Serv. Corp., 35 F.3d 164, 167 (5th Cir. 1994),
cert. denied, 514 U.S. 1016 (1995); Cf. In re Ripley, 926 F.2d 440 (5th Cir. 1991) (the debtor's liability
and IRS's claim is determined by the date the tax return is due). Return to article
4 Additionally, the majority view rejects the minority view's reliance on §542(b) as a basis to the allowance of the setoff.
Section 542(b) requires payment to the trustee of a debt that is property of the estate unless the debt is subject to offset. Therefore,
courts have reasoned that §542(b) is an exception to §522(c) because §542(b) "enables a creditor who has a valid right of setoff
to retain the property, regardless of its exempt status." Bourne, 262 B.R. at 754; quoting Eggemeyer v. IRS (In re
Eggemeyer), 75 B.R. 20, 22 (Bankr. S.D. Ill. 1987). The majority notes that §542(b) only deals with the turnover
of property of the estate. Because the debtor has exempted the tax refund, it is no longer property of the estate, and §542(b) is
inapplicable. Bourne, 262 B.R. at 754. The majority view further finds that the refund is subject to turnover under §542(a)
because an entity in possession of property that is subject to exemption must turn over the property to the trustee or debtor. Section
542(a) is not limited by a right of setoff. Id. The Bourne court reasoned that §542(a) would not apply to setoff because
§542(a) only addresses property of the estate held by a third party, rather than a debt owed to each other. Id. Return to article
5 Judge Emilio Garza wrote a thoughtful dissent that would have found that the bankruptcy court lacked jurisdiction to hear the matter
because the refund did not benefit the estate, and that alternatively, the court should have abstained. Return to article
6 "A discharge in a case in this title...operates as an injunction against the commencement or continuation of an action...[to]
offset any such debt as a personal liability of the debtor, whether or not discharge of such debt is waived." Return to article
7 Accord, In re DeLaurentiis Entertainment Group Inc., 963 F.2d 1269 (9th Cir. 1992), cert. denied, Carolco
Tele. Inc. v. Nat'l. Broadcasting Co. Inc., 506 U.S. 918 (1992); In re Deutchman, 192 F.3d 457 (4th Cir.
1999); In re Davidovich, 901 F.2d 1533 (10th Cir. 1990). Return to article
8 This theory would only apply in chapter 7. Anecdotal evidence suggests to me that this possibility is limited. Return to article
9 After discharge, the debtor moved to reopen her case to amend her schedules to exempt the tax refund. Return to article
10 The Fifth Circuit left open the question of whether section 522(c) immunizes exempt property from setoff. Return to article