9 December 2005

IRS Allowed to Offset Debtors´ Tax Overpayment Against Unpaid Debt

Duane Morris LLP


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Setoff, a traditional common law right, provides a creditor with the right to offset a mutual debt owing by the creditor to a debtor, provided the debts are in fact mutual and arise prepetition.
United States Litigation, Mediation & Arbitration
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Setoff, a traditional common law right, provides a creditor with the right to offset a mutual debt owing by the creditor to a debtor, provided the debts are in fact mutual and arise prepetition. While many regard the right to setoff as practical and intuitive, it is often difficult to apply, especially in situations where bankruptcy law and tax law meet.

The U.S. Bankruptcy Court for the Southern District of Alabama recently stepped into this controversy and held that a prepetition federal tax overpayment made by husband and wife debtors to the Internal Revenue Service was not part of the debtors' bankruptcy estate until issued by the IRS as a refund. Before the IRS was required to remit any refund, the court permitted the IRS to offset the debtors' prepetition tax overpayment against the debtors' unpaid dischargeable tax debt.

In In re Pigott, a husband and wife filed for Chapter 7 bankruptcy relief and listed the IRS as a creditor, as the debtors owed unsecured income tax debts for several years. The debtors also sought to exempt a potential tax refund from property of their estate. The IRS objected to the exemption, claiming a right to offset any tax overpayment made by the debtors against the unpaid dischargeable tax debt of the debtors.

Bankruptcy Judge Margaret A. Mahoney sustained the government's objection, holding that Section 6402(c) of the Internal Revenue Code precluded the debtors' tax overpayment from being part of the debtors' bankruptcy estate until the overpayment was released to the debtors as a refund. Key to the court's rationale was the distinction between a tax overpayment, which gives rise to a taxpayer's right to a refund, and the refund itself, which under the Internal Revenue Code need not be made by the IRS until after offsets have occurred.

Facts and Background

On Jan. 20, 2005, Adam and Katherine Pigott filed a petition for bankruptcy relief under Chapter 7. The Pigotts identified the IRS as a creditor owed a total of $10,236 in unsecured income tax debts for the years 1996, 1998, 1999, 2000 and 2003. On Schedule C of their bankruptcy petition, the Pigotts claimed an exemption in "Potential 2004 Federal and State Tax Refunds" of $5,125.

At the time the Pigotts filed their bankruptcy case, they had not yet filed their 2004 federal tax return. On April 15, the Pigotts filed a request for an extension of their 2004 federal tax return. As of Aug. 5, the date the court issued its opinion, the court did not know whether the tax return had yet been filed, nor did the Pigotts know the exact amount of their refund, if any. Nevertheless, the Pigotts claimed $5,152 as an exempt asset.

The Pigotts and the IRS initially disagreed about whether all of the tax debts for 1996, 1998, 1999 and 2000 were dischargeable due to the Pigotts' bankruptcy filing. However, they eventually reached agreement that the 1996 and 1998 tax debts were dischargeable, while the 1999 and 2000 tax debts were not. On May 12, the IRS filed an objection to the debtors' claimed exemption.

The Court's Analysis

The court identified the issue in this case to be whether the IRS was entitled to offset any tax overpayment made by the Pigotts against their dischargeable tax debt before remitting a refund to the Pigotts. The court viewed this issue in terms of the intersection 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 is the Bankruptcy Code's setoff provision, which recognizes a debtor's right to setoff where there are reciprocal prepetition debts between debtor and creditor, and a right to setoff exists under non-bankruptcy law. The court found that while Section 553 does not create a federal right of setoff, it does preserve setoff rights that are otherwise present under nonbankruptcy law.

In this case, the IRS claimed a right under the Internal Revenue Code to offset any 2004 tax overpayment against the Pigotts' unpaid tax debts - the dischargeable ones first. This nonbankruptcy setoff statute (26 U.S.C. Section 6402) is implicated when a debtor files a bankruptcy petition and has not yet received a tax refund owing for the year preceding the filing.

Section 6402(a) states, "[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 the balance to such person."

Mahoney went on to recognize a distinction in case law between an "overpayment," defined as any payment made by the taxpayer over and above the tax liability, and a "refund," defined as an obligation of the IRS to pay the taxpayer an overpayment. She relied on reported cases from other jurisdictions for the proposition that since a taxpayer has no right to the refund of an overpayment until the IRS exercises its discretionary powers under Section 6402(a), the overpayment does not automatically create a debt due the taxpayer.

Quoting an earlier 3rd U.S. Circuit Court of Appeals case, Estate of Bender v. Comm'r of Internal Revenue Serv., the court reasoned that because overpayments do not become taxpayer assets until the IRS credits any overpayment to unpaid taxes, it is not "reasonable for a taxpayer to assume that he will receive an income tax refund from the IRS when he has a net income tax liability in his overall account, particularly when the published policy of the IRS states that offsets are applied as a matter of course."

Reconciling Sections 553 and 522

Even though the court had little trouble reconciling Section 553 of the Bankruptcy Code with Section 6402 of the Internal Revenue Code, it recognized a conflict of these provisions with Bankruptcy Code Section 522(c), which generally provides that with some exceptions not relevant to the Pigotts' case, property exempted under Section 522 is not liable for a debtor's dischargeable debts.

Mahoney began her analysis with reference to cases allowing the IRS to offset a tax overpayment against nondischargeable taxes only, thereby dictating that Section 522 trumps Section 553. These cases identify three factors leading to the conclusion that Section 522 should govern.

First, by allowing a setoff only against non-exempt property, a court could give effect to both Section 522(c) and Section 553(a). Conversely, by allowing setoff against exempt property, a court would nullify the effect of Section 522(c). Second, giving priority to Section 522(c) would further a principal policy of the Bankruptcy Code - to provide the debtor with a "fresh start." Third, the legislative history of Section 522(c) contains the rejection of a draft that would specifically have allowed the IRS to perform the setoff of an otherwise dischargeable debt, indicating that Congress did not intend for this to be permissible.

Unfortunately for the Pigotts, the court's analysis did not end here. Mahoney cited another line of reported cases quoting the plain language of Section 553: "[the Bankruptcy Code] does not affect any right of a creditor to offset a mutual debt." Using this plain language as their premise, the courts in these cases reasoned that Section 522 could be read to permit a debtor to exempt any part of a tax refund not subject to setoff under Section 553. From there, Mahoney also relied on Section 542, which provides that "an entity that owes debt that is property of the estate . . . shall pay such debt to . . . the trustee, except to the extent that such debt may be offset under Section 553 of this title against a claim against the debtor."

She then recognized a new argument successfully raised in a recent line of cases: that a tax refund is not even property of the estate that can be exempted until after the IRS effects any discretionary setoff. This most recent line of cases provides that a debtor's claim to a tax refund is property of the estate, but that 26 U.S.C. Section 6402(a) gives the IRS discretion to offset the debtor's overpayment against a debtor's tax liability before the IRS issues the refund.

Based on her analysis of this line of cases, Mahoney concluded that 26 U.S.C. Section 6402(a) precluded the Pigotts' 2004 tax overpayment from becoming property of the bankruptcy estate until the IRS released the overpayment to them as a refund. The court sustained the IRS' objection, holding that to the extent the United States could exercise a right of setoff pursuant to Section 553 of the Bankruptcy Code and Section 6402 of the Internal Revenue Code, the Pigotts had no legal right to a refund. Their $5,000 tax overpayment would never become property of the estate, because the IRS could first offset it against the $10,000 in dischargeable and nondischargeable tax debt owed by the Pigotts.


Though the right to setoff may appear at first blush to be a basic concept, its higher applications and intersection with tax law often prove very complex. While there might still be opposing views on whether Section 522 trumps Section 553, the Pigott court's decision resolves this conflict in favor of the IRS.

Rudolph J. Di Massa, Jr., a partner at Duane Morris, 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.

Matthew E. Hoffman is a first-year associate at Duane Morris in the Business Reorganization and Financial Restructuring Practice Group. He is a 2005 graduate of the Columbia University School of Law, where he was awarded the national Clinical Legal Education Association Outstanding Student Award, and a cum laude graduate of Brandeis University.

This article is for general information and does not include full legal analysis of the matters presented. It should not be construed or relied upon as legal advice or legal opinion on any specific facts or circumstances. The description of the results of any specific case or transaction contained herein does not mean or suggest that similar results can or could be obtained in any other matter. Each legal matter should be considered to be unique and subject to varying results. The invitation to contact the authors or attorneys in our firm is not a solicitation to provide professional services and should not be construed as a statement as to any availability to perform legal services in any jurisdiction in which such attorney is not permitted to practice.

Duane Morris LLP, among the 100 largest law firms in the United States, is a full-service firm of more than 600 lawyers. In addition to legal services, Duane Morris has independent affiliates employing approximately 100 professionals engaged in other disciplines. With offices in major markets, and as part of an international network of independent law firms, Duane Morris represents clients across the nation and around the world.

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