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Rights of the IRS to Set Off a Tax Overpayment Against a Tax Deficiency

Affairs of State Written by:
Deborah M. Perry
Jackson Walker LLP; Dallas

Web posted and Copyright © October 1, 2001, American Bankruptcy Institute.

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


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