IRS setoff of tax overpayment upheld in bankruptcy

Government's right withstands Chapter 7 debtors' attempt to exempt tax overpayment.
By Mark Aquilio, CPA, J.D., LL.M.

The Fourth Circuit, in a case of first impression, vacated a federal district court decision affirming a bankruptcy court ruling, which had ordered the IRS to remit a tax overpayment to Chapter 7 bankruptcy debtors. The appellate court ruled that the tax overpayment was part of the bankruptcy estate; however, the government's right to offset the overpayment against the debtors' preexisting tax liabilities was not affected or superseded by the debtors' right to exempt the overpayment from the bankruptcy estate.

Facts: Matthew and Jolinda Copley filed a petition for Chapter 7 bankruptcy in 2014, identifying the IRS as a priority creditor and preexisting tax liabilities totaling $13,547. Also, they claimed a 2013 federal tax overpayment of $3,208 due to excess withholdings as property exempt from collection pursuant to U.S. Bankruptcy Code (Title 11) Section 522 and Va. Code Section 34-4. The latter provision authorizes a debtor to exempt from a creditor's collection "money and debts due the householder not exceeding $5,000 in value."

In 2014, the Copleys filed their 2013 tax return and claimed a refund for the $3,208 overpayment. Rather than send the Copleys a refund, the IRS set off the overpayment against their preexisting tax liabilities based on its right under Sec. 6402(a). The Copleys sought relief in bankruptcy court, which required the IRS to remit the overpayment to them (In re Copley, 547 B.R. 176 (Bankr. E.D. Va. 2016)). The district court affirmed the bankruptcy court's judgment (Copley, 591 B.R. 263 (E.D. Va. 2018)), and the government appealed to the Fourth Circuit.

Issues: Sec. 6402(a) provides that "[i]n the case of any overpayment, the secretary [IRS] ... may credit [offset] the amount of such overpayment ... against any liability in respect of an internal revenue tax on the part of the person who made the overpayment" (emphasis added).

Bankruptcy Code Section 522(b) permits a debtor to exempt certain property from the bankruptcy estate, including some property exempt under applicable state law.

Bankruptcy Code Section 522(c) generally provides that property exempt from the bankruptcy estate cannot be used to satisfy any of the debtor's prepetition debts.

Bankruptcy Code Section 542(b) provides that any "entity that owes a debt that is property of the estate ... shall pay such debt to ... the trustee, except to the extent that such debt may be offset under section 553 of this title against a claim against the debtor."

Bankruptcy Code Section 553(a) provides, with certain exceptions not relevant here, that "this title does not affect any right of a creditor to offset a mutual debt owing by such creditor to the debtor that arose before the commencement of the case under this title against a claim of such creditor against the debtor that arose before the commencement of the case" (emphasis added). Thus, a creditor's right to offset a mutual prepetition debt with a bankruptcy debtor is not affected by Title 11 (Bankruptcy).

The issue before the court was whether Sec. 6402(a), affording the IRS the right to offset the tax overpayment against the prepetition tax liabilities, takes precedence over the debtors' right to exempt the tax overpayment from the reach of creditors, pursuant to Bankruptcy Code Section 522.

Holding: The court ruled that the IRS could offset the overpayment, as its right of offset provided in Sec. 6402(a) prevails over the debtors' right of exemption under Bankruptcy Code Section 522.

The court held that the tax overpayment was a part of the bankruptcy estate, regardless of the government's possible setoff rights. However, it found that the plain and unambiguous terms and broad scope of Bankruptcy Code Section 553(a) include the property exemption in Bankruptcy Code Section 522(c). Thus, the latter provision cannot subordinate or in any way affect the government's right to offset a mutual prepetition debt and is superseded by the right of offset.

The court noted that Bankruptcy Code Section 553(a) does not create a right of offset; rather, it preserves a creditor's offset right. It reasoned that Sec. 6402(a) is the source of the IRS's right of offset. Focusing on the phrase "any overpayment," the court found that Sec. 6402(a) is unambiguous and leaves no room for any exception for tax overpayments of a taxpayer who later declares bankruptcy. Also, it held that the plain language of Bankruptcy Code Section 553(a) does not allow for such an implicit exception based on the language of Bankruptcy Code Section 522(c).

Accordingly, based on its ruling that the IRS could offset the tax overpayment, the court vacated the district court's decision and remanded the case.

  • Copley, 959 F.3d 118 (4th Cir. 2020)

By Mark Aquilio, CPA, J.D., LL.M., professor of Accounting and Taxation, St. John's University, Queens, N.Y.

Where to find February’s flipbook issue

The Journal of Accountancy is now completely digital. 





Get Clients Ready for Tax Season

This comprehensive report looks at the changes to the child tax credit, earned income tax credit, and child and dependent care credit caused by the expiration of provisions in the American Rescue Plan Act; the ability e-file more returns in the Form 1040 series; automobile mileage deductions; the alternative minimum tax; gift tax exemptions; strategies for accelerating or postponing income and deductions; and retirement and estate planning.