Setoff Rights of the IRS Prevail over a Debtor’s Attempt to Exempt a Tax Refund

The Bankruptcy Code and the Internal Revenue Code seem in conflict about the ability of the IRS to offset a tax refund that the debtor claims to be exempt. Resolving a question of first impression where the lower courts disagree, the Fourth Circuit came down on the side of the government and its right to offset.

A couple filed a chapter 7 petition in 2014. Virginia law includes a $5,000 exemption for “money.” They claimed an exemption covering a $3,200 refund they were to receive after bankruptcy on their 2013 taxes.

The IRS approved the refund but claimed a right to offset the refund against an unpaid tax debt of $13,500. The couple filed a complaint to determine whether they or the IRS was entitled to the refund.

The bankruptcy court sided with the debtors based on Section 522(c), which provides that exempt property is not liable for any debt that arose before filing. The district court affirmed.

The Fourth Circuit reversed in a May 12 opinion by Circuit Judge Barbara Milano Keenan.

The IRS argued that the refund was not property of the estate, thereby giving the debtor nothing to claim as an exemption.

Judge Keenan disagreed. She explained how the IRS Code requires a three-step process before the IRS can accomplish an offset.

In the case at hand, the government had not taken all of the steps, so the offset had not been completed. Because the setoff was not “successfully exercised,” Judge Keenan decided that the refund was estate property. She noted that “nothing in the bankruptcy code indicates that property interests subject to setoff are excluded from the bankruptcy estate.”

Judge Keenan then turned to the IRS’s right of offset, which turned on the interplay of three statutes.

Section 6402(a) of the IRS Code, 26 U.S.C. § 6402(a), provides that the IRS may offset “any overpayment” against any tax liability. Section 522(c) is seemingly in conflict with the IRS Code because it provides that “property exempted under this section is not liable during or after the case for any debt of the debtor that arose . . . before the commencement of the case . . . .”

Of course, the debtor relied on Section 522(c), while the IRS was the champion of Section 6402.

For Judge Keenan, however, Section 553(a) was of paramount importance. It provides that “this title [meaning the Bankruptcy Code] does not affect any right of a creditor to offset a mutual debt . . . that arose before the commencement of the case . . . .”

Judge Keenan concluded that the IRS comes out on top based on the “plain language” of Section 553(a). She interpreted the section to mean that “no provision [in the Bankruptcy Code] ‘affect[s]’ a creditor’s right to offset a mutual, prepetition debt with a bankruptcy debtor.”

Judge Keenan explained that Section 522(c) “must be read in conjunction with the unambiguous language of Section 553(a) . . . . A contrary construction, permitting Section 522(c) to subordinate the government’s offset rights, would violate that statutory directive.” She therefore held that Section 6402(a) permits the IRS to offset the tax refund, “notwithstanding the [debtors’] attempt to claim the property as exempt.”