Income tax refund offsets have been a hot topic on Procedurally Taxing, especially of late. While there has been interest in offset bypass refunds and injured spouse relief since long before the pandemic, the CARES Act added some new wrinkles. As has been well documented on this blog, Economic Impact Payments generally were not subject to offset, with some limited exceptions such as past due child support. Offset questions came up again in the context of the Recovery Rebate Credit.
As we followed the legislative and administrative changes and implementation, it sparked conversations about how and when the IRS should exercise its discretionary refund offset authority under section 6402. Nina Olson revitalized a proposal that she had made prior to the pandemic, urging the IRS to be more proactive in granting offset relief in cases of economic hardship. Along similar lines, the ABA Section of Taxation recommended that the IRS implement systemic offset bypass relief for three categories of taxpayers during the pandemic.
Meanwhile, the Fourth Circuit has also had occasion to think about section 6402 in the last year, not in the context of COVID or offset bypass refunds, but in the context of bankruptcy. Two recent decisions from the circuit underscore how powerful a collection tool section 6402 remains for the IRS, leaving no ambiguity as to where the circuit stands on a question that has divided lower courts.
Keith blogged about the first decision, Copley v. United States, 959 F.3d 118 (4th Cir. 2020). Anticipating an income tax refund for tax year 2013, the Copleys listed the refund as a homestead exemption on their bankruptcy schedule prior to filing their income tax return. The Copleys had outstanding federal income tax liabilities for tax years 2008, 2009, and 2010; the tax debt for 2008 and 2009 was dischargeable in bankruptcy, while the debt for 2010 was nondischargeable. Despite the Copleys’ exemption claim, the IRS used its discretionary authority under IRC 6402(a) to offset the refund, applying it to tax years 2008 and 2009. Of course, applying it to the dischargeable tax debt was in the best interest of the IRS while also the worst possible economic outcome for the Copleys: if the homestead exemption did not entitle them to keep the refund for their fresh start, presumably they would prefer that it be applied to reduce the nondischargeable tax debt.
The Copleys brought an adversary proceeding in bankruptcy court seeking turnover of their tax refund, asserting that they had properly claimed it as exempt under Virginia’s homestead exemption provision as allowed by BC 522. Ultimately the matter was decided by the Fourth Circuit, which held that the refund became part of the Copleys’ bankruptcy estate, but that BC 553(a) preserves the IRS’s right of offset notwithstanding the Copleys’ exemption rights under BC 522(c). I wrote a forthcoming article about Copley in which I traced the case law split on this issue and discussed the significance of the Fourth Circuit’s holding.
The lower court case law is mixed and at times confusing, in part because it includes cases in which the IRS offset tax refunds to tax debt and also cases in which the Treasury made TOP offsets to nontax debt. The Bankruptcy Code’s automatic stay rule generally prohibits offset against prepetition debts; however, in 2005, Congress enacted BC 362(b)(26), an exception that allows the IRS to offset a prepetition income tax refund against a prepetition income tax liability. As Keith has discussed, this exception does not extend to TOP offsets – the automatic stay limits the government’s right to offset a tax refund against a nontax debt.
Copley is the first circuit court opinion to resolve the tension between BC 522 and 553 while also finding the tax refund was part of the bankruptcy estate. In the conclusion of my article, I queried whether courts might limit the Copley holding to offsets of tax refunds against tax debts, as distinguished from offsets of tax refunds against nontax debts. Last month, while the article was still in the editing stages with the South Carolina Law Review, the Fourth Circuit provided an answer.
In Wood v. U.S. Department of Housing & Urban Development, 993 F. 3d 245 (4th Cir. 2021), the Fourth Circuit followed Copley, holding that the government’s right under IRC 6402 to offset a tax refund against a preexisting nontax debt prevails over the debtors’ right under BC 522(c) to claim an exemption in their tax refund.
The Woods defaulted on a HUD-backed loan, which was subject to the Treasury Offset Program. The Woods filed bankruptcy in March 2018 and a week later filed their 2017 income tax return. Pursuant to IRC 6402(d), the government offset the federal income tax refund against the outstanding debt to HUD. The Woods brought an adversary proceeding in bankruptcy court, asserting that the tax refund was part of their bankruptcy estate, was protected by the automatic stay, and was protected by exemption under BC 522. The government argued that the tax overpayment was not considered a tax refund under IRC 6402, was thus not part of the bankruptcy estate, and therefore was not subject to exemption and not protected by the automatic stay. At the time of the adversary proceeding, the Fourth Circuit had not decided Copley.
Keith blogged about Wood last year when the district court affirmed the bankruptcy court’s finding that the exemption provision of BC 522 disallowed a setoff under BC 553. While acknowledging a split on the issue, the district court found that the tax refund was part of the bankruptcy estate; it then followed other bankruptcy courts within the Fourth Circuit in finding that “a properly-claimed exemption trumps a creditor’s right to offset mutual prepetition debts and liabilities.” However, as Judge Wilkinson noted in Wood, “those courts lacked the guidance of [the Fourth Circuit’s decision in] Copley.” Judge Wilkinson’s Wood decision refers to IRC 6402(a) (offset against tax debts) and 6402(d) (offset against TOP debts) as “sister provision[s].” Importantly, the Wood decision notes that an offset under section 6402(a) is discretionary while an offset under 6402(d) is mandatory, with the result that “the case for a statutory setoff right is even stronger [in Wood] for § 6402(d) than it was in Copley for § 6402(a).”
But as the opinion notes, that “is not the end of the matter” because unlike in Copley, the Wood court still had to had to address the applicability of the automatic stay. The district court in Wood noted that BC 362(b)(26)’s automatic stay exception does not apply to a TOP offset, with the result that the Woods’ tax refund was protected by the automatic stay. The district court rejected the government’s argument for retroactive annulment of the stay. In his blog post, Keith expressed surprise that the DOJ lawyer representing HUD would argue that the United States had the right to seek a retroactive annulment of the automatic stay to allow the offset. Keith noted that other federal agencies would need to go to Congress and have 362(b)(26) expanded if they wanted to use TOP while an individual was in bankruptcy.
The Fourth Circuit in Wood did not find this problematic, however. While acknowledging that 362(b)(26) does not apply to an offset against a HUD liability, and that the government’s actions violated the automatic stay, the court also noted that the government can seek relief from the stay and that “barring exceptional circumstances, the government’s motion for relief from the automatic stay in cases of this kind should ordinarily be granted” (citing Cumberland Glass Mfg. Co. v. De Witt on this point). In remanding Wood to the lower court to consider that question, the Fourth Circuit emphasized the Copley precedent and its finding that “the government’s statutory setoff rights under § 6402 trump the Woods’ right to exempt their overpayment.”
It remains to be seen whether other circuits will follow the Fourth Circuit’s holdings in Copley and Wood as to the primacy of IRC 6402. In the meantime, debtors and bankruptcy attorneys should take note. In my article I outline a few takeaways, each of which highlight the need for careful planning when a bankruptcy debtor has outstanding tax debt. While Keith and Nancy Ryan come to my mind as notable exceptions, it is my observation that tax lawyers are not typically also bankruptcy experts and bankruptcy lawyers are not typically also tax experts. These two Fourth Circuit cases, however, are a reminder that both types of lawyers must be cognizant of the ways in which the statutory worlds of bankruptcy and tax collide.