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Court Disallows IRS Setoff in Farm Bankruptcy, but Can't Order IRS to Issue a Refund

(Parker Tax Publishing May 2020)

In a chapter 12 bankruptcy involving an Indiana farm, a bankruptcy court held that under 11 U.S.C. Sec. 1232(a), the IRS did not have the right to setoff a refund of post-petition taxes to the debtor against a liability for taxes arising from the sale of farm assets. However, the court found that it lacked jurisdiction to order the IRS to issue a refund of the prohibited setoff because the debtor failed to follow the required procedures for requesting a refund under Code Sec. 7422. In re Richards, 2020 PTC 138 (Bankr. S.D. Ind. 2020).


Eric and Katherine Richards are Indiana farmers who filed for bankruptcy under chapter 12 of the Bankruptcy Code in May 2018. Their plan was confirmed in October 2018. The confirmed plan provided the IRS's priority claim for 2016 was $0 and its priority claim for 2017 was $5,681. While the couple's tax liability for 2018 had not yet become due, the plan provided that there would be an additional liquidation of farm assets in 2018, occurring during the pendency of the case, that would qualify for treatment under 11 U.S.C. Sec. 1232.

Section 1232 is a priority stripping provision that was enacted by Congress in 2017 and that had previously been contained in 11 U.S.C. Section 1222(a)(2)(A), a provision added to the Bankruptcy Code by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA). Section 1222(a)(2)(A) dealt with the requirement that a chapter 12 plan must provide for full payment of Section 507 priority claims, but carved out an exception for claims owed to a governmental unit that arose as a result of the sale, transfer, exchange, or other disposition of any farm asset used in the debtor's farming operation. If such a claim otherwise would have been entitled to Section 507 priority, the new Section 1222(a)(2)(A) provided, instead, that it would be treated as a general unsecured claim subject to discharge.

Observation: This was seen as a huge advantage to farmers who sought chapter 12 relief because the provision was aimed at mitigating the tax expense often incurred by farmers who have significant taxable capital gains or depreciation recapture when their low basis farm assets are foreclosed, sold, or otherwise disposed of by their creditors. Formerly, these dispositions created large priority tax claims that barred confirmation of chapter 12 plans. By stripping these claims of their priority status and rendering them unsecured claims for distribution and discharge purposes, the drafters of BAPCPA sought to facilitate farmers' use of chapter 12.

A split among the circuits arose as to whether Section 1222(a)(2)(A) covered taxes from the post-petition sale of farm assets during the pendency of the chapter 12 case. The Supreme Court answered in the negative in Hall v. U.S., 2012 PTC 110 (S. Ct. 2012). In Hall, the court noted that, for Section 1222(a)(2)(A) to apply, the tax first had to be a tax that otherwise would be entitled to Section 507 priority. Of the several priority categories under Section 507, only two addressed taxes. Section 507(a)(8) covered pre-petition taxes and didn't apply. Section 507(a)(2) covered administrative expenses allowed under Section 503(b). Section 503(b)(1)(B)(i) covered administrative taxes, but a prerequisite to that section was the tax had to be "incurred by the estate." Unlike Chapter 7 and Chapter 11 cases, Code Sec. 1399 provided that no separate taxable estate is created upon a chapter 12 filing, and thus, chapter 12 administrative taxes are not "incurred by the estate." Consequently, taxes arising from the disposition of farm assets during the pendency of a chapter 12 case did not enjoy Section 1222(a)(2)(A) treatment. In October 2017, Congress enacted legislation that took out subsection (A) from Section 1222(a)(2) and added new Section 1232. The "priority stripping" attributes of former Section 1222(a)(2)(A) were carried over to Section 1232 and extended to taxes arising from post-petition sales, thus effectively overruling Hall.

The Richards filed their chapter 12 case in May 2018 after the enactment of Section 1232. The IRS did not object to the plan and it was confirmed on October 22, 2018. In March 2019, the Richards filed their 2019 federal tax return which included taxes attributable to the sale of farm assets during 2018. To single out the Section 1232 taxes from other taxes incurred during 2018, the Richards filed both a 2018 pro forma tax return and a Form 1040. The pro forma return indicated that the Richards were entitled to a $6,414 refund for 2018 (the "2018 Refund").

In October 2019, the IRS amended its claim (the "Second Amended Claim") which indicated that the 2018 refund had been applied to the 2016 priority taxes and the Section 1232 related general unsecured claim arising from the 2018 sale of farm assets. The Richards objected to the IRS's claim on two grounds: (1) they asserted that the setoff was prohibited by the express terms of the confirmed plan, and (2) they sought an order from the bankruptcy court directing the IRS to issue the 2018 refund.


The bankruptcy court sustained the Richards' objection to the Second Amended Claim to the extent the 2018 refund was applied to the IRS's claim in a manner other than provided for under the confirmed plan and overruled the Richards as to all other relief requested. The court held that the 2018 refund was a post-petition payment owed to the Richards and was appropriately applied against the Section 1232 taxes arising from the 2018 sale of farm assets. Section 1232 taxes are treated as dischargeable, pre-petition tax under 11 U.S.C. Sec. 1232(a)(1), the court said. Therefore, the court held that the setoff was not among mutual, pre-petition obligations as required under 11 U.S.C. Sec. 553, and was therefore in derogation of the plan. The court noted that the plan contained incongruities by prohibiting setoffs unless specifically authorized by the plan while also allowing the exercise of a valid setoff under Section 553. However, the court found that it did not need to resolve this conflict, because the IRS's setoff was not of the kind permitted under Section 553.

However, the court found that it did not have jurisdiction to order the IRS to issue a refund to the Richards. The court observed that under 11 U.S.C. Sec. 502(b), the government's sovereign immunity is waived with respect to claims against it that are property of the bankruptcy estate. Therefore, for the court to have jurisdiction to direct the turnover of the 2018 refund, it had to be property of the bankruptcy estate. The court found that in the Seventh Circuit, the only property that remains property of the estate post confirmation is the property needed to fund the confirmed plan. The court noted that, in this case, nothing in the plan or confirmation order provided that post-petition tax refunds remained property of the estate, and the Richards made no assertion that the 2018 refund was needed to fund the plan. The court also noted that the chapter 12 trustee also did not seek turnover of the 2018 refund to augment the plan. In the court's view, even assuming that the 2018 refund qualified as property of the estate, it no longer was, as it vested in the Richards upon confirmation.

Under 11 U.S.C. Sec. 505(a)(2)(B), the court stated, a bankruptcy court has the power to determine the right of the estate to a tax refund, but the court cannot determine such right before the earlier of (1) 120 days after the trustee properly requests the refund, or (2) a determination by the governmental unit of such request. The court found that the intended purpose of Section 505(a)(2)(B) is to prevent a refund claim from languishing in the administrative process, thus permitting the bankruptcy court to make a determination of a refund if the taxing authority does not act on a refund claim within 120 days. The court noted that in In re Longo, 259 F.3d. 323 (5th Cir. 2001), the Fifth Circuit rejected the notion that the Section 505(a)(2)(B) grant of jurisdiction is limited to refunds that benefit the estate.

However, the court determined that it did not need to address that issue, because it concluded that even if the refund fell within the limits of Section 505(a)(2)(B), the Richards did not follow the appropriate administrative procedures under Code Sec. 7422 for requesting a refund from the IRS. Thus, the court concluded that it lacked jurisdiction to make any determination with respect to the amount or the turnover of the 2018 refund.

For a discussion of the tax 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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