IRS Can't Offset Withheld Taxes Against Bankrupt Farm's Capital Gains Tax Debt

(Parker Tax Publishing May 2020)

In a case of first impression, a bankruptcy court held that, in a Chapter 12 bankruptcy of a family farm, 11 U.S.C. Section 1232(a) precluded the IRS from offsetting withheld taxes, for which the debtor would otherwise be owed a refund, against the debtor's liability for capital gains taxes arising from sales of farm property before the bankruptcy. The court found that the rule in 11 U.S.C. Section 1232(a), which treats a farm's prepetition capital gains tax liability as an unsecured, nonpriority claim, was intended to allow family farmers to reorganize using proceeds from the sales of farm property without incurring large capital gains tax liabilities, and this purpose would be frustrated by allowing the IRS to offset withheld taxes. In re Devries, 2020 PTC 135 (Bankr. N.D. Iowa 2020).

Background

Philip and Angie DeVries are married. Mr. Devries has worked as a farmer for over 20 years. He spent most of that time working with his brother, Mark DeVries. Mrs. Devries maintained employment outside the farm. In 2016, the DeVries brothers began mediation with their major secured creditor. They separated their business interest during that process. As part of this mediation, the Devries were required to sell a significant amount of farmland and farming machinery. These sales took place in 2017, adding $986,612 in capital gains to the Devries' taxable income for the year. As a result of this sale, the Devries thus owed a significant amount of unpaid income taxes. This amount was reduced somewhat by $4,584 in federal income tax withholdings from Mrs. DeVries' non-farm employment.

In order to gain relief from this heavy tax debt, the Devries filed for Chapter 12 bankruptcy. The Devries sought confirmation of a plan of reorganization under which the IRS was required to refund the $4,584 overpayment of 2017 income taxes to the Devries within 60 days of the order of confirmation. The Devries filed a pro forma tax return for 2017 showing what the owed income tax would have been without the farmland and equipment sales. The return showed that, but for those capital gains, the Devries would have been entitled to a refund for the full value of the taxes withheld from Mrs. Devries' earnings.

The IRS objected to the plan. It argued that it had already rightfully offset the withheld taxes against the tax debt, and that the setoff was valid under 11 U.S.C. Sec. 553(a). That section generally preserves a right to setoff mutual prepetition obligations where the creditor's claim arose against the debtor before the bankruptcy. The Devries argued that the refund of their withheld taxes was required under 11 U.S.C. Sec. 1232(a), which provides that a government unit's unsecured claim resulting from the sale of any property used in the debtor's farming operation is treated as an unsecured, nonpriority claim. According to the Devries, under Section 1232(a), income tax debt arising from the sale of farming property cannot be offset against tax collected already; the collected taxes must be returned to the bankruptcy estate.

Analysis

The bankruptcy court agreed with the Devries and held that under Section 1232(a), their plan was permitted to require a refund of their withheld taxes. The court noted that the issue of whether Sections 553(a) and 1232(a) were in conflict and, if so, which one prevailed, was one of first impression.

Applying the rule of statutory construction that where two statutes conflict, the specific governs over the general, and the court reasoned that while Section 553(a) is a statute of general applicability, Section 1232(a) deals with specific scenarios, and thus Section 1232(a) would apply if the two statutes were in conflict. The court went on to find that, even though Section 1232(a) does not refer to a creditor's setoff right, the two sections were in conflict, considering the purpose of Section 1232(a).

The court reviewed the legislative history of Section 1232(a) and found that Congress's intent in enacting the provision was to limit the impact of the substantial capital gains taxes that tend to follow the sale of farm land or equipment and put that capital in the hands of the farmers rather than the taxing authorities. The court reasoned that allowing taxing entities to setoff withheld taxes against these capital gains taxes runs directly counter to these objectives. Thus, the court concluded that the meaning of Section 1232(a) contradicted the general provision in Section 553(a) allowing creditors to maintain their setoff rights in bankruptcy, and therefore, the specific provision in Section 1232(a) controlled. The court concluded that under Section 1232(a), family farmers in a Chapter 12 bankruptcy who have capital gains tax debt may require taxing entities to issue a refund of withheld income taxes to the bankruptcy estate.

For a discussion of the treatment of income, deductions, and credits of a bankruptcy estate, see Parker Tax ¶16,150.

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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