United States: Setoff of Debtor´s Tax Overpayment Trumps Bankruptcy Code Exemption

Both the Internal Revenue Code and Bankruptcy Code (titles 26 and 11, respectively, of the U.S. Code) contain provisions regarding setoff, a common law right that permits a creditor to offset a mutual debt owing by the creditor to a debtor. Across the various circuits, there have been many opinions issued in attempts to resolve the conflict of these setoff provisions and the Bankruptcy Code provisions involving exemptions from the bankrupt estate, particularly with regard to tax overpayments.

The U.S. District Court for the District of Massachusetts recently weighed in, holding that a Chapter 7 debtor's federal tax overpayment to the Internal Revenue Service was not part of the debtor's bankruptcy estate and thus could be offset by the IRS against the debtor's prepetition tax liability.

In Beaucage v. United States (In re Beaucage), an individual filed for Chapter 7 bankruptcy relief and listed the Internal Revenue Service as a creditor, as the debtor had unpaid income tax liabilities that spanned several years. At the same time, the debtor sought to recover from the IRS an overpayment which she had identified in her 2004 tax return. The IRS refused to accommodate the debtor and applied that overpayment to the debtor's accrued tax liability.

District Court Judge Richard G. Stearns affirmed the decision of Bankruptcy Judge William C. Hillman permitting the IRS to offset this overpayment under Section 6402 of the Internal Revenue Code. Hillman further ruled (and Stearns affirmed) that the IRS setoff extinguished any right the debtor had to a refund and, as a result, there was no asset that the debtor could exempt under Section 522 of the Bankruptcy Code.

Stearns highlighted the distinction between a tax overpayment (which gives rise to a taxpayer's right to a refund), and a refund (which, under the Internal Revenue Code, need not be made by the IRS until after setoff has occurred).

On Jan. 7, 2005, Patti-Ann Beaucage filed a petition for relief under Chapter 7 of the Bankruptcy Code. She listed the IRS as a creditor holding unsecured nonpriority claims totaling $5,452.77 for the tax years 1998, 1999 and 2000. After initiating the bankruptcy proceeding, Beaucage filed her 2004 tax return and claimed an "overpayment" of $1,497, which she attributed to her eligibility for an earned income credit, a wage subsidy for low income earners.

Pursuant to 11 U.S.C. Section 522(b), Beaucage listed this overpayment as an exempt asset. After the IRS failed to object to Beaucage's exemption claim in a timely fashion, Beaucage made demand on the IRS for payment. The IRS denied this demand and applied the overpayment to Beaucage's accrued tax liability.

An adversary proceeding ensued in the U.S. Bankruptcy Court for the District of Massachusetts, where Hillman ruled that the IRS's setoff was authorized by 26 U.S.C. section 6402(a), a provision of the Internal Revenue Code. Hillman stated that Bankruptcy Code Section 522 permits a debtor to exempt an asset, but only if such asset is property of the debtor's estate. He found that Beaucage never "owned" the tax refund because the IRS' setoff had extinguished any right she had to one; as such, there was no asset for Beaucage to exempt under Section 522 of the Bankruptcy Code.

On Dec. 16, Beaucage brought her appeal to the U.S. District Court for the District of Massachusetts, which reviewed the bankruptcy court proceedings de novo. The court framed the issue to be whether the IRS's setoff of Beaucage's 2004 tax overpayment against her tax liability violated Secion 522(b) of the Bankruptcy Code. The court was careful to distinguish an "overpayment" from a "refund," noting that an overpayment is a payment made by a taxpayer over and above his or her tax liability, while a refund is an obligation of the IRS to pay the taxpayer an overpayment.

This opinion deals with a widely recognized and often problematic interplay of two provisions of the Bankruptcy Code and one provision of the Internal Revenue Code: 11 U.S.C. sections 553 and 522, and 26 U.S.C. Section 6402. Section 553 recognizes a creditor's right to offset a mutual prepetition debt. Section 6402(a) provides that "[i]n the case of any overpayment, the secretary [of the Treasury] . . . may credit the amount of such overpayment, including any interest allowed thereon, against any liability in respect of an internal revenue tax on the part of the person who made the overpayment and shall . . . refund any balance to such person."

While it would seem that these provisions would permit the IRS' setoff, the court had to decide whether the recognition of a right to setoff under Section 553 subordinates the exemption provisions of the Bankruptcy Code to the setoff provisions of the Internal Revenue Code.

Section 522 of the Bankruptcy Code permits a debtor to exempt certain assets from the bankruptcy estate under either federal or state law. Though Beaucage was ineligible for a Massachusetts homestead allowance because she didn't own her home, she did qualify for a federal "wild card" exemption under Section 522(d)(5), which permits a debtor to exempt an asset valued at up to $975, plus up to $9,250 of any unused amount of the homestead exemption set forth in Section 522(d)(1).

Beaucage claimed her tax refund as her "wild card," arguing that this exemption trumps the setoff provisions of the Internal Revenue Code "as evidenced by the fact that Congress divided income tax debts into both nonpriority dischargeable debts and priority nondischargeable debts."

Beaucage argued that Hillman failed to consider the automatic stay, which took effect upon the filing of her petition for bankruptcy relief. She argued that the automatic stay froze her outstanding liabilities as of her petition date, including her accrued nonpriority debt owed to the IRS, and that the bankruptcy court decision essentially permitted the IRS to ignore the constraints of the Bankruptcy Code. Stearns agreed with Hillman and found Beaucage's argument to be based on her misconception that a tax refund was due and owing to her when she listed the overpayment as exempt.

When Beaucage filed her 2004 tax return, she had no vested right to a refund. Any such right was contingent on the decision of the secretary of the Treasury with respect to the exercise of the set-off option of Section 6402(a) of the Tax Code. When, in Beaucage's case, the secretary exercised the option, the contingent right to a refund was extinguished.

Stearns looked to opinions on either side of the issue. In In re Luongo, the 5th U.S. Circuit Court of Appeals found that where prior unpaid tax liability was greater than the amount of a debtor's overpayment, the debtor was not entitled to a refund, and the refund never became property of the estate. As such, the debtor could not exempt the refund under Section 522.

However, in In re Alexander, the Western District of Kentucky found that a creditor's right to setoff under Section 553 had to yield to a debtor's right to exempt assets under Section 522 in order to give effect to Section 522(c). To find otherwise, reasoned the court, would be to violate a canon of construction that two conflicting provisions of a statute should be interpreted as to give meaning to the whole.

Stearns found Luongo to be more persuasive, stating that, like Beaucage, the Alexander court mistakenly assumed a tax overpayment to be an asset of the debtor's estate, "rather than a property right contingent on the secretary's exercise of discretion." When the secretary exercised discretion to apply the Beaucage's overpayment to her accrued tax liability, this contingent right to a refund was terminated.

In spite of the opposing views exemplified by Luongo and Alexander, the Beaucage opinion is in accordance with what seems to be the majority view when courts deal with this intersection of bankruptcy and tax law. This controversy is still alive in many circuits, and it may take a decision of the U.S. Supreme Court to resolve it.

Rudolph J. Di Massa, Jr., a partner at Duane Morris, is a member of the business reorganization and financial restructuring practice group. He concentrates his practice in the areas of commercial litigation and creditors’ rights. He is a member of the American Bankruptcy Institute, the American Bar Association and its business law section, the Commercial Law League of America, the Pennsylvania Bar Association and the business law section of the Philadelphia Bar Association.

This article originally appeared in The Legal Intelligencer and is republished here with permission from law.com.

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