The IRS’ Right to Setoff Under the Bankruptcy Code

By Bruce M. Bird, J. Harrison McCraw, and Michael D. Raper

In Brief

Expanded IRS Collection Powers

Debtors in bankruptcy court often have unpaid federal income taxes. To collect, the IRS must pursue its claim as a creditor of the bankruptcy estate. One option is for the IRS to offset the taxpayer’s prefiling debts against overpayments. When the provisions of the Internal Revenue Code and the Bankruptcy Code conflict, specific resolution through the courts becomes necessary. One such decision, Luongo, should significantly expand the IRS’ right to setoff under the Bankruptcy Code. Nevertheless, questions remain about the position other appellate courts have taken on the issue.

The provisions of the Internal Revenue Code and the Bankruptcy Code can sometimes conflict, leading to conflict between the debtor, the creditors, and the trustee of the bankruptcy estate. IRC section 6402(a) provides that the IRS is entitled to offset a taxpayer’s overpayment against an unpaid tax liability. When a taxpayer has filed a petition in bankruptcy, Bankruptcy Code (BC) section 553, under certain circumstances, allows the IRS the right to offset a taxpayer’s prefiling debt against certain tax overpayments to which the taxpayer would otherwise be entitled. Nevertheless, BC section 522 also contains language prohibiting a creditor from offsetting any debt that has already been discharged in bankruptcy. Recently, in Constance Luongo [00-10475, 7/18/2001 (5th Cir.)], the U.S. Court of Appeals for the Fifth Circuit analyzed the IRS’ right to setoff in the context of a debtor’s bankruptcy proceeding, and came to a decision with significant consequences.

Luongo

In May 1998, Constance Luongo filed for relief under Chapter 7 of the Bankruptcy Code. At the time of filing, Luongo owed the IRS unpaid taxes arising out of her 1993 tax year. Her Chapter 7 case was classified as a “no asset case,” and as a result the IRS did not file a proof of claim with the bankruptcy court.

In August 1998, the taxpayer filed her 1997 individual income tax return, which showed an overpayment. Because the taxpayer’s 1997 tax year ended on December 31, 1997, her income tax overpayment arose prepetition. In September 1998 the bankruptcy court discharged, among other debts, the taxpayer’s personal liability for unpaid taxes arising from 1993. In November 1998, the IRS offset all of the taxpayer’s 1997 income tax overpayment against her unpaid 1993 income tax liabilities.

In December 1998, Luongo moved to reopen her bankruptcy case and filed amended schedules listing, for the first time, her 1997 income tax overpayment as an exempt asset. The IRS did not file any objection to the reopening of her case or to her amended schedule of exempt assets.

In January 1999, the taxpayer filed a motion for summary judgment in bankruptcy court, seeking an order requiring the IRS to turn over her 1997 income tax overpayment. She asserted that the IRS had acted improperly, because her 1993 tax debt had been discharged in bankruptcy and her 1997 tax overpayment had been exempted from her bankruptcy estate.

In response, the IRS argued that the bankruptcy court lacked jurisdiction or that it should abstain from hearing the matter. The IRS further asserted that BC section 553 preserved the IRS’ right to setoff under IRC section 6402(a).

The bankruptcy court in Luongo cited with approval the decision In re Alexander [225 B.R. 145 (Bankr. W.D. Ky. 1998)]. In a matter of first impression, the Bankruptcy Court for the Western District of Kentucky held that the IRS was not entitled to offset a debtor’s tax obligation against a tax refund that qualified under state law as exempt property. Under state law, the tax refund at issue, a claimed earned-income credit, constituted a public assistance benefit exempt from levy or execution. Accordingly, the bankruptcy court in Luongo granted the taxpayer’s motion for summary judgment.

The IRS appealed the bankruptcy court’s decision, the district court reversed it [In re: Constance Luongo, U.S. Dist. Ct., N.D. Tex. (4:99-CV-1033-E)], and, in turn, the taxpayer appealed the district court’s decision to the Court of Appeals for the Fifth Circuit.

The Fifth Circuit’s Decision

The Court of Appeals for the Fifth Circuit first examined the IRS’ contention that the bankruptcy court lacked jurisdiction to consider the taxpayer’s motion for summary judgment. BC section 505 generally authorizes bankruptcy courts to determine the amount or legality of any tax liability of the estate or the debtor. However, the IRS contended that, under BC section 505(b), it is only the bankruptcy trustee, acting on behalf of the estate—rather than the taxpayer/debtor acting on their own behalf—that has the right to file a motion in bankruptcy court to obtain the tax refund from the IRS.

After analyzing the language of BC section 505 and its legislative history, the court concluded that, absent certain express statutory limitations, bankruptcy courts have universally recognized their jurisdiction to consider tax issues brought by the debtor, limited only by their discretion.

The IRS also contended that, even if the bankruptcy court had jurisdiction, it should have abstained from deciding the matter. The appellate court held that in cases where bankruptcy issues predominate and the Bankruptcy Code’s objectives might be impaired, bankruptcy courts should generally exercise jurisdiction. Conversely, absent any bankruptcy issues or implications concerning the objectives of the Bankruptcy Code, it is usually appropriate for the bankruptcy court to decline or relinquish jurisdiction. The court held that the resolution of the issues in controversy required the bankruptcy court to interpret conflicting sections of the Bankruptcy Code and to determine the proper scope of the parties’ rights to dischargeability, exemption, and setoff. For this and other reasons, the Court of Appeals for the Fifth Circuit held that the bankruptcy court’s decision not to abstain was clearly proper.

The court next examined the taxpayer’s contention that the discharge of her 1993 tax liability under BC section 524(a)(2) barred the IRS from executing its claim to setoff. This section provides that a discharge “operates as an injunction against the continuation of an action, the employment of process, or an act to collect, recover, or offset any such debt as a personal liability of the debtor.”

The appellate court then noted that an apparent inconsistency exists between the prohibition of offsets under BC section 524 (a)(2) and the recognition of setoff rights under BC section 553(a). This section generally provides that a creditor has the right to offset a mutual debt that arose before the commencement of the bankruptcy case against a prepetition claim against the debtor. The appellate court, in agreeing with the vast majority of courts considering the relationship between BC sections 553 and 524(a), held that a debtor’s discharge in bankruptcy does not bar a creditor from asserting its right to setoff.

In order to establish a valid right to setoff under BC section 553, the IRS must prove the following:

The tax refund for the debtor’s 1997 tax year—the “debt owed by the creditor to the debtor”—accrued as of December 31, 1997, prior to the taxpayer’s filing in bankruptcy court, thus representing a prepetition debt. The IRS satisfied the second requirement, because the claim arose in 1993. The third requirement, that both the debt and claim be mutual obligations, required the debts involved to be between the same parties standing in the same capacity. As a result, the appellate court held that the IRS had satisfied all three requirements under BC section 553 to establish a valid right of setoff.

In the original proceedings in bankruptcy court, after the IRS executed its setoff rights, Luongo made a motion to reopen her bankruptcy case and to file amended schedules treating her 1997 tax overpayment as exempt property. The IRS did not object, and the motion was granted.

In the appeal to the Court of Appeals for the Fifth Circuit, Luongo also contended that, even if the IRS had the right of setoff, it could not exercise it, because the tax overpayment constituted exempt property. The appellate court noted that the commencement of a bankruptcy case creates a bankruptcy estate. Under BC section 522, a debtor is permitted to exempt certain property from the bankruptcy estate, which is removed from the estate for the benefit of the debtor. Property cannot be exempted by the debtor, however, unless it is first a part of the bankruptcy estate.

While a bankrupt debtor’s claim to a tax refund is a part of a bankruptcy estate, under IRC section 6402(a), the debtor is generally only entitled to a tax refund to the extent that the overpayment exceeds the unpaid tax liability. Luongo’s 1997 tax overpayment of $1,396 did not exceed the bankruptcy estate’s prior unpaid tax liability of $3,800. As a result, the appellate court held that the debtor was not entitled to a refund and the tax refund did not become property of the estate. Absent a property interest in the refund by the estate, the refund could not properly be exempted by the debtor under BC section 522.

Dissenting opinion. Although the holding in Luongo was not unanimous, the dissenting opinion by Judge Garza would also have dismissed Luongo’s action, albeit for a different reason. The dissent would have dismissed the case on the ground that the bankruptcy court’s jurisdiction extends only to claims for refunds that benefit the estate.

Other Courts

The result in Luongo is consistent with a number of bankruptcy court decisions. In Conti [50 B.R. 142 (Bankr. E.D. Va. 1985)], the Bankruptcy Court for the Eastern District of Virginia found that a creditor’s prepetition right to setoff is unaffected by a debtor’s discharge. In reaching this conclusion, the court compared a creditor’s postdischarge right to setoff to the automatic stay. Specifically, the automatic stay does not destroy the right to setoff itself. While courts have allowed a creditor to seek relief from an automatic stay in order to exercise setoff rights prior to discharge, according to Conti “nothing in the Code or in the case law would indicate that discharge would bar a creditor from exercising a right to setoff which existed at the time of filing the petition.”

The holding in Conti has been adopted by numerous courts. In In re Posey [156 B.R. 910 (W.D. N.Y., 1993)], the Bankruptcy Court for the Western District of New York held that it was proper for the bankruptcy judge to allow setoff against discharged income tax liability.

In re American Payroll Network, Inc. [U.S. Bankr. Ct., N.D. N.Y., 95-10658 (1998)] is another New York bankruptcy court decision involving the right to setoff. In it, the court dealt with a debtor corporation that operated an employee leasing service company. In February 1995 the debtor filed a petition under Chapter 11 (later converted to Chapter 7) of the Bankruptcy Code. Prior to filing, the IRS assessed failure to deposit (FTD) penalties on unpaid payroll and federal income tax payments and withholdings. The FTD penalties related to the taxable quarters ending December 1992 through December 1993. The IRS later abated some of the FTD penalties; the last abatement occurred in May 1994. From February 1994 until November 1994 the corporation made substantial payments of the FTD penalties.

After filing for bankruptcy, the debtor entered into a closing agreement with the IRS whereby the IRS and debtor agreed to a further abatement of the penalties. Taking into account all of the abatements made, the debtor’s payments exceeded the FTD penalties by $163,500. The IRS then applied the $163,500 as a setoff against non-payroll taxes owed by the debtor during the prepetition period. In response, the bankruptcy trustee filed a proceeding to compel the IRS to turn over to the estate the total payments that the debtor made on the FTD penalties within a year of filing for bankruptcy.

In making the setoff determination, the American Payroll court examined other decisions of the Court of Appeals for the Second Circuit: “[T]he rule allowing setoffs, both before and after bankruptcy, is not one that the courts are free to ignore when they think that application would be ‘unjust’. It is a rule that has been embodied in every bankruptcy act the nation has had, and creditors have long acted in reliance upon it.” The Second Circuit had indicated its reluctance to disturb the policy allowing setoff rights, unless compelling circumstances required it, such as when allowing a creditor’s right to setoff would be inconsistent with the Bankruptcy Code’s provisions and purposes as a whole.

As a result, the American Payroll court held that an overpayment which resulted from a bankrupt taxpayer’s payment of penalties that were later abated could be offset against the debtor’s other tax liabilities. Although the abatement was made after the debtor had filed its bankruptcy petition, the overpayment was treated as having arisen prepetition because it resulted from, and related to, payments the debtor made before bankruptcy.

Significance of Luongo

While the result in Luongo is consistent with other bankruptcy court decisions, it should be noted that the reasoning used by the Fifth Circuit Court of Appeals has effectively broken new ground. The appellate court in Luongo ruled that when the debtor’s prepetition unpaid tax liability exceeds the amount of the debtor’s overpayment, no “refund” exists. Stated alternatively, whether an overpayment constitutes a refund is entirely within the IRS’ discretion. A bankruptcy estate does not have a property interest in an overpayment. Accordingly, the debtor cannot exempt (under BC section 522) a so-called property interest of the estate that does not in fact exist.

Major caveat. The Circuit Courts are split with regard to the IRS’ setoff rights. Although Luongo and a number of related decisions have supported the IRS’ right to setoff, the majority of decisions outside the Fifth and Second Circuit have reached the opposite conclusion. Under current law, a majority of jurisdictions outside the Second Circuit allow the bankruptcy trustee (and in some cases the debtor) to treat a prepetition tax overpayment against the debtor’s prior year’s tax liability as exempt property not subject to setoff by the IRS. As a result, in determining whether the majority or minority view applies to IRS’ setoff rights, bankrupt taxpayers should consult with their tax and legal advisors