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.

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