On an issue where the courts are hopelessly divided, a district court in Richmond, Va., ruled in favor of the debtor by barring the Internal Revenue Service from setting off a tax refund when the debtors were claiming an exemption in the refund.
In her September 10 opinion, District Judge M. Hannah Lauck also rejected the government’s claim of sovereign immunity.
Twice this week, we have featured Judge Lauck in this column. On September 10, we described how the Fourth Circuit adopted her opinion regarding appellate standing and equitable mootness. Mar-Bow Value Partners LLC v. McKinsey Recovery & Transformation Services US LLC (In re Alpha Natural Resources Inc.), 17-2268, 2018 BL 321354 (4th Cir. Sept. 6, 2018). To read the ABI discussion, click here.
Simple Facts, Difficult Question
A couple filed a chapter 7 petition in May 2014, owing the IRS about $13,500 in unpaid taxes for the years 2008 through 2010. For the year 2013, the couple were entitled to a refund of some $3,000 for overpayment of taxes.
Using Virginia’s $5,000 wildcard exemption, the debtors claimed an exemption in the entire $3,000 refund. The IRS did not object to the exemption.
After the debtors filed their 2013 tax return in June 2014, the IRS notified the couple that it was offsetting the refund against the unpaid taxes.
Later, the couple sued the IRS in bankruptcy court, seeking a declaration that their exemption precluded setoff.
On cross motions for summary judgment, Bankruptcy Judge Keith L. Phillips of Richmond ruled in favor of the couple. He concluded that the debtors’ exemption took precedence over the IRS’s right of setoff and directed the IRS to turn over the $3,000 to the debtors. Judge Lauck affirmed in a 35-page opinion. She agreed with Judge Phillips that the debtors’ right to an exemption “supersedes” the government’s right of setoff.
Exemption vs. Setoff: Who Wins?
Deciding whether an exemption overrides the right of setoff is “a difficult legal issue,” Judge Lauck said. Courts around the country “have taken varying approaches, and reached contrary outcomes, when addressing the interplay of setoffs and exemptions under the Bankruptcy Code.” Even federal courts in Virginia do not agree, she said.
Judge Lauck demonstrated that the debtors properly claimed an exemption in the $3,000 under Virginia law and Section 522 of the Bankruptcy Code. On the other hand, the government had a right of setoff under Section 553, which provides that nothing in the Bankruptcy Code, aside from Sections 362 and 363, affects “any right of a creditor to offset a mutual debt . . . .”
Judge Lauck said the courts “have struggled to reconcile Sections 522 and 553, resulting in courts reaching conflicting outcomes.”
Significantly, Judge Lauck said that the standard of appeal for disallowance of setoff is abuse of discretion, because the applicability of Section 553 “is permissive, rather than mandatory.” A bankruptcy court, she said, “may exercise its equitable discretion to determine whether to apply an offset provision in the Bankruptcy Code.”
Similarly, Judge Lauck said that the government’s ability to credit an overpayment of taxes against a tax liability is “discretionary” under Section 6402 of the IRS Code.
The government, however, argued that the tax refund never became estate property, precluding the exercise of a right of exemption. Although some courts have ruled otherwise, Judge Lauck agreed with the majority to hold that the right to a refund became property of the estate on the filing date in 2014 because the debtors’ right to the refund had vested on December 31, 2013.
Since the refund was estate property, Judge Lauck said the IRS was required to comply with the Bankruptcy Code and could not “unilaterally take property from the bankruptcy estate” by exercising a right of setoff. However, she did not rest her opinion on the government’s failure to lodge a timely objection to the exemption claim.
Weighing the government’s right of offset against the debtors’ right to an exemption, Judge Lauck concluded that the bankruptcy court “did not abuse its equitable discretion in holding that the IRS’s right of setoff under Section 553 appropriately gave way to the Debtors’ claimed exemption under Section 522.”
“Section 553 is permissive in application, not mandatory,” Judge Lauck said, and “prioritizing Section 522 over Section 553 best supports the fundamental goals of the Bankruptcy Code.” She went on to say that “Section 533’s permissive application must yield to Section 522’s unqualified authorization to Debtors to exempt property pursuant to its requirements.”
Because the standard of appeal was abuse of discretion, Judge Lauck conceivably could have upheld the bankruptcy court even had Judge Phillips reached the opposite legal conclusion. Nonetheless, Judge Lauck said that Judge Phillips “did not err in [his] application of the law.”
Judge Lauck gave primacy to the debtors’ exemption. Because “Section 553’s applicability is permissive, rather than mandatory, and because nothing similarly narrows the scope of Section 522, the Court finds Section 522’s exemption rights superior to Section 553’s setoff rights. Such an interpretation gives meaning to both sections without nullifying either.”
Although Judge Lauck found “persuasive arguments on either side of the debate,” she concluded that Judge Phillips did not err on the legal issue “and did not abuse [his] discretion in disallowing the setoff . . . because compelling circumstances exist to disallow setoff.”
In a footnote, Judge Lauck said that the Fourth Circuit issued a nonprecedential opinion in 1996 finding that a right of setoff cannot be exercised against an exempt asset.
Sovereign Immunity
The government argued that sovereign immunity divested the bankruptcy court of jurisdiction to bar setoff. According to the IRS, there was no waiver of sovereign immunity under Section 106(a)(1) because none of the 59 listed provisions of the Bankruptcy Code creates a cause of action allowing the debtors to bar an exercise of setoff.
Judge Lauck rejected the government’s sovereign immunity argument. She said that the debtors’ suit “directly implicates Sections 522 and 553,” which are both listed in Section 106(a)(1). Because “resolving the case requires resolving the tensions between Sections 522 and 553” she said “the case squarely falls within the scope of Sections 522 and 553.”
The government argued there was no waiver of sovereign immunity, since neither section creates a cause of action. Judge Lauck said that the argument lacked merit, because Section 106(a)(2) allows the court to “hear and determine any issue arising with respect to” the sections enumerated in Section 106(a)(1).
Section 106 waived sovereign immunity, according to Judge Lauck, because the two sections “constitute the heart of the case.”