In United States v. White, 365 B.R. 457 (Bankr. M.D.
Pa. 2007), the U.S. Bankruptcy Court for the Middle District of
Pennsylvania addressed the issue of whether the Internal Revenue
Service (“IRS”) may setoff the entire pre-petition debt against
pre-petition claims that have been declared exempt, or whether the
IRS is only allowed to setoff up to the amount of the priority
claim. The court held that the IRS may setoff the entire debt and
is not limited to the amount of the priority claim.
The proper treatment of the IRS’ setoff right in bankruptcy is
unclear because of a possible conflict between sections 522(c) and
section 553 of the Bankruptcy Code. Outside of bankruptcy, the IRS
may normally offset tax overpayments (tax refunds) against a
debtor’s outstanding tax liability. This right is typically
protected in bankruptcy by the operation of section 553, which
provides that Title 11 “does not affect any right of a creditor to
offset a mutual debt” that arose before the commencement of the
case against a claim that also arose before the commencement of the
case. However, in an effort to ensure that a debtor in a bankruptcy
proceeding has the ability make a fresh start, section 522 provides
that certain assets may be declared exempt, protecting them from
the reach of creditors. In order to protect these exempt assets
from creditors, section 522(c) provides that exempt assets may not
be “liable” during or after the bankruptcy proceedings for any debt
that arose before the case, with some limited exceptions. One of
these exceptions “specifically subjects these exemptions to
pre-petition, priority claims,” White, 365 B.R. at 459,
which is why priority debt is not barred from setoff by section
522.
The source of the conflict is that it is unclear how these two
statutes work together when there is a pre-existing right to setoff
against assets the debtor has declared exempt. If the IRS would
have a valid right to offset the debt outside bankruptcy, but the
debtor has declared the overpayment exempt, section 522(c) dictates
that the IRS could not take more than the amount of priority debt.
However, section 553 dictates that the bankruptcy code cannot alter
the IRS’ right to setoff. Whether the right of setoff of exempted
assets is limited to the amount of the priority debt or whether it
is allowed up to the full amount of overpayment is dependant on
whether the court gives preference to section 553 or to section
522.
>
View Full PDF
Robert Griswold, J.D. Candidate 2010
No. 12, Vol. 1 (2009)