IS IRS OFFSET OF REFUND VIOLATION OF BANKRUPTCY STAY?

Client files a chapter 7 bankruptcy to discharge $100,000 of income taxes. He files his bankruptcy on March 30, 2014. On schedule B of his bankruptcy petition, he claims his 2013 tax refund of $10,000 as exempt property. On April 15, 2014, he files his 2013 tax returns. Instead of giving the $10,000 tax refund to the debtor or the bankruptcy trustee, the IRS offsets the $10,000 against the $100,000 of income taxes that client seeks to discharge in bankruptcy. The IRS position is that the agency has the legal right to offset a refund against taxes owed for previous years even if there is a bankruptcy. Client position is that the IRS offset is illegal because it violates the automatic stay order of the bankruptcy court which took effect on March 30, 2014. Who is correct?

The bankruptcy automatic stay is a court order that stops all collection efforts of creditors, including the IRS once the bankruptcy petition is filed. There are very limited exceptions to the stay.

In Re Sexton, debtor filed for Chapter 7 relief on February 13, 2013. She scheduled her anticipated 2012 federal tax refund, which she estimated to be $4,200, as an asset of her estate, and claimed it as exempt. She scheduled a liability of $114,617 owed to the U.S. Department of Agriculture Rural Development Service. This debt was a deficiency following the foreclosure sale of the debtor’s property. After the debtor filed for bankruptcy, the Department of the Treasury notified the debtor that it was withholding her 2012 tax refund in order to apply it to the “Non-Tax Federal Debt” she owed to the USDA. The government subsequently explained that the refund was withheld under the Treasury Offset Program, pursuant to 26 U.S.C. § 6402(d), also known as the federal intercept statute.” What a nice name! The debtor’s lawyer reminded the government, as I do now with my client, that the debtor had filed for bankruptcy, and advised that the refund should be sent to the trustee. Treasury did not respond to the lawyer’s letter, and the refund was not sent to the trustee. Instead, it was applied to the prepetition debt. The debtor filed an adversary proceeding against the government, asserting that its actions violated the automatic stay. The government responded that the debtor only possessed a contingent interest in the overpayment until after the Secretary of the Treasury complied with offset directive. The bankruptcy court denied the government’s motions to dismiss, as well as its motion for entry of a nunc pro tunc order retroactively annulling the automatic stay.

The court found that the debtor’s interest in her tax refund vested on December 31, 2012. When she filed her bankruptcy petition, that interest was included in her bankruptcy estate, and properly claimed as exempt. Because that interest was included in the debtor’s bankruptcy estate, it was protected by the automatic stay, including subsection (a)(7) that specifically stays setoff actions. “To constrain the reach of the automatic stay, Congress enacted Section 362(b). Subpart 26 of that section specifically excepts from violating the automatic stay, the setoff under applicable non-bankruptcy law of an income tax refund, by a governmental unit, with respect to a taxable period that ended before the date of the order for relief against an income tax liability,” the court said. “If the debtor’s interest in a tax overpayment did not become property of that debtor’s bankruptcy estate until after the government applied its offset under Section 6402(a) of the Tax Code.”

Congress had no reason to enact Section 362(b)(26) to except from the protections of the automatic stay such an offset. Congress’ enactment of Section 362(b)(26) presupposes that such property interests become part of the state subject to the stay, except for this express carve out. If the Court were to hold for the property interest in question is not subject to the stay, it would render Section 362(b)(26) unnecessary surplusage. The court concluded that the offset violated the automatic stay. But it seems that my client is out of luck on this one.

“Those who wait for the Lord will gain new strength; they will mount up with wings like eagles, they will run and not get tired, they wall walk and not become weary.” – Isaiah 40:31.

Lawrence Bautista Yang is a graduate of Georgetown University Law Center and has been in law practice for thirty years.  He specializes in bankruptcy, business and civil litigation and has handled more than five thousand successful bankruptcy cases in California.  He speaks Mandarin and Fujien and looks forward to discussing your case with you personally.  Please call (626) 284-1142 for an appointment at 1000 S Fremont Ave, Mailstop 58, Bldg A-1 Suite 1125, Alhambra, CA 91803.