by A debtor’s right to an exemption for a tax refund overrides the IRS’s right to set-off of that refund to pay tax liabilities. United States of Amer. v. Copley, No. 16-207 (E.D. Va. Sept. 10, 2018).
In their chapter 7 bankruptcy, Matthew and Jolinda Copley listed tax liabilities for the years 2008, 2009, and 2010, as priority claims held by the IRS. They also sought to exempt their 2013 tax refund of $3,208.00. But the IRS withheld the refund as set-off against a portion of the tax debts. The bankruptcy court ordered the IRS to turn over the refund to the debtors.
On appeal, the IRS raised four arguments: 1) that sovereign immunity barred the bankruptcy court from exercising jurisdiction to order turnover, 2) that the refund did not become part of the bankruptcy estate until after the IRS had taken its set-off, 3) because the refund did not enter the estate, the IRS had no obligation to object to the exemption, and 4) the right to set-off under section 553 supersedes the debtor’s right to the exemption under section 522.
The district court began with section 106(a)(1) which abrogates the government’s sovereign immunity with respect to certain specified bankruptcy claims including those under sections 522 and 553. The district court agreed that the bankruptcy court properly exercised its jurisdiction over the case. The Copleys’ claim directly implicated the tension between their right to take an exemption under section 522 and the government’s right to set-off under section 553. The court rejected the government’s narrow reading of section 106(a) to abrogate sovereign immunity only to the extent that the underlying Code section permits independent claims, as in the case of section 522(f) (lien avoidance) and, to a limited and inapplicable extent, the right to set-off under section 553. The court found this argument contrary to the essential purposes of bankruptcy in general and section 106(a) in particular, including consolidating causes of action under one roof, and providing debtors with a fresh start. The court’s conclusion found support in section 106(a)(2)’s broad language extending abrogation of immunity to “any claim” arising out of the specified bankruptcy sections.
The district court next dispatched the IRS’s argument that the refund never became part of the bankruptcy estate. The court disagreed with the finding in In re Luongo 259 F.3d 323 (5th Cir. 2001), that a debtor’s interest in a tax refund is merely a contingent claim which is eliminated when the IRS exercises its right to set-off. Rather, the court found that because the IRS failed to assert its set-off rights under 42 U.S.C section 6402 before the refund vested in the Copleys on December 31, 2014, the refund became part of the bankruptcy estate.
Turning to the issue of whether the Copleys could prevent the IRS’s otherwise permissible set-off by claiming their tax refund as an exemption, the court found that they could. In so holding, the court noted that while a party’s set-off rights in existence prior to bankruptcy are not altered by reason of the bankruptcy, those rights are not unlimited.
On their faces, the language of section 522(c), which provides that “property exempted under this section is not liable during or after the case for any debt,” and 553(a) which provides that “this title does not affect any right of a creditor to offset a mutual debt,” grant mutually exclusive rights. Thus, the court was required to look beyond the plain text of the provisions for guidance on their interpretation.
The district court was persuaded in part by the historically non-mandatory nature of section 553. So long as the bankruptcy court adheres to correct factual and legal conclusions, its decision to allow or not allow set-off is a matter of discretion and “compelling circumstances” may justify denial of set-off. In contrast, a debtor’s right to an exemption is unqualified and applies to “any debt.”
In the event of conflict between Code provisions, the court resolved the conflict in such a way as to give both provisions relevance. Courts coming down on opposite sides of the exemption-versus-offset debate have done so on the basis that allowing one nullifies the other, with the disagreement being which of the two rights to privilege. Here, the court found that granting an exemption would not necessarily nullify a creditor’s right to set-off as exemptions are typically limited in amount and a creditor could still take a set-off using any amount of the asset in excess of the exemption—although, in this case, the exemption would engulf the entire set-off.
Also weighing in favor of allowing the exemption is the general principle that exemptions are intended to further one of the fundamental goals of bankruptcy: the debtor’s fresh start.
The court affirmed the bankruptcy court’s order that the government release the refund to the Copleys.