An important bankruptcy case was decided by the Fourth Circuit last spring that I missed, perhaps due to the pandemic – at least that’s my excuse because both Carl Smith and Nancy Ryan brought it to my attention at the time. It came to my attention again last month thanks to Michelle Drumbl who directs the tax clinic at Washington and Lee and who will serve as interim dean there in the coming academic year. This past semester Michelle was on sabbatical in Northern Ireland with her family but, as with most sabbaticals, she was writing during her time away from school producing at least one article on the cross over topic of bankruptcy and taxes. Fortunately for me, she asked that I take a look at her draft of the article which caused me to finally pay attention to an interesting case that I ignored when Nancy and Carl brought it to my attention. Michelle’s forthcoming article focuses on the case of Copley v. United States, 125 AFTR 2d 2020-XXXX (4th Cir. 2020) involving the issue of the interplay of IRC 6402, BC 362(b)(26), BC 522, BC 541 and BC 553.
In prose the case concerns whether the IRS can offset a pre-petition income tax refund that the taxpayer claimed as exempt in his bankruptcy case against a pre-petition income tax debt. The debtor argues that when the refund became exempt property it received a type of protection from the IRS offset not otherwise available, while the IRS argues the opposite. The Fourth Circuit holds that exempting the refund does not protect it from offset. I found this outcome totally unsurprising; however, the fact that the Fourth Circuit decision reversed the decisions of the two lower court judges in Richmond I happen to know as well as the absence of authority on this point did surprise me. See the bankruptcy court’s opinion here and the district court’s opinion here.
The Copleys filed a chapter 7 bankruptcy in May 29, 2014 listing the IRS as a priority creditor for over $13,000 claiming as exempt their 2013 tax refund of $3,208. Virginia provides debtors a fairly stingy exempt property option, as do many former English colonies along the East Coast. It allows the debtor to protect “money and debts due the householder not exceeding $5,000 in value.” The Copleys used the exemption to elect to protect their 2013 refund and neither the IRS nor anyone else objected. After making their exemption election, the Copleys filed their 2013 tax return on June 6, 2014, and the IRS offset the refund pursuant to IRC 6402 and BC 362(b)(26) which came into existence in the 2005 bankruptcy refund legislation and permits the IRS to exercise its offset rights despite the automatic stay prohibition against offset in BC 362(a)(7). The automatic stay exception limits the IRS to offsetting pre-petition refunds against pre-petition debts of the same type of tax. Here, the debt and the refund both satisfied the conditions of type and time. No one objected to the offset based on a stay violation of BC 362(a)(7) rather the fight turns on the power of the exemption versus the power of the right to offset.
In appealing the case the IRS made two arguments. First, it argued that the 2013 refund never became part of the Copleys’ bankruptcy estate. Second, it argued that their right to exempt the property does not supersede the IRS right to offset.
The property of the estate argument raises the question of whether the Copleys even had the right to exempt the refund since they could only exempt property of the estate. The IRS argued that:
A taxpayer can only have a property interest in a tax refund, not a tax overpayment, and the taxpayer can only have an interest in a refund if the overpayment exceeds preexisting tax liabilities. Because the Copleys’ overpayment did not exceed their preexisting tax liabilities, the government asserts that their interest in the refund was valueless and, therefore, did not become part of the bankruptcy estate. (emphasis in original)
The Fourth Circuit did not buy this argument and that did not surprise me. It pointed to the expansive nature of the concept of property of the estate, citing prior Fourth Circuit law as well as Supreme Court law. The Court did note in footnote 3 that offset under IRC 6402 is discretionary which is inconsistent with the government’s position. Two prior Fourth Circuit cases went to the Supreme Court that dealt with property of the estate. I suspect this circuit may be more sensitive to this issue that almost any other circuit given that history. Here, it cited to one of those prior cases that dealt explicitly with offset, Citizens Bank of Md. v. Strumpf, 516 U.S. 16 (1995) in pointing out that three things had to happen before offset could take place and none of those things had happened at the time of the bankruptcy petition. In the IRS’s defense Strumpf and the other case, Patterson v. Shumate, 540 U.S. 753 (1992) pre-dated the 2005 amendment to IRC 362 excepting certain offsets from the automatic stay; however, that change did not remove the property from the estate under BC 541. Rather than spending much of its time focusing on whether the Copleys’ refund became property of the bankruptcy estate, quickly concluding that it did, the Fourth Circuit moves on to describing the primary issue as one of the preservation of the right of offset despite the fact that the refund became part of the bankruptcy estate.
The IRS relied on the case of IRS v. Luongo, 259 F.3d 323 (5th Cir. 2001) where the debtor did not claim the refund as exempt until after the offset occurred. The facts in Luongo were:
On May 19, 1998, Appellant Luongo filed for relief under Chapter 7 of the Bankruptcy Code. At the time of her filing she owed the IRS $3,800 in unpaid taxes from her 1993 tax year. On August 15, 1998, Appellant filed her 1997 income tax return showing an overpayment of $1,395.94. The bankruptcy court entered an order on September 10, 1998 discharging Appellant’s personal liability for her 1993 income tax deficiency. Subsequently, in November 1998, the IRS executed its claim to setoff and applied all of Appellant’s 1997 tax overpayment to her unpaid 1993 tax liability.
Only after discharge and after offset did the debtors in Luongo seek to reopen their bankruptcy case and claim the refund as exempt.
Luongo involved a number of arguments not present in Copley but one of the argument the IRS won and on which it relied here was that the refund was not part of the estate. The Fourth Circuit in Copley says that it does not dispute that conclusion of the Luongo decision. I cannot reconcile the Copley decision and the reason for the Copley decision with that statement but, in the end, it does not matter whether the refund comes into the estate or not because of the decision of the Fourth Circuit on the second issue.
The second issue pits BC 553 preserving a creditor’s right to offset against BC 522 and the debtor’s right to exempt property. The court acknowledges a conflict between BC 522 which protects exempt property against “any” prepetition debts and IRC 6402 which permits the IRS to offset “any overpayment” against preexisting liabilities. It finds that BC 553 resolves the apparent conflict.
The critical language of BC 553 states “this title does not affect any right of a creditor to offset a mutual debt.” That broad language, which caused me not to think that this case presented much of an issue, persuades the Fourth Circuit that the IRS can still make the offset even through the Copleys exempted the property. It views acceptance of the Copleys’ argument as one which would violate the statutory directive of BC 553. The court notes that BC 553 does not create the right of offset but only preserves an existing right. Since IRC 6402 created a clear existing right, BC 553 steps in to preserve that right.
The court then addressed the Copleys’ arguments and knocked them down. The one that most interested me was the argument that bankruptcy courts had the discretion to decide if BC 553 would apply. The Fourth Circuit found that while bankruptcy courts could strike down a creditor’s attempt to offset, the basis for doing so derived from the questioning of the validity of the right of offset and not from some equitable discretionary ability to do so.
I think the Fourth Circuit got it right on both counts. The refund comes into the estate but the IRS, or any other creditor with a valid right of offset, can exercise that right with the proper permission of the statute or the bankruptcy court. Despite what I think, the lower courts here found the IRS could not offset. This issue does not have much case law even though the bankruptcy code is well into middle age. Perhaps, other debtors in other circuits will make this argument to see where it leads.