The Fourth Circuit all but gave the federal government a free pass for violating the automatic stay by effecting a setoff without having first obtained a modification of the automatic stay.
The Government Tax Refund Setoff
Several years before bankruptcy, the debtors defaulted on a federally guaranteed home mortgage. Also before bankruptcy, the Department of Housing and Urban Development, or HUD, paid the $23,000 deficiency owing to the lender and served the debtors with a notice of intent to collect by a so-called treasury offset.
Before bankruptcy, HUD had recovered almost $10,000 of the deficiency by offsetting a federal tax overpayment for 2016.
The debtors filed a chapter 7 petition in West Virginia in early 2018, before they filed their 2017 tax return. The couple claimed an exemption covering the expected 2017 federal tax overpayment. After bankruptcy, the debtors filed a tax return seeking a $6,000 refund. Subsequent to bankruptcy and without obtaining a modification of the automatic stay, the U.S. Treasury offset the 2017 overpayment against the deficiency owing to HUD.
The debtors initiated an adversary proceeding to recover and exempt the 2017 refund that the Treasury had offset. Affirmed in district court, the bankruptcy judge ruled that the 2017 refund was estate property and that the debtors’ right to claim an exemption took precedence over the government’s offset rights. To read ABI’s reports on the bankruptcy and district courts decisions, click here and here.
HUD appealed to the Fourth Circuit.
Copley
After the district court’s affirmance in December 2019, the Fourth Circuit handed down Copley v. United States, 959 F.3d 118 (4th Cir. May 12, 2020). There, 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 claimed a right to offset the refund against an unpaid tax debt of $13,500. The couple filed a complaint to determine whether the IRS or they were 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 Copley, based on Section 6402(a) of the IRS Code, 26 U.S.C. § 6402(a). It provides that the IRS “may” offset “any overpayment” against any tax liability. To read ABI’s report, click here.
Copley Required Reversal
Where Copley invoked Section 6402(a), the new case in the Fourth Circuit dealt with Section 6402(d). Also part of the Treasury Offset Program, subsection (d) calls for federal agencies to notify the Treasury when someone owes a past-due and legally enforceable debt. Section 6402(d)(1) goes on to provide that the Treasury Secretary “shall” reduce the taxpayer’s overpayment by the amount of the debt, pay the agency, and notify the taxpayer.
In his opinion for the appeals court on April 7, Circuit Judge J. Harvie Wilkinson, III said that the lower courts “lacked the guidance of Copley.” He observed that the government’s offset rights were even stronger than they were in Copley because subsection (d) uses the word “shall,” which is “imperative,” while subsection (a) uses the word “may.”
Based on Copley and the word “shall,” Judge Wilkinson had little difficulty reversing and holding that the government’s right of setoff nixed the debtor’s right to exempt the tax refund under Section 522(c). That section provides that an exempted asset “is not liable during or after the case” for a debt that arose before commencement of the case.
In other words, Judge Wilkinson said, the debtors’ “income tax overpayment is not exemptible” because the government’s “offset right superseded the general exemption protections of Section 522(c).”
The Stay Violation
The government was not out of the woods in view of Section 362(a)(7), which bars “the setoff of any debt owing to the debtor that arose before the commencement of the case . . . against any claim against the debtor.”
Judge Wilkinson found a stay violation because “the government did exactly what the Code forbids.” He upheld the district court’s finding of a stay violation.
Judge Wilkinson did not himself set aside the setoff as a sanction for the stay violation because the automatic stay may be “retroactively annulled” under Section 362(d). “Barring exceptional circumstances,” he said that “the government’s motion for relief from the automatic stay in cases of this kind should ordinarily be granted.”
Judge Wilkinson did not go so far as to say that the government should have a free pass on remand. Given that the government had not yet filed a motion to annul the stay, he directed that “the lower court must, in considering this motion, give proper weight to the government’s rights under § 6402(d), consistent with the carefully wrought requirements of the Bankruptcy Code.”
Observations
The opinion does not say outright that the government should have a stay annulment and suffer no sanction for a stay violation. However, the stay violation occurred before Copley, when there was no clear-cut precedent affirming the government’s setoff rights. The government can argue “no harm, no foul,” and Judge Wilkinson himself said that annulment should “ordinarily” be granted “in cases of this kind.”
This writer hopes the opinion will not be understood to mean that the government may effect a setoff without first obtaining a stay modification. After this opinion, the government is certainly on notice that a stay modification is required.
However, there is a shortcoming in the decision.
Under Section 522(a), creditors are only entitled to offset “mutual” debts and credits.
There was no mutuality problem in Copley, because the IRS was offsetting a tax refund against a tax liability. On the other hand, there was a mutuality question in the new case because the IRS was offsetting a tax refund against a debt owing to HUD, another government agency.
The mutuality question was raised by the debtors’ counsel in the Fourth Circuit, but the opinion did not touch on the subject. The result might be different in cases in the future if the court were to deal with the mutuality requirement in the context of the Treasury Offset Program.
The Fourth Circuit all but gave the federal government a free pass for violating the automatic stay by effecting a setoff without having first obtained a modification of the automatic stay.
The Government Tax Refund Setoff
Several years before bankruptcy, the debtors defaulted on a federally guaranteed home mortgage. Also before bankruptcy, the Department of Housing and Urban Development, or HUD, paid the $23,000 deficiency owing to the lender and served the debtors with a notice of intent to collect by a so-called treasury offset.
Before bankruptcy, HUD had recovered almost $10,000 of the deficiency by offsetting a federal tax overpayment for 2016.
The debtors filed a chapter 7 petition in West Virginia in early 2018, before they filed their 2017 tax return. The couple claimed an exemption covering the expected 2017 federal tax overpayment. After bankruptcy, the debtors filed a tax return seeking a $6,000 refund. Subsequent to bankruptcy and without obtaining a modification of the automatic stay, the U.S. Treasury offset the 2017 overpayment against the deficiency owing to HUD.
The debtors initiated an adversary proceeding to recover and exempt the 2017 refund that the Treasury had offset. Affirmed in district court, the bankruptcy judge ruled that the 2017 refund was estate property and that the debtors’ right to claim an exemption took precedence over the government’s offset rights. To read ABI’s reports on the bankruptcy and district courts decisions, click here and here.
HUD appealed to the Fourth Circuit.