Rights of the IRS to Set Off a Tax Overpayment Against a Tax Deficiency
Deborah M. Perry
Jackson Walker LLP; Dallas
Web posted and Copyright ©
October 1, 2001, American Bankruptcy
he case of Matter of Luongo, 259 F.3d 323 (5th Cir. 2001),
addresses the complex issues of bankruptcy court jurisdiction, the abstention doctrine,
dischargeability, rights of setoff and rights to exempt property.
Facts of the Case
On May 19, 1998, Constance Luongo (the debtor) filed for chapter 7
relief. She was indebted to the Internal Revenue Service (IRS) for $3,800 in
unpaid pre-petition taxes for the year 1993 (the deficiency). On Aug. 15,
1998, the debtor overpaid her 1997 income taxes by $1,395.94. She was
discharged from liability for the deficiency pursuant to §727 of the Bankruptcy
Code, and subsequent to the discharge, the IRS exercised its setoff rights and
applied the overpayment to the deficiency. The debtor then moved to reopen the
bankruptcy case and filed amended schedules listing the overpayment as an exempt asset.
The bankruptcy court granted the motion to reopen and allowed the amendment. Luongo,
259 F.3d at 327.
The debtor filed an adversary proceeding seeking to recover the overpayment, asserting
that the setoff by the IRS was improper because "(1) the 1993 tax debt had
been discharged in bankruptcy, and (2) the 1997 tax overpayment had been exempted
from her bankruptcy estate." Id. The IRS contended, as a threshold matter, that
the bankruptcy court did not possess jurisdiction over the matter and argued that it
should abstain from hearing it. Furthermore, it was the IRS's position that §553
of the Bankruptcy Code preserved the IRS's right to setoff under 26 U.S.C.
§6402(a); therefore, the setoff was valid. On summary judgment, the bankruptcy
court ruled in the debtor's favor, holding that the IRS could not setoff the
deficiency by using the overpayment that the court held was exempt. On appeal, the
district court reversed, holding that the IRS properly setoff the overpayment against
the deficiency even though the court found the overpayment to be exempt property.
United States v. Luongo, 255 B.R. 424, 428 (N.D. Tex. 2000),
aff'd., 259 F.3d 323 (5th Cir. 2001). The Fifth Circuit affirmed
the district court's decision, but unlike the district court, held that the overpayment
was not exempt, thereby not reaching the question of whether the IRS could setoff
the deficiency against an exempt asset. Luongo, 259 F.3d at 336.
11 U.S.C. §505(a)(1) of the Bankruptcy Code vests bankruptcy courts
with the authority to determine the tax liability of a debtor, subject to certain
limitations. It provides, in pertinent part, "[e]xcept as provided in paragraph (2)
of this subsection, the court may determine the amount or legality of any tax, any
fine or penalty relating to a tax, or any addition to tax, whether or not previously
assessed, whether or not paid, and whether or not contested before and adjudicated
by a judicial or administrative tribunal of competent jurisdiction." One of the
limitations imposed on bankruptcy courts by 11 U.S.C. §505(a)(2) is that
they may not determine "(B) any right of the estate to a tax refund before the
earlier of (i) 120 days after the trustee properly requests such refund from the
governmental unit from which such refund is claimed, or (ii) a determination by such
governmental unit of such request." The IRS argued that the above language precluded
the bankruptcy court from determining the debtor's tax liability because it supposedly
only contemplated that a trustee could obtain a tax refund on behalf of the bankruptcy
estate. Id. at 328.
The court rejected this argument, noting that the position taken by the IRS was
contrary to the broad jurisdictional grant under §505(a)(1). Citing the
legislative history accompanying §505(a)(1), the court stated that it is clear
that §505 "authorizes the bankruptcy court to rule on the merits of any tax claim
involving an unpaid tax, fine, or penalty relating to a tax, or any addition to
a tax, of the debtor or the estate." "[T]he bankruptcy judge will have authority to
determine which court will determine the merits of the tax claim both as to claims
against the estate and claims against the debtor concerning his personal liability for
non-dischargeable taxes." Id. at 328.
The court then considered the abstention issue raised by the IRS. Section
505(a)(1) allows, but does not mandate, that bankruptcy courts adjudicate a
debtor's tax liability; therefore, a bankruptcy court may abstain from such adjudication.
Generally, courts consider the following factors when determining whether or not to
abstain from adjudicating a question of tax liability: (1) the complexity of the tax
issue, (2) the need to administer the case in an orderly and efficient manner,
(3) the length of time for trial and decision, (4) the assets and liabilities
of the debtor, (5) the prejudice to the taxing authority and (6) the burden on
the bankruptcy court's docket. Id. at 330. In addition to considering these
factors, the court made the observation that, "where bankruptcy issues predominate and
the Code's objectives will potentially be impaired, bankruptcy courts should generally
exercise jurisdiction." Id. Since the issues before it were predominantly governed by
bankruptcy law, the court determined that it should not abstain. The following material
issues were identified by the court as being before it"first, whether [the debtor] could
exempt her tax overpayment under §522; second, whether §522(c) immunizes exempt
property from setoff; and third, whether §§524(a)(2) and 553 of the
Bankruptcy Code permit a creditor to setoff against discharged debt." Id. at 332.
Ultimately, the court only rendered a decision on two of these three issues.
Discharge, Exemption and Setoff
The Fifth Circuit joined the majority of courts that have considered the interplay
between dischargeability and setoff in holding that "a debtor's discharge in bankruptcy
does not bar a creditor from asserting its right to setoff." Id. at 333. Section
553 expressly provides that "this title [the Bankruptcy Code] does not affect any
right of a creditor to offset..." Under §553, the IRS must prove the following
to show that it had a valid right of offset: "(1) a debt owed by the creditor
to the debtor which arose prior to the commencement of the bankruptcy case, (2)
a claim of the creditor against the debtor which arose prior to the commencement of
the bankruptcy case, and (3) the debt and claim must be mutual obligations." Id.
Only the satisfaction of the first element was at issue in this case. The court found
that it had been satisfied because the overpayment arose pre-petition since all of the
events necessary to establish the debtor's tax liability for the 1997 tax year
occurred pre-petition.1 Id.
The court noted that a contrary ruling that the IRS improperly offset the overpayment
against the debtor's discharged deficiency "impermissibly would open the proverbial floodgates
to all manner of deception. Specifically with regard to taxes, allowing dischargeability
to act as a bar would permit a debtor to shelter assets from his creditors by making
substantial overpayments to the IRS during a given tax year. The debtor could withhold
the filing of his tax return until after he had filed for bankruptcy and received a
discharge. Such a result would not comport with the equitable nature of the Bankruptcy
Code." Id. at 334-35.
After resolving the issue of dischargeability, the court then addressed the question
of whether or not the overpayment was exempt. Generally, property that is properly
exempted under §522 is immunized against liability for pre-bankruptcy debts. Id.
at 335. Property may only be exempted if it is property of the estate, and a
debtor's claim to a tax refund is property of the estate. Id. "However, under 26
U.S.C. §6402(a), the debtor is generally only entitled to a tax refund to
the extent that her overpayment exceeds her unpaid tax liability." Id. Section
6402 also grants the IRS discretion to offset an overpayment against a debtor's
unpaid tax liability or to refund the overpayment to the taxpayer. Id. In the
present case, the deficiency exceeded the amount of the overpayment; therefore, the
debtor was not entitled to a refund and the refund did not become property of the
estate. Since the estate did not have an interest in the refund, it could not be
properly exempted by the debtor under §522. The court left open the question of
whether §522(c) immunizes exempt property from setoff.
1 "As of Dec. 31, 1997, all of the events necessary to establish [the debtor's] tax liability for her 1997 tax year
had occurred. The date she actually filed her return is not relevant in determining when the debt arose." Luongo, 259 F.3d at 334. Return to article