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Diving Beneath the Surface of In re Webb

Posted on Jan. 4, 2022

We welcome back Ken Weil to help us parse a technical bankruptcy issue impacting taxes.  Ken has his own practice in Seattle that focuses on representing individuals with tax debt and resolving that debt through administrative action with the IRS or through bankruptcy. He has written a book on his specialty area, Weil, Taxes and Bankruptcy, (CCH IntelliConnect Service Online Only) (3d ed. 2014). He is one of the top experts at the crossroads of personal bankruptcy and taxes. We are fortunate to have him back with us again. Keith

In Webb v. Internal Revenue Service (In re Webb), Bankr. N.D. W.Va. Adv. Proc. No 21-00014 (November 8, 2021), a Chapter 13 debtor brought an adversary proceeding to hold the IRS in contempt for an improper setoff of a tax refund against a tax debt. On the IRS’s Rule 12(b)(6) motion to dismiss, the court held for the IRS.

The court stated that “[a]n order of contempt is a serious reprimand and is appropriate only in the case of a deliberate violation in the face of succinct directions to the contrary.” Id. at p.3. Because the debtor’s Chapter 13 plan did not explicitly prevent tax setoffs, the court found that the high standard necessary to hold the IRS in contempt was not met. In note 2, the court stated that it “need not discuss the legality of the IRS’s actions because the Debtor only alleges the [IRS’s] actions constituted contempt of the confirmation order.”

Because contempt was the only issue before him, Judge Bissett decided the case without diving into the more complicated issues lurking beneath the surface. What makes this case blog-worthy are the issues that would or could have been before the court if the case had been presented differently. In particular, because of the IRS’s implicit election to treat its 2019 tax debt to Ms. Webb as a prepetition debt, there are multiple opportunities to discuss an analytical tool that I call deemed versus defined, which I first learned from Professor Harvey Dale almost 40 years ago.

  1.  Factual background.

         In November 2019, Marie Webb (the Debtor) filed a Chapter 13 petition. In her schedules, she listed taxes owed for 2013 and 2018. In April 2020, the IRS filed its proof of claim, which it amended subsequently. It listed the 2013 tax owed as an unsecured general claim, i.e., nonpriority claim. It listed the 2018 tax owed as an unsecured priority claim. In addition to the taxes scheduled by the Debtor, the IRS’s proof of claim listed the 2019 tax year as an unsecured priority claim and estimated the tax due.

         In her Chapter 13 plan, the Debtor agreed to pay the 2019 tax debt as a priority obligation. Corrective Order Confirming Chapter 13 Plan, Webb Docket No. 45, p.5, ¶ 10 (February 19, 2021) (Corrective Order). The Debtor’s Chapter 13 plan left all property the Debtor acquired postpetition in the bankruptcy estate. Corrective Order p.8, ¶ 10.

         In March 2021, the IRS set off the Debtor’s 2020 tax refund (IRS’s debt) against the 2019 tax obligation (IRS’s claim). In the Bankruptcy Code, setoffs are viewed from the creditor’s perspective. Thus, the IRS’s refund owed is the debt, and the taxpayer’s unpaid tax obligation is the claim. The Tax Code and 11 U.S.C. § 553 use the word “offset.” I use “setoff” when used as a noun or adjective and “set off” when used as a verb. The Debtor objected to the setoff by filing an adversary proceeding seeking to hold the IRS in contempt.

    2.  Applicable law and its application in Webb.

         This paragraph discusses the law that would have been applicable if some of the underlying issues had been raised and argued by the parties.

         a.  I.R.C. §§ 1398-1399.

         Tax Code §§ 1398 and 1399 provide rules for when a debtor’s tax year in the year of filing can be bifurcated. The only time an individual’s tax year can be bifurcated is in an asset, Chapter 7 case. Assuming a calendar year-end, if the tax year of filing is bifurcated, a prepetition tax year runs from January 1 to the day before the petition is filed. A second, postpetition year runs from the day of filing to December 31. See I.R.C. § 1398(d) (rules for taxable years of individual debtors); I.R.C. § 1399 (“Except in any case to which section 1398 applies, no separate taxable entity shall result from the commencement of a case under title 11 ….”); and Hall v. United States, 566 U.S. 506, 516 (2012) (Chapter 13 postpetition taxes are not incurred by the estate; they are a liability of the debtor).

         The Debtor filed for bankruptcy in November 2019. This means the 2019 tax year ended after the bankruptcy filing and was a postpetition tax year. The IRS’s proof of claim treated 2019 as a prepetition tax year.

         b.  11 U.S.C. § 1305.

         This paragraph discusses the things we know and do not know about 11 U.S.C. § 1305, and it looks at Webb through a § 1305 lens.

              i.  What we know about § 1305.

         Under 11 U.S.C. § 1305, a governmental unit can elect to file a proof of claim for taxes that [first] become payable while the case is pending. 11 U.S.C. §§ 1305(a)(1) and 1322(b)(6); and see Joye v. Franchise Tax Board Cal. (In re Joye), 578 F.3d 1070, 1075-1077 (9th Cir. 2009) (payable means first becomes payable); and In re DeVries, Bankr. D. Id. No. 13-41591 (April 28, 2015), 2015-1 USTC ¶ 50,287 (only governmental entity may file § 1305 claim). Internal Revenue Manual guidance is found at IRM (08-07-2018).

         Beyond the proof of claim, no special form is needed for a governmental unit to elect § 1305. The IRM states that IRS personnel should file a proof of claim and add to the proof of claim language stating that the proof of claim is being filed under the authority of § 1305. IRM (08-07-2018). The IRS’s proofs of claim in Webb did not have this language.

         If the governmental unit so elects and the proof of claim is accepted as filed, the governmental unit’s postpetition claim is treated as if it were a prepetition claim. In other words, a postpetition claim is deemed to be a prepetition claim. Beyond this point, the applicable law is murky.

              ii. The confusing world of § 1305.

         The election to use § 1305 raises a number of confusing issues.

                    I. Are § 1305 claims entitled to priority?

         The argument that § 1305 claims do not receive priority is based on 11 U.S.C. § 507(a)(8), which has no provision for priority treatment of a deemed prepetition claim under § 1305. In re Jagours, 236 B.R. 616, 619-620 (Bankr. E.D. Tex. 1999) (postpetition claim treated as filed prepetition but not entitled to priority because such a claim does not fit within the language of § 507(a)(8)(i)). Cases that allow priority rely on § 1305(b), which states that a § 1305 claim shall be allowed or disallowed the same as if such claim had arisen prepetition. In re Jagours, 236 B.R. at 616 n.3. The IRM straddles the fence. Compare IRM (08-07-2018) (benefit of filing § 1305 claim is that “Service will be paid as a priority creditor”), with IRM (08-07-2018) (risk of filing § 1305 claim is that “§ 1305 claims may not be accorded priority status”).

                    II. Is a § 1305 claim dischargeable?

         In dicta, Jagours stated that § 1305 claims are not dischargeable. In re Jagours, 236 B.R. at 620 (“rights of the creditor to collect are not impaired by the Chapter 13 plan”). The IRM appears to disagree. IRM (08-27-08) (“Once provided for in the plan, the tax liability may be dischargeable.”)

                    III. Is postpetition interest paid on § 1305 claims?

         Assuming funds are insufficient to pay interest to unsecured creditors, postpetition interest will not run on a discharged § 1305 claim, regardless of whether the § 1305 claim is paid-in-full. If the § 1305 claim is not discharged or if it is deemed a postpetition claim, postpetition interest will continue to run. See Ward v. Bd. of Equalization of Cal. (In re Artisan Woodworkers), 204 F.3d 888 (9th Cir. 2000) (postpetition interest payable on nondischargeable tax debt fully paid through a Chapter 12 plan).

                    IV. Are penalties paid on § 1305 claims?

         In Webb, what happens to the failure-to-pay penalty (assuming the Debtor filed her 2019 return timely)? If a prepetition claim, during the bankruptcy, the penalty does not accrue. I.R.C. § 6658. If a prepetition claim, the portion of the penalty that accrued prepetition is dischargeable in the bankruptcy, regardless of age. See 11 U.S.C. § 1328(a)(2) (by omission from the listed exceptions, all penalties discharged regardless of age; this rule is one of the last vestiges of the old Chapter 13 superdischarge that disappeared with the 2005 revisions to the Bankruptcy Code). If a postpetition claim, the penalty accrues.  

               iii. Webb and § 1305.

         With its proofs of claim in Webb, the IRS implicitly filed a § 1305 claim and took the position that it was entitled to priority. The Debtor agreed to that treatment. If the plan is completed, the tax would be paid-in-full. At that point, only the payment of interest would turn on the dischargeability issue.

         If postpetition interest and penalties are not paid, this is a sweet deal for the Debtor, as a postpetition tax is paid interest-free over the life of the plan.

         c.  11 U.S.C. §§ 541, 1306, and 1327(b).

         Bankruptcy Code §§ 541 and 1306 tell us what property is included in the bankruptcy estate. Section 541 broadly defines bankruptcy estate property. Section 1306(a)(1) provides that property of the estate includes all property that the Chapter 13 “debtor acquires after the commencement of the case but before the case is closed, dismissed or converted ….” Upon plan confirmation, all property of the estate vests in the debtor. 11 U.S.C. § 1327(b). Section 1327(b) does not override § 1306. In re Shay, 553 B.R. 412, 417-418 (Bankr. W.D. Wash. 2016) (Lynch J.). A priori, it applies to prepetition property that is returned to the debtor upon confirmation.

         The Debtor’s Chapter 13 plan included all property acquired postpetition in her bankruptcy estate, which means it included any potential tax refund in her bankruptcy estate. Whether the refund could even be estate property is also debatable. Because the right to overpayment arose before the IRS made its setoff, it was most likely estate property. Copley v. United States, 959 F.3d 118, 122-123 (4th Cir. 2020). West Virginia is in the Fourth Circuit. Otherwise, under I.R.C. § 6402(a), a “debtor is generally only entitled to a tax refund to the extent that her overpayment exceeds her unpaid tax liability.” IRS v. Luongo (In re Luongo), 259 F.3d 323, 335 (5th Cir. 2001); and United States v. Gould (In re Gould), 401 B.R. 415, 424-425 (B.A.P. 9th Cir. 2009) (citing Luongo with approval), aff’d, Gould v. United States (In re Gould), 603 F.3d 1100 (9th Cir. 2010) (adopting BAP opinion).

         d.  11 U.S.C. §§ 327(a), 362(a)(3), (b)(26), and (c)(1).

         The automatic stay protects the debtor from collection action by creditors while a bankruptcy case is pending and before discharge is entered. In particular, the creditor may not act to obtain possession of estate property. 11 U.S.C. § 362(a)(3). An exception is that a governmental unit may set off postpetition a prepetition debt (a tax refund) against a prepetition claim (a debtor’s unpaid tax debt). 11 U.S.C. § 362(b)(26). Here, the 2020 tax refund is a postpetition debt.

         The Debtor’s plan kept all property in the bankruptcy estate, and § 362(a)(3) stayed collection as to that property. The automatic stay remained in place as long as the property remained bankruptcy estate property. 11 U.S.C. § 362(c)(1); and see also 11 U.S.C. § 362(c)(2) (if property had been returned to debtor, stay would have remained in place until the case was closed, dismissed, or the debtor received a discharge.)

         Judge Bissett stated correctly that the Debtor’s plan failed to address explicitly whether the setoff of a postpetition tax refund was permissible. Consistent with § 1306, the plan did state that all property acquired postpetition would be property of the bankruptcy estate. It also provided that the Debtor could keep the first $1,500 of any tax refund and the remainder should be sent to the Chapter 13 trustee. Corrective Order p.2, ¶ 3.

         Pursuant to 11 U.S.C. § 1327(a), all creditors, including the IRS were bound by the terms of the plan, and the Debtor’s complaint so alleged. Webb v. Internal Revenue Service (In re Webb), Bankr. N.D. W.Va.Adv. Proc. No. 21-00014, Docket No. 1, Complaint ¶ 23 (June 21, 2021).

         e.  Setoffs, mutuality of obligation, and deemed versus defined.

         This paragraph discusses when setoffs are allowed in bankruptcy and the concept of mutuality of obligation. It then applies the analytical tool of deemed versus defined to ask whether mutuality of obligation existed when the IRS made its setoff in Webb. For a thorough analysis of setoffs and taxes, see K. Fogg, “The Role of Offset in the Collection of Federal Taxes,” added to SSRN on February 26, 2021 and forthcoming in the Florida Tax Review.

              i. Setoffs and mutuality of obligation.

         As a general rule, the Bankruptcy Code “does not affect any right of a creditor to offset a mutual debt owing by such creditor to the debtor that arose” prepetition against a claim of the debtor that arose prepetition. One exception is the improvement-in-position test that a bankruptcy trustee can use to claw back into the bankruptcy estate setoffs made in the 90-day prepetition period. 11 U.S.C. § 553(b).11 U.S.C. § 553(a).

         Valid setoffs require a mutual debt, i.e., mutuality of obligation. The debt and claim must be between the same persons. Because a bankruptcy filing creates a new entity, i.e., the postpetition debtor, the mutual debt requirement may be flunked while a bankruptcy case is active. For example, a setoff of a postpetition debt (IRS refund owed to the debtor in bankruptcy) against a prepetition claim owed by the prepetition debtor (IRS’s right to unpaid tax) is not a mutual debt. After a bankruptcy case closes, this issue disappears. There is no longer an existing bankruptcy case to force a division between events arising pre and postpetition.

              ii. Did mutuality of obligation exist in Webb?

         The combination of the IRS’s implicit § 1305 election and its setoff of the 2020 refund against the 2019 claim also puts the deemed versus defined concept in play. If the IRS’s 2019 tax claim is treated as defined, mutuality of obligation exists because the IRS set off a postpetition obligation against a postpetition claim. This must be how the IRS viewed the world. Yet, as long as the Debtor has rights in the overpayment, see n.3, supra, this setoff would violate the automatic stay. 11 U.S.C. §§ 1306 and 362(c)(1). If the 2019 tax refund is treated as deemed, i.e., prepetition treatment under the Debtor’s Chapter 13 plan, mutuality of obligation does not exist. The IRS set off its postpetition debt against its prepetition claim.  

    3.  Conclusion.

         Judge Bissett is a wise man. He found the straight-forward answer to the issue at hand. He wisely and successfully avoided the difficult issues that were lurking beneath the surface. See Webb at n.2 (“the court need not discuss the legality of the IRS’s actions”).

         In lieu of filing an adversary proceeding alleging contempt and depending on the legal analysis one thinks is correct, the Debtor might have sued the IRS for (i) turnover under 11 U.S.C. § 542(b) for failing to pay the tax refund to the bankruptcy estate, (ii) violation of the automatic stay for exercising control over estate property, or (iii) making a setoff without mutuality of obligation.

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