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Individual's Claim of Exemption in Bankruptcy Did Not Shield EITC Refund from IRS Offset

(Parker Tax Publishing April 2017)

After noting an apparent conflict in the Bankruptcy Code with respect to whether a tax credit can be shielded from the IRS in bankruptcy, a bankruptcy court held that the IRS could offset an individual's refund resulting from application of the earned income tax credit against the individual's tax liability for a prior year. The court also ruled that it had jurisdiction over the individual's action for a refund because sovereign immunity was waived. In re Benson vs. U.S., 2017 PTC 159 (Bankr. W.D. Va. 2017).


Kerie Benson filed for bankruptcy under Chapter 7 of the Bankruptcy Code in March 2016. The IRS was a creditor with an unsecured claim for approximately $12,730 in unpaid taxes for the 2006 and 2011 tax years. Benson's 2006 tax liability was approximately $10,882. In her bankruptcy filings, Benson claimed her expected tax refund for 2015 as exempt from creditors. Benson filed her 2015 tax return in April 2016 and, after applying the earned income tax credit (EITC), she determined that she had overpaid $6,417 for the 2015 tax year. In May 2016, she amended her bankruptcy filings to claim an exemption for the expected refund. On May 19, 2016, Benson further amended her homestead deed to claim $5,993 of her expected refund as exempt.

When the IRS processed Benson's 2015 tax return, it offset her $6,417 overpayment against her 2006 tax liability of $10,882. The IRS notified her that she owed the difference of approximately $4,465 for 2006. Benson argued that the offset was improper because of her claimed exemption.

Before the bankruptcy court, the IRS made two arguments in support of its right to offset Benson's refund against her 2006 tax liability. First, it said that the court lacked jurisdiction because sovereign immunity had not been waived. Second, the IRS contended that its offset rights trumped Benson's claimed exemption. The bankruptcy court found that sovereign immunity was waived because the provisions directly implicated in this case, 11 U.S.C. Sections 522 and 553, were both specifically covered under the sovereign immunity waiver in 11 U.S.C. Section 106(a). The bankruptcy court also found that the IRS could offset Benson's 2015 EITC refund against her 2006 tax liability.

Exemption vs. Setoff Rights

The court observed an apparent conflict in the Bankruptcy Code between exemption and offset rights. Under 11 U.S.C. Section 553(a), a creditor has the right to set off a debt owed by the creditor to the debtor that arose before the filing of the bankruptcy. But 11 U.S.C. 522(c) says that property claimed as exempt is not liable for debts that arose before the bankruptcy was filed. The court noted that there was no controlling precedent in the Fourth Circuit, the circuit to which the case would be appealable, on this issue.

First, the court reviewed a line of cases where a debtor's exemption right trumped a creditor's offset and cited In re Alexander, 225 B.R. 145, 149 (Bankr. W.D. Ky. 1998) as the best representative of these decisions. Like Benson, the debtor in Alexander wanted to shield an EITC refund from being offset against a prior year tax liability. The Alexander court noted that the 11 U.S.C. Section 553(a) offset rule had previously been construed as permissive and that courts had discretion in applying it. The court also observed that in Kentucky, the EITC was considered a public assistance benefit. As no objection to the offset had been asserted by the IRS, the court found that the debtor's tax refund was exempt under 11 U.S.C. Section 522(a). Addressing the conflict between 11 U.S.C. Sections 553(a) and 522(c), the Alexander court found that the creditor's setoff right was subordinate to the debtor's exemption right because to rule otherwise would render 11 U.S.C. Section 522(c) meaningless. The Alexander court also found that this interpretation was consistent with the policy of the bankruptcy statute to give debtors a fresh start.

Next, the bankruptcy court considered In re Bourne, 262 B.R. 745 (Bankr. E.D. Tenn. 2001), a decision reaching the opposite result in holding that offset rights were not subordinate to a debtor's claimed exemption. In Bourne, the debtor defaulted on a loan which was guaranteed by the Department of Housing and Urban Development (HUD) and claimed an exemption for her tax refund. The IRS, without seeking relief from stay, intercepted the tax refund and applied it to the unpaid HUD liability. The Bourne court found that the federal intercept statute under which the IRS offset the refund made no allowance for state law personal property exemptions and that a state law exemption may not defeat the federal government's setoff rights. The Bourne court then responded to the arguments the Alexander court made in deciding that exemption rights trumped setoff rights. First, the court said that an equally logical interpretation that would give effect to both 11 U.S.C. Sections 522(c) and 553(a) was to hold that a debtor can claim an exemption which is valid as to all creditors except one having a right of offset. Second, the court found several examples of debts not dischargeable in bankruptcy and noted that the policy of a fresh start for the debtor is often subordinated to other societal goals and economic objectives. Finally, the court reviewed the legislative history of 11 U.S.C. Section 522 and found no mention of setoff rights or whether they could be defeated by an exemption. The Bourne court ultimately held that the debtor had no greater exemption rights with respect to her tax refund than she would have had if the bankruptcy case had not been filed.

The bankruptcy court also made note of the decision in In re Buttrill, 549 B.R. 197 (Bankr. E.D. Tenn. 2016), which expanded on Bourne in finding that the debtor's property interest in a tax refund is a contingent interest that can be defeated by a remedy acknowledged and preserved by bankruptcy rules.

Setoff Rights Trump Exemption Rights

In the instant case, the bankruptcy court ultimately reached a similar result as the decisions in Bourne and Buttrill, but took a different approach.

The court began by noting that under 11 U.S.C. Section 506(a), a creditor's claim that is subject to setoff under 11 U.S.C. Section 553 is a secured claim to the extent of the setoff amount. The court noted that to give adequate protection to this secured status, 11 U.S.C. Section 553(a) provides that "this title" does not affect any right of a creditor to offset a debt owing by the creditor to the debtor that arose before the filing of the bankruptcy. The court reasoned that "this title" means the entire U.S. Bankruptcy Code except for the enumerated exceptions, which do not include the debtor's exemption right under 11 U.S.C. Section 522(c). Thus, to give effect to 11 U.S.C. Section 506(a), preservation of a setoff right should, in the court's view, take precedence over the right to claim an exemption.

The court then reviewed the Supreme Court's decision in Taylor v. Freeland & Kronz, 503 U.S. 638 (1992), which held that if a debtor claims an exemption in a tax refund and no one objects, then the exemption claim prevails. In the bankruptcy court's view, the general rule in Taylor was that failing to timely object to the validity of an exemption is fatal to the objection. However, the bankruptcy court reasoned that a debtor cannot "bootstrap himself into" ownership of a property interest by claiming an exemption in something subject to a valid offset, and then claim the exemption invalidated the offset because no one objected. The debtor must, according the bankruptcy court, take affirmative action to challenge or void the offset.

Finally, the court reconciled its own ruling in a previous case, In re Addison, 2016 PTC 39 (Bankr. W.D. Va. 2015). In that case, the district court affirmed on appeal the bankruptcy court's finding of a stay violation under 11 U.S.C. Section 362 where the government set off the debtor's tax refund against a non-income tax liability without first obtaining relief from stay. First, the bankruptcy court noted that Addison did not address the interplay between 11 U.S.C. Sections 522(c) and 553. The bankruptcy court said that Addison was limited to the holding that if a bankruptcy stay is instituted before an offset, the overpaid funds are protected by the stay, and the government is treated like any other creditor. Because the present case involved the setoff of a tax refund against an income tax liability, the bankruptcy court found that 11 U.S.C. Section 362(b)(26) provided an express exception to the stay rule. That exception did not apply in Addison because the setoff in that case was against a non-tax debt. Thus, the holding in Addison that a stay under 11 U.S.C. Section 362(a) would prevent the setoff of a non-income tax liability was given full deference.

For a discussion of the IRS's right to offset a refund against a tax liability, see Parker Tax ¶16,180.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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