By: Kyle J. TumSuden
St. John’s Law Student
American Bankruptcy Institute Law Review Staff
Recently, in In re Pugh, the Bankruptcy Court for the Eastern District of Wisconsin modified the automatic stay to allow the IRS to offset the debtor’s post-petition claim for tax overpayment against the debtor’s prepetition tax liability due to the IRS. In Pugh, the chapter 13 debtor confirmed her plan, which provided that she would be able to keep any federal or state tax refunds received during the term of the plan. Sometime after the debtor had filed, the IRS audited her prepetition tax returns and discovered a tax liability for 2011. The debtor then filed a proof of claim on behalf of the IRS for the tax liability for 2011, and the IRS subsequently filed an amended proof of claim. In early 2014, the debtor filed her 2013 federal income tax return, claiming a refund based on an overpayment. The IRS did not remit the refund to the debtor and instead moved for an order modifying the automatic stay to allow the IRS to offset the debtor’s post-petition claim to a tax overpayment against prepetition tax liabilities. The debtor that, pursuant to section 541(a)(7) of the Bankruptcy Code, the right to the refund was property of the estate because the 2013 tax refund did not exist at the time of the bankruptcy filing. In addition, the debtor argued that the 2011 tax obligation arose post-petition because, at the time of filing, she did not owe any taxes for 2011. The IRS, however, maintained that the overpayment for 2013 was not property of the debtor or the estate because under section 6402 of the Internal Revenue Code, the IRS was entitled to offset such against the tax liability for 2011. Therefore, the IRS argued that the debtor was entitled to a refund only if there was a net amount remaining after offset. Ultimately, the court granted the IRS’ order modifying the automatic stay, thereby allowing the IRS to offset the debtor’s post-petition tax overpayment for 2013 against the debtor’s prepetition 2011 tax liability.
Courts are split as to whether the IRS may offset a prepetition tax liability against a post-petition tax overpayment. On one hand, courts following the majority approach, discussed in In re Luongo, treat a tax refund as part of the bankruptcy estate; the tax refund, however, does not vest in the estate until after the Treasury has complied with 26 U.S.C. § 6402(a), leaving only a net amount as part of the estate. On the other hand, some courts following the minority approach have refused to allow the IRS to offset unpaid tax debt against any tax overpayment prior to remitting a refund to the debtors regardless of the Treasury’s compliance with 26 U.S.C. § 6402(a). The minority courts reason that although the IRS has the right to setoff, as provided by 26 U.S.C. § 6402(a), right does not constitute “cause” to lift the automatic stay. In Pugh, the court adopted the from Luongo and held that the IRS had the right to offset the prepetition tax liability against the post-petition overpayment because section 6402 of the Internal Revenue Code provides how much of the debtor’s overpayment in any tax year will result in a refund to which the debtor is entitled. Therefore, the Pugh court concluded that the debtor’s bankruptcy plan could not force payment of a refund to the debtor while the debtor’s pre-petition taxes remain unpaid.
The split over whether a debtor who overpaid his post-petition taxes for a given year will be entitled to a tax refund if the debtor has a pre-petition tax liability discussed in Pugh may have for an individual debtor. ebtors within minority jurisdictions should be somewhat relieved that the IRS will most likely not be able to offset their unpaid tax debt against any tax overpayment. should rs because the ultimate outcome, while arguably inconvenient, was largely harmless to the debtor and probably was in her best interest. In particular, the debtor was upset that she would not be able to keep her return to spend how she liked while paying the IRS its claim over the life of the plan. While the debtor apparently wanted the instant gratification of receiving a tax refund, using the overpayment to pay the tax liability, which was a non-dischargeable, priority claim, ultimately makes more sense given the high failure rate of individual chapter 11 and chapter 13 cases. If the debtor ultimately failed to complete her plan, she would at least owe less in back taxes. Thus, by using a post-petition overpayment of taxes to offset (whether voluntarily or involuntarily) a pre-petition tax liability, a chapter 11 or chapter 13 debtor can improve his ultimate financial position by immediately decreasing or eliminating his tax liability, which would not otherwise be discharged if his case is dismissed or converted to chapter 7.
 In re Pugh, 510 B.R. 862, 868 (Bankr. E.D. Wis. 2014).
 See id.
 Id. at 862.
 See In re Pugh, 510 B.R. at 862.
 See id. at 864. Section 541(a)(7) of the Bankruptcy Code states that an estate is created following a debtor’s voluntary petition for bankruptcy; the estate is to be comprised of “[a]ny interest in property that the estate acquires after the commencement of the case.” 11 U.S.C. § 541(a)(7).
 See In re Pugh, 510 B.R. at 864.
 See id.
 See id. Here, the IRS argued that the debtor was not owed a refund because there was no net amount after the offset; the debtor’s overpayment for 2013 was less than the debtor’s tax liability for 2011. Id.
 See In re Pugh, 510 B.R. at 866.
 In re Luongo, 259 F.3d 323 (5th Cir. 2001).
 See Pettibone Corp. v. United States, 34 F.3d 536 (7th Cir. 1994). In Pettibone Corp., the court upheld the “accounting method” of continuously netting the chapter 11 taxpayer’s underpayments and overpayments in each tax year, so as to calculate the debtor’s total deficiency at the time of the bankruptcy filing. See also, In re Pigott, 330 B.R. 797 (Bankr. S.D. Ala.2005). In Pigott, the court held that tax overpayment does not necessarily create debt due to the taxpayer because an overpayment is not the same as a refund. Id. at 802. “Since an overpayment is not credited to the debtor until after offsets have occurred, if the IRS chooses to make such offset, there is no interest in a debtor until the refund has been declared.” Id.
 See In re Pigott, 330 B.R. at 797. See also, In re Sexton, 508 B.R. 646, 662 (Bankr.W.D.Va. 2014). In Sexton, the court did not allow the IRS to lift to automatic stay to offset the tax debt against the tax overpayment because, according to 11 U.S.C. § 541(b), the debtor’s property interests vested in the debtor’s bankruptcy estate. Id. If the IRS wanted to use the overpayment for a setoff under § 6402, it must first get relief from the stay or find an exemption to § 541(b) enumerated in § 362(b).
 See In re Sexton, 508 B.R. at 662.
 See, e.g., In re Vargas, 342 B.R. 762 (Bankr. N.D. Ohio 2006). In Vargas, the IRS was not entitled to relief from stay simply because it held the right of setoff. Id. at 765.
 See In re Vargas, 342 B.R. at 762.
 See id.
 See, e.g., Susan Ladika, Chapter 13 Bankruptcy: How it Works, Fox Business (May 09, 2013, 10:04 AM), http://www.foxbusiness.com/personal-finance/2013/04/19/chapter-13-bankru... U.S. Bankruptcy Court data shows 240,000 Chapter 13 cases were closed in 2011, with just 22% completed. Id. see also, Anne Lawton, Commentary, Chapter 11 Triage: Diagnosing a Debtor’s Prospect for Success, 54 Ariz. L. Rev. 985, 1005 (2012). The article suggests that more than 70% of Chapter 11 cases are not successful. Id. In 36 of the 269 studied cases with confirmed plans, the court either dismissed or converted the case, or the debtor re- filed for bankruptcy post-confirmation. In total, 13% of the confirmed-plan cases failed. Id.