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Limited Ability to Offset Tax Refunds

Posted on Jan. 3, 2020

The case of U.S. Dept. of Housing and Urban Development v. Larry Edward Wood et ux.; No. 5:19-cv-00302 (S.D. W. VA. 2019) shows a limitation on the government’s right to set off a tax claim against a debt owed to another federal agency.  The outcome here did not surprise me (except maybe that HUD was not required to pay something for offsetting a prepetition debt in violation of the automatic stay.)  The law has evolved to allow the IRS to offset an income tax refund against another income tax liability, but there is no exception in the automatic stay allowing the offset of a tax refund to satisfy the liability of another government agency (or even another type of tax.)

Mr. and Mrs. Wood bought a mobile home in 2008. They borrowed almost $40,000 to make the purchase. The Department of Housing and Urban Development (HUD) guaranteed the loan. Unfortunately, the Woods defaulted in 2014 causing HUD to cover the debt and then to come after them to satisfy the outstanding debt which by that point totaled about $23,000. In December of 2015, HUD certified the debt to Treasury so that it could benefit from the Treasury offset program (TOP). This paid off in early 2017 when HUD scooped up over $9,000 of a federal tax refund that would otherwise have gone to the Woods. Perhaps because of the loss of this refund or perhaps because of other causes, or both, the Woods filed a bankruptcy petition on March 21, 2018.

Their 2017 tax refund of over $6,000 was scheduled for payment after they filed their return on March 26, 2018, but instead was sent to HUD to continue paying off the debt on the mobile home. The Woods brought an adversary proceeding in bankruptcy court arguing that the offset of their 2017 was barred by the bankruptcy laws. They made two arguments in support of their position. I will discuss both below. The argument regarding the automatic stay surprises me, as the law clearly bars offset in this situation. The bankruptcy court held for the Woods and in this decision, the district court sustains the decision of the bankruptcy judge.

Outside of bankruptcy, the TOP offset presents no problem for HUD. At issue here is the difference, if any, brought about by the bankruptcy code once the Woods filed their petition.

Exempt Property Argument

Bankruptcy allows debtors to claim certain property of the estate as exempt from creditors. As a threshold matter the court looks at whether the refund is property of the bankruptcy estate. It cites a split in the circuits in situations in which the refund is less than the amount owed to the government and decides to follow the majority rule that in all situations the refund is property of the estate. Just because property comes into the estate, however, does not mean that it is available for creditors and Congress allows debtors to exempt certain property in order to protect that property and provide debtors with some amount of assets moving forward after bankruptcy.

BC 522 sets out the rules for claiming these personal exemptions. BC 522 has its own exemption provisions but also allows states to opt for their own exemption rules which almost all states have done. Some states have very generous exemption rules while others, typically states in the east heavily reliant on common law, provide more miserly exemptions for debtors. In West Virginia the Woods could claim this refund as exempt and they did so. The bankruptcy court determined that the exempt trumps the offset provisions in 553. As such, the debtors could recover the refund taken from them by offset. This does not mean that their liability to HUD is forgiven or forgotten, but only that HUD cannot take this refund while the Woods remain in bankruptcy to satisfy the outstanding debt.

Automatic Stay Argument

The court next looks at the automatic stay and its impact on the taking of the refund. BC 362 sets out the automatic stay in paragraph (a) where there are eight separate provisions providing coverage from creditors once the debtors file their bankruptcy petition. Subparagraph (7) stays offset during the bankruptcy case. This provision came into the law in 1978 with the enactment of the current bankruptcy code. It caused major headaches for the IRS because it had to turn off its computers to avoid violating the stay. Finally, in 2005 the IRS succeeded in convincing Congress to provide some relief from this provision. As with the relief it provided in 1994 with respect to the stay on assessment found in subparagraph (6), that really threw a wrench into the tax system, Congress did not change BC 362(a)(7) but instead added an exception to the list of exceptions found in 362(b). In this case it added subparagraph (b)(26). The fact that there are 26 subparagraphs in the section dealing with exceptions to the automatic stay says Congress has lots of actions it wants to continue despite the stay.

BC 362(b)(26) allows offset despite the prohibition on offset in (a)(7) but the allowance only allows offset in a narrow circumstance. The exception “constrains the reach of the automatic stay by excepting from violating the automatic stay, the setoff under applicable nonbankruptcy law of an income tax refund . . . against an income tax liability.” This exception to the automatic stay does not allow the IRS to offset an income tax refund against an outstanding trust fund recovery penalty or against any other type of tax debt. Furthermore, it does not allow the offset of the income tax refund against any other type of federal debt. Aside from the narrow allowance made plain in the statutory language, prior case law also made clear that the income tax refund could not be offset against other federal debt. I have trouble understanding what the DOJ lawyers representing HUD thought they could argue here. I did not pull the briefs filed to see if they had some terrific argument that does not leap out from a reading of the opinion or of the statute.

HUD also argued that equity should allow it to offset the debt based on a retroactive annulment of the automatic stay. The bankruptcy court took only a few sentences disposing of this argument.

The case demonstrates the limited scope of the exception to the automatic stay regarding offset. While the exception provides a significant benefit to the IRS, it provides no benefit to other federal agencies. If they want to use TOP while an individual’s bankruptcy case exists, someone will need to go back to Congress and get (b)(26) expanded. I don’t expect that to happen anytime soon.

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