By: Robert Griswold
St. John's Law Student
American Bankruptcy Institute Law Review Staff
In U.S. v. White,
a debtor owed $8,922.40 to the Internal Revenue Service (“IRS”), $1,780.52 of which was considered priority debt.
[2]
The debtor filed for chapter 13 bankruptcy in February of 2004 and claimed as exempt a $3,148 tax overpayment for the 2003 tax year.
[3]
The IRS moved to lift the automatic stay in order to allow it to setoff the entire 2003 overpayment against its pre-petition tax claim.
[4]
In the decision appealed from, the Pennsylvania bankruptcy court allowed the IRS to setoff only to the extent of the priority debt, requiring the remainder of the overpayment to be returned to the debtor as a tax refund.
[5]
The district court reversed, holding that the IRS could setoff the entire 2003 overpayment.
[6]
The court acknowledged a split of authority regarding whether the IRS’ right to setoff non-priority debt is allowed against exempt assets of the debtor or whether its right to setoff is limited to priority claims,
[7]
but found the reasoning behind the cases allowing setoff of the overpayment against entire pre-petition claim more compelling.
[8]
Outside of bankruptcy, the IRS may setoff tax overpayments against the debtor’s tax outstanding tax liability.
[9]
The proper treatment of that setoff right in bankruptcy is unclear because of a conflict between sections 522(c) and section 553 of the Bankruptcy Code. Section 522 allows the debtor to exempt certain assets, and section 522(c) states that exempt assets may not be liable during or after the bankruptcy proceeding for any debt that arose before the case, with some limited exceptions.
[10]
One of these exceptions “specifically subjects these exemptions to pre-petition, priority claims,”
[11]
which is why priority debt is not barred from setoff by section 522.
[12]
Courts permitting setoff of non-priority debt look to section 553, which provides that Title 11 “does not affect any right of a creditor to offset a mutual debt . . .” that arose before the commencement of the case against debt that also arose before the commencement of the case.
[13]
These courts reason that “the clear and unambiguous language of [section] 553(a)”
[14]
means that no section of the Title, including section 522(c), should affect the IRS’ pre-existing right to setoff.
[15]
Some courts argue instead that section 553 stands in direct conflict with section 522.
[16]
The courts that favor exemption argue that section 553 has been construed as being “permissive in nature, rather than mandatory.”
[17]
Therefore, according to these courts, upholding the pre-existing right of setoff is at the discretion of the court.
[18]
The two lines of cases also disagree on the Congressional intent involved,
[19]
the proper method of statutory interpretation and the predominant policy consideration.
[20]
Courts limiting setoff rights focus on the section 522 policy of providing a lifeline to debtors declaring bankruptcy by allowing some property to be off limits, ensuring that the debtor emerges from bankruptcy with the basic means to survive and the ability to make a fresh start.
[21]
The contrary view notes that there are many other exceptions to the debtor’s exemption rights and that the fresh start policy is “not always paramount and is often subordinated to other social and economic concerns and objectives.”
[22]
The Bankruptcy Code reflects a balance between the fresh start for the debtor and providing a fair distribution of assets to creditors,
[23]
and section 553 demonstrates that the fresh start policy does not “trump the common law rights of creditors of setoff of mutual debts.”
[24]
[9]
See 26 U.S.C. § 6402(a) (2006) (allowing IRS to setoff any overpayments by amount of pre-existing debt).
[15]
See In re Martinez, 258 B.R. 364, 366 (Bankr. W.D. Tex. 2000) (“The clear and unambiguous language of section 553(a) states that Title 11 does not affect a creditor’s right of setoff.”); In re Kitty Hawk, 255 B.R. at 427–28 (suggesting that the IRS’ right of setoff is unaffected by the working of the bankruptcy proceeding).
[16]
In re Jones, 230 B.R. 875 (Bankr. M.D. Ala. 1999) (“There is . . . an apparent conflict between § 522(c) and § 553(a).”). But see In re Kitty Hawk, Inc., 255 B.R. at 427 (suggesting there is no conflict between sections 522 and 553).
[17]
In re Alexander, 225 B.R. 145, 147 (Bankr. W.D. Ky. 1998); see In re Pace, 257 B.R. 918, 919 (Bankr. W.D. Mo. 2000) (“[T]he language of § 553(a) has been construed as being permissive in nature, rather than mandatory.”).
See In re Tarbuck, 318 B.R. 78, 85 (Bankr. W.D. Pa. 2004) (“It is within this court’s discretion whether to permit setoff.”); In re Pace, 257 B.R. at 919 (explaining that section 553’s application ‘‘rests in the discretion of [the] court”); In re Alexander, 225 B.R. at 147 (stating section 553 is applied at discretion of the court).
[19]
The Senate version of section 522 specifically allowed for exempted property to remain liable for discharged tax debts, but this wording was dropped before the law was enacted. In re Alexander, 225 B.R. at 150. Some argue that this is an indication that Congress did not intend exempt property to be subject to section 553. Id. The courts favoring setoff suggest that Congress did not prohibit the setoff of exempt property, and thus the removal of the restriction is not a clear indication of Congressional intent. In re Martinez, 258 B.R. at 367.
[20]
Courts favoring exemption suggest that allowing setoff of exempt assets would nullify section 522, and that statutes should be interpreted in a way that avoids nullification. See, e.g., In re Alexander, 225 B.R. at 147. Others, such as the court in In Re Bourne, do not agree that allowing setoff would nullify section 522, which would still be effective against creditors without a right of setoff. 262 B.R. 745 (Bankr. E.D. Tenn. 2001).
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